The sale of a software business may involve the sale of the shares in the company (a ‘share sale’) or the sale of the business assets, including the software (an ‘asset sale’). Which of these routes is chosen is often determined by tax considerations.
In broad terms, a share sale will usually be more tax efficient for the sellers. On a share sale, the business owners and any employee shareholders can expect to be taxed to capital gains tax on their proceeds. They will typically qualify for entrepreneurs’ relief which reduces the rate of capital gains tax to 10% on £10m of proceeds. A share sale is therefore often the preferred exit route as it gives rise to a low tax cost on realisation the value built up.
From the buyer’s perspective, on a share sale the buyer acquires the shares at the price paid for them and they become an investment held at that cost in the balance sheet. No tax relief is available on the cost of purchasing the shares until such time as they are disposed of, when the acquisition cost is deducted from proceeds of a sale.
If the sale is an asset sale, any profit received by the company on the sale of its assets is likely to be taxed to corporation tax. In particular when software is sold at a profit, the company receives a ‘credit’ for corporation tax purposes this credit is included in the corporation tax computation in the accounting period of sale. Once the assets have been sold, if the shareholders want to realise the proceeds of the asset sale they must either be paid a dividend (taxed to income tax), or liquidate the company (taxed to capital gains tax, subject to anti-avoidance rules). Either way there will be further tax at shareholder level in addition to the corporation tax already paid. The overall tax cost of an asset sale is therefore likely to be higher than for a share sale.
For the buyer, an asset sale can be more tax efficient. Acquired software can be amortised in the accounts of the buyer so that tax relief is given for the cost of the asset either upfront or during the ownership period. In addition, in buying the assets the buyer does not take on the tax history of the company and the risk of any historic tax liabilities up to the date of the acquisition (see further below).
Other tax dynamics
Whilst the above sets out a common position, in reality the tax dynamics are often more complex. The seller may be able to hive down the assets into new subsidiary and sell that to the buyer without tax charges arising meaning no tax in the seller company and the delivery of a ‘clean company’ to the buyer. In other circumstances, the buyer may want to buy the original shares rather than assets to ensure that it preserves any accrued tax losses in the original company. Typically, considerations will include three tax dynamics – the tax cost of realisation by the seller, the tax history and tax attributes of the targeted company, and the commercial tax requirements of the buyer. These together, together with the relative bargaining power of the parties will determine the sale structure.
Dealing with tax risks on a share sale
The sale and purchase agreement (‘SPA’) which deals with the sale of the shares will contain specific provisions in respect of tax. These include ‘tax warranties’ given by the sellers which will include, as a minimum, warranties that the company has paid its taxes on time, and that there are no historic or ongoing disputes with the tax authorities. In addition to tax compliance warranties, the buyer will usually want to include more extensive tax warranties which are aimed at providing information to the buyer to support its tax due diligence process (see below) and to prepare for a smooth transition to the business to the new owners. For example, these might include warranties that there are no hidden tax costs (for example if an asset has a tax base cost lower than its value in the accounts), warranties as to retention of tax records, warranties that that all transactions and current agreements are at arms’ length and warranties that no tax planning strategies have been implemented. It is possible to negotiate the extent of the warranties where they are onerous or excessive taking into account the size and nature of the company.
Tax warranties typically endure for 7 years – significantly longer than for standard business and ownership warranties. This reflects the period that HMRC can open enquiries or investigations into the tax returns of the company. The buyer is therefore protected for tax claims that arise from any HMRC investigations up to and including into the tax return for the accounting period which spans completion. If a seller is found to have been in breach of a tax warranty, the seller must pay the buyer for any resulting diminution in the value of the shares (which may or may not equal the tax liability in question).
In addition to tax warranties, it is market practice in the UK for sellers of a company to give a ‘tax covenant’. This is also known as a tax indemnity. Contained in a separate schedule to the SPA or sometimes in a separate document known as a ‘tax deed’, the tax covenant is a promise by the seller to pay to the buyer the amount of any tax liability of the company arising from or related to any period before the sale. The tax covenant also lasts for 7 years, but provides for recovery on a pound for pound basis of the tax liability. The buyer does not have to show loss in the value of the shares and so claim under the tax covenant is usually preferred to one under the tax warranties.
The tax covenant has some unusual features. It covers both actual tax liabilities for periods before completion, but also deemed tax liabilities, such as the loss of any tax reliefs which were included as assets in the accounts of the company (the argument is that the buyer has ‘paid’ for these reliefs). It also provides for a claim where there would have been an actual tax liability but for the use of an accounts relief, or but for the use of a post-sale relief. In certain circumstances the tax covenant extends to tax liabilities that arise after the sale, such as ‘secondary tax’ liabilities (where the company is secondarily liable for the tax of the sellers or seller group), and PAYE taxes that arise as a result of the grant of share options or other share incentives to employees before the sale.
Finally the tax covenant will often list specific tax indemnities – these are specific tax issues which have been identified in the buyer’s tax due diligence review. They are listed individually both so the parties are on notice and so they can be excluded from any financial limitations that apply to any claim under the general terms of the SPA. A buyer would always expect to recover any specific tax liabilities from the seller irrespective of any exclusions or limitations in the SPA.
Tax due diligence during the sale process
The buyer will usually instruct accountants to carry out tax due diligence in respect of the tax affairs of any company it seeks to buy. The seller will be expected to answer detailed questions on its tax history and the buyer will want to review the historic tax returns. As well as this general review, in relation to software companies, a buyer may want to review any tax relief claims made for research and development expenditure to ensure claims were properly made. Other areas often relevant to companies developing IP include PAYE issues arising from long term use of contractors, and issues arising from the complex tax regime applying to share incentives provided to employees as sweat capital. To the extent that any areas of tax concern can be identified and quantified in due diligence the buyer will usually prefer a price chip or retention of funds to deal with any tax risk, rather than to reply on a post-sale claim under the tax covenant.
Tax issues on an asset sale
Tax issues on an asset sale are typically more straightforward. The seller is retaining the company and its tax history and so any liability stays with the company. No tax covenant is given but a buyer may nonetheless seek warranties that the tax has been paid in relation to all asset transferred (for example stamp duty land tax on business premises), that no special tax arrangements exist with HMRC which may be relevant to the assets purchased and that PAYE records are in order in respect of transferring employees. Tax warranties on an asset sale rarely give rise to difficulties in practice.