Watch out for long warranty periods in deals!

The issue

Nearly all business sales will include warranties. A warranty broadly means that a seller states that something is or will be the case and then a buyer can claim a claw-back on sale consideration to the extent that the warranty proves to be untrue.

There are various tax reasons for restructuring an earn-out deal as a deferred consideration deal with a warranty. This is because earn-out deals can limit the amount of Entrepreneurs’ Relief available to the seller.

 

Example

Fred has agreed heads of terms whereby he will sell his trading company for £2M plus £1 for every £1 by which average profits of the next three years exceed £150,000.

For tax purposes he would be treated as receiving £2M and a ‘chose in action’ (a ‘right’ to receive a future payment) which would need to be valued and taxed on sale. This ‘chose in action’ would then be treated as being disposed of when the earn-out proceeds are known (for those proceeds). The tax issue here is that any gain on disposal of the ‘chose in action’ would not usually qualify for Entrepreneurs’ Relief because the conditions (5% shareholding etc) would not be met for a year up to the date of disposal.

Following advice, the deal is restructured so that the consideration is expressed as £3M but with a warranty being made that average profits will be £1,150,000 for the three years.  If the warranty condition is not met, then it is agreed that the share consideration shall be reduced £ for £ by up to a maximum of £1 million. This effectively gives Fred the certainty that he will enjoy Entrepreneurs’ Relief in respect of all his proceeds (including the earnout) – although he will have to pay this tax upfront.

You may well ask what happens if the average profits are less than £1,150,000? The answer is that the warranty will kick in and consideration will be reduced on a £ for £ basis. In reality this is likely to mean that the purchaser will simply withhold portions of the consideration. Fortunately section 49 TCGA 1992 allows the seller to get a tax refund to account for any excessive tax payments which become apparent after the warranty claim.

 

Section 49 limitations

Although section 49 is generally helpful one should not forget that a tax refund is only possible if a claim is made within 4 years of the tax year in which the transaction takes place.  This means that any tax planning should not rely on section 49 where warranty claims can be made beyond 4 years. For example if the profit period in the above example was 5 years then section 49 would be out of time and any warranty payments that are required would get no tax relief. This means that where possible it makes sense to limit any warranty claims to 46 months (say) after the end of the tax year in which the disposal took place.

 

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