Sellers who negotiate an earn-out as part of a share sale need to be careful that the payments don’t get reclassified as employment income. If that happens, the tax bill can jump significantly, since income tax rates are often much higher than capital gains tax rates.
An earn-out is a payment tied to the future performance of the business after the sale. For example, a seller might receive 2% of profits above £500,000 for each of the two accounting periods following the sale of their shares. It’s a commercial tool that bridges the gap when buyers and sellers can’t agree on a price, often because the company lacks a consistent profit track record or there’s uncertainty over a major contract renewal.
The difference between income tax and capital gains tax rates can be as much as 27% where Business Asset Disposal Relief is available. That gap is why sellers push hard for capital gains treatment on as much of the consideration as possible. HM Revenue & Customs, for its part, is focused on making sure any relevant amounts are subject to income tax instead.
An income tax charge on a share sale can arise through the ‘transactions in securities’ anti-avoidance legislation, the employment-related securities legislation, or simply because the payment counts as general earnings under employment tax rules.
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The question of whether consideration for shares should be taxed as earnings was tested in Grays Timber Products Limited v HMRC ([2010] UKSC 4). The ruling supports the view that when an employee receives more than the market value for their shares, the excess is income, not capital gains.
Earn-outs attract particular attention from HMRC when the former shareholder stays involved in the business after the sale. The agency has set out its interpretation in its manuals (ERSM110940), and the paperwork needs to reflect the right structure from the start.
It must be clear throughout negotiations and in the legal documents that the earn-out forms part of the consideration for the shares being sold. The earn-out also has to relate to the capital value of the shares, not the seller’s ongoing involvement in the business.
Several indicators support this position. If the seller continues to be employed, they should receive a market-rate remuneration package for their services. Other shareholders who aren’t employed post-sale should receive the earn-out on the same basis as those who stay. The earn-out shouldn’t contain performance targets specific to the seller, and it shouldn’t be conditional on continued employment beyond what’s reasonable for a smooth transition.
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There’s a real risk of reclassification when contracted bonuses are forgone in lieu of the earn-out. In the absence of that, it comes down to the overall picture and how much risk exists that all or part of the payment could be treated as earnings.
The company making the payment after the sale — now under the purchaser’s control — must make a reasonable judgement about whether any of the earn-out should be subject to PAYE. That’s a point worth settling during negotiation with professional advice, rather than discovering the issue when the payment lands. Tax is just one factor in a commercial transaction, but getting advisors involved early helps ensure the commercial drivers are met while managing the tax risk for everyone involved.
Mark Baxter is a tax partner at Mercer & Hole.