rhb Chartered Accountants, Tax, Business Services, Tauranga

Tax implications can differ depending on how you exit your business....

Do you sell the shares in the company that owns the business, or the business itself?

Most small to medium businesses are owned by a company.  To exit a business owned in a company, there are two main options:

• The shareholders sell their shares in the company; or
• The company sells the business.

Generally, a prospective purchaser will prefer to acquire the business from the company, rather than purchase the shares in the company. 

The risks associated to acquiring shares in a company

If a purchaser was to acquire the shares in a company that owns the business the purchaser acquires all liabilities, and contingent liabilities, of the company.  The liabilities could have arisen from the current business owned by the company, or previous businesses that the company may have operated.

Therefore, it is generally not recommended that a purchaser acquire the shares in a company to gain ownership, but sometimes for commercial reasons this approach is adopted.  If the purchaser does acquire the shares in a company the sale and purchase agreement should provide certain warranties and indemnities to the purchaser from the existing shareholders and directors for past activities of the company. 

However, the effectiveness of the warranties and indemnities for the new owner can be outweighed by the costs and time that the purchaser would have to incur to pursue the former shareholders and directors under those warranties or indemnities.

The tax implications of selling shares in a company

Any capital gain resulting from the sale of the shares in the company will generally not be subject to income tax in the hands of the shareholder. This is on the basis that the shareholders of the company who are selling their shares did not acquire the shares with a dominant intention or purpose of selling the shares for a profit in the future, or are not in the business of dealing in shares. 

Furthermore, the shareholders receive the funds from the sale directly in their hands.  However, if the business is being sold by the company, consideration needs to be given to how the shareholders access those funds from the company.

With the above in mind, it will generally be simpler from a tax perspective for shareholders to sell their shares in a company in order to exit a business.

However, as discussed earlier, a purchaser will generally prefer to acquire the business from the company, rather than purchase the shares in the company.

The tax implications for a company when selling a business

When a company sells a business, tax implications may arise for the company in the year of sale.  This may include additional taxable income resulting from any profit made on the sale of trading stock, depreciation recovered from the sale of assets and any income that may be triggered under the financial accruals regime.

Generally, any capital gains resulting from the sale of the business (i.e. goodwill) will not trigger taxable income in the company.

The issue then arises as to how the shareholders get their money out of the company in a tax efficient manner.

The tax implications for shareholders receiving funds after the company has sold the business

When the company has sold the business there will normally be cash in the bank.  How company pays those funds to the shareholders determines the tax consequences (if any) that arise.

Where the shareholders have advanced funds to the company, the company can simply use the proceeds from the sale of the business to repay these advances.  The repayment of an advance to a shareholder will not trigger taxable income in the hands of the shareholder.  This is a straightforward option for getting funds out to the shareholders “tax free”.

If there are no shareholder advances or there is still an excess of funds in the company that the shareholders want to access (i.e. capital gains) the tax implications become more complex.  The following is a very high level and brief overview of some of the tax complexities.

The complexities will differ depending on whether the company continues to operate or is placed into liquidation.

The company is to continue

If there are commercial reasons for the company to continue, rather than be liquidated, any distribution by the company to the shareholders will generally be taxable income in the hands of the shareholder.  This is on the proviso that the company is not a Qualifying Company (“QC”) or a Look Through Company (“LTC”) for tax purposes.

If the company is a QC there are separate tax rules that determine whether a distribution is a taxable distribution or a capital (i.e. non taxable) distribution.  The new LTC regime allows for distributions from a company to be treated as exempt income in the hands of the shareholders.

If the Company is not a QC or LTC there may be other options for the company to distribute the excess funds from the sale of the business to the shareholders tax free, however such options are highly dependent on the individual circumstances of the company and need to be considered on a case by case basis.

The Company is placed into liquidation

Generally, the return of share capital and the distribution of capital gains by a company during a liquidation will not be taxable in the hands of the shareholders.  Any distribution of retained profits by the company to the shareholders will still be taxable in the hands of the shareholders, although the availability of tax credits (i.e. imputation credits) that the company can attach to the distributions may relieve or reduce the final tax burden on the shareholders.

However, there can be fishhooks in regards to the distribution of capital gains by the company, even if that distribution was made in the course of liquidating the company.  The fishhook relates to a situation where the capital gain has arisen as a result of a transaction with a purchaser who was associated to the company at the time the transaction occurred.  If the company and purchaser were associated the distribution may be subject to income tax in the hands of the shareholders when distributed by the company.  This depends on whether the capital gain arose before liquidation, or during the course of liquidation.  If the capital gain arises during the course of liquidation, there may be an opportunity to treat the distribution as tax free in the hands of the shareholder.  Whether this is the case depends on the individual circumstances of the parties, and needs to be considered on a case by case basis.

As you will note from the above it is very important that consideration is given to all of the different options of exiting a business, and the varying tax implications of each option, as you don’t want to find yourself in a situation where you are subject to income tax on the sale of a business, or the proceeds from the sale, that should have otherwise been a tax free capital gain.  Unfortunately, we have seen a number of instances where shareholders have been subject to an income tax liability due to the exit strategy adopted, which could have been avoided. 

Robbie Neilson is a Director of RHB Chartered Accountants Limited and acknowledges Bevan Spalding’s (Senior Tax Manager) assistance in writing this article.

Published in Bay Business Times, April 2011