You are here: home

The cost of success

06/07/2016 by David Gibbens, Director, Poole Waterfield

As we all know, one of the costs of success in business can be a hefty tax bill, but sometimes this can arise in unexpected ways.

Building up big reserves of cash in a business often gives the owner managers a real sense of comfort and, let’s face it, they must have got something right! But there can be an unwelcome downside to a situation where, in the eyes of HMRC, the company has more cash than it realistically needs.

There are two tax reliefs that can be affected by what is termed as “excess cash”: these are Entrepreneurs’ Relief and Business Property Relief. These are usually referred to by their initials and ER is a relief that reduces Capital Gain Tax to 10% on the sale of a qualifying business rather than the normal 20% that applies to higher rate tax payers.

BPR is a relief that applies to Inheritance Tax and it has the effect of keeping qualifying business assets free of tax on the death of the owner.

The below scenarios explain what can happen to ER and BPR when excess cash is an issue. 

*Scenario one:

Phil and Rachel owned and operated a highly successful IT company for many years. In the early years of the business they invested their profits in marketing and product development but more recently they tended to let cash balances grow.

The balance sheet excluding goodwill had a net value of £3.5million and of this £2million was cash. This has broadly been the position for several years. To operate the business normally a bank balance of no more than £200,000 was needed.

Following an approach by a competitor, they agreed to sell their shares for £5million assuming that their tax on the sale would be no more than £500,000.

Phil and Rachel didn’t receive any tax advice prior to the sale and they eventually paid tax based on their belief that their shares qualified for ER. A few months following the filing of their tax returns Phil and Rachel each receive a letter from HMRC asking for more information about the company and the sale.  

HMRC argue that £1.8million of the £2million cash held in the two years leading up to the sale was excess and not needed for the business. They accepted that the asset base of the company, including goodwill, was the £5million paid in the share sale. As £1.8million excess cash represented 36% of that asset base, HMRC seeks to disapply ER on the sale using the argument that a substantial part of the business was not trading. Generally speaking, 20% is a guide that HMRC apply to criteria such as profits, turnover, management time and asset base when considering whether ER applies.

If successful, HMRC would double Phil and Rachel’s tax bill to £1m. ER would be disallowed on all of the gains arising from the share sale and not just the excess cash.

What should they have done?

Phil and Rachel should have been advised by an accountant experienced in the tax implications of share sales. They would have explained the excess cash position and discussed ways that it could be managed, for instance by turning some of the cash into business assets or by withdrawing some of the cash altogether, possibly by dividends or by means of pension contributions etc. If there was still a concern, advance clearance could have been sought from HMRC before the sale was agreed.
Ideally, Phil and Rachel should have been advised well in advance of any sale as it is generally much easier to deal with uses such as excess cash in a planned way, rather than as a matter of urgency.

*Scenario two:

Imagine that Phil and Rachel didn’t sell their shares but continued in business for several years more. Phil passes away unexpectedly and leaves Rachel as the sole shareholder in the company. Rachel is now in her mid-seventies and although active in the business she is conscious that a succession plan is needed. Her daughters Anna and Philippa are interested in joining the company and Rachel plans to leave her shares to them. Rachel has managed her affairs so that her home and investments are in line with the IHT nil rate band. She expects to be able to leave the business and her other assets to her daughters free of tax as she believes that her shares qualify for BPR.

The balance sheet and goodwill value remains as it was in example 1. On this occasion, Rachel seeks advice while she is still young enough to take action if needed. She is told that while the company is a trading entity and that her shares should qualify for BPR, unfortunately, the excess cash of £1.8million would be treated as an “excepted asset” and be excluded from relief. In other words, as things currently stand Rachel’s taxable estate on death might be £1.8million, rather than being free from tax as she had hoped. The tax cost could be £720,000!  Luckily for Rachel, she had time to plan ways to reduce the excess cash.
The above are just a couple of examples of tax traps for the unwary, there are many more – even if you don’t have a bulging bank balance! 

*\r\n \r\n \r\n \r\n \r\n \r\n\r\n \t Enter the full text\r\n\t\t","inTOC":false,"regions":[{"label":"Top Article","type":"ml","tocTitle":false}]}]">The above is for interest only and should not be regarded as advice or guidance. If you have any issues in respect of matters related to this article you should obtain relevant professional advice. Contact Us

Category: David Gibbens Blog Author: David Gibbens, Director, Poole Waterfield

Our Services
  • Audit and Assurance
  • Accounts Preparation
  • Management Accounts
  • Book-Keeping
  • Business Start-ups
  • Tax for business
  • Tax for individuals
  • Tax planning
  • VAT
  • Wealth protection
  • Payroll
  • Growth, profit & cash improvement strategies
  • Business restructuring & incorporations
  • Business sales, acquisitions, mergers & business valuations
  • Raising finance