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UK Mid-Market M&A: Top 10 tax issues for US buyers

Ten UK tax issues that US buyers should be aware of when undertaking a UK acquisition.

We have seen an upward trend in UK M&A deals since Q4 of 2020, particularly those deals involving buyers in the USA. In fact, the first six weeks of 2021 set new records with over £25bn of new UK M&A deals. This increased confidence on both sides of the Atlantic, driven by a combination of pent-up demand, potential changes to UK Capital Gains Tax rates and perceived value in UK assets, has led to very favourable deal conditions.

In this article we summarise ten UK tax areas that a buyer from the USA should be aware of when undertaking a UK acquisition.

1. Structuring

UK vendors that are UK resident individuals will likely have a strong preference to dispose of stock (i.e. shares) rather than undertake a trade and asset deal. This is driven primarily by taxation – a sale of stock can potentially benefit from a more favourable (10%) rate of Capital Gains Tax under ‘UK Business Asset Disposal relief’ (which used to be known as Entrepreneur’s Relief). US buyers are used to acquiring trade and assets in domestic deals and so an international stock deal can add additional complexity and increase the need for more detailed UK tax due diligence.

In terms of capital structure, US buyers should be aware that capital contributions are not a recognised concept in the UK and are potentially taxable in the hands of the UK recipient company (as a taxable gift). If equity is pushed down the acquisition structure, it is commonplace for UK entities to issue at least one share in return for the capital contribution as this should remove the risk of a UK taxable event.

Any debt introduced as part of the transaction will need additional review as the UK has a number of rules that can restrict the availability of tax deductions for interest expense. The application of these rules can be influenced by the purpose of the loans and the wider group structure (e.g., if there are any hybrid entities or entities where US tax elections have been made). Any loans from the US parent will also require Treaty clearance to pay interest gross, which must be obtained before any payments are made.

2. Loans to shareholders or related companies

Owner-managed UK target companies often make loans to their shareholders, directors, employees, or other related companies. Common issues with such loans include:

  • Poor/no formal documentation
  • Incorrect treatment for UK tax purposes
  • Company tax charges on loans to shareholders (‘section 455’) where loan balances have been cleared pre year-end but then recycled
  • Unpaid employment benefits where loans are interest free
  • Dividends reclassified as loans where a company does not have sufficient distributable reserves.

Balances owed between connected companies can often be waived on a tax neutral basis ahead of a sale. However, this treatment requires the debt to arise from a ‘loan relationship’ under UK tax rules, which will not be the case for all intragroup balances. Careful documentation is required to support tax neutral treatment and may require additional documentation and review in the UK (and possibly overseas).

3. Intellectual Property

The UK has an attractive IP regime with many incentives available e.g., R&D, patent box, amortisation, etc. However, to benefit from these incentives, it is important the control functions relating to the IP are exercised from the UK. We have found that many groups have not appropriately considered or defined the ownership of their group IP and there could be a disparity between the jurisdiction where IP is owned from a legal perspective vs. from a tax (economic) perspective. This could be the case if for example the CTO or other senior team members are based outside of the UK and can give rise to material overseas tax exposures.

4. R&D tax credits

Innovative UK companies often make use of the UK’s R&D tax credit system, which can be highly beneficial. However, we have seen instances where R&D claims have been incorrectly made and the business has had to repay the tax credits to HMRC. Examples of issues identified include:

  • Aggressive approaches to historic claims e.g., including ineligible costs.
  • Incorrectly assessing the company’s size for R&D purposes e.g., due to impact of certain non-controlling shareholders.
  • Claims made under the wrong R&D scheme because grant funding or other subsidies have been received (meaning the company should have claimed under the less favourable large company R&D scheme).

5. Transfer Pricing

Mid-market M&A deals may have historically relied upon an exemption from UK transfer pricing rules that applies to certain small and medium sized enterprises. However, the UK tax authorities have an increased focus on TP policies and new rules introduced from April 2019 (the ‘Profit Fragmentation’ rules) effectively import the transfer pricing rules to groups and individuals of all sizes. Key areas to consider include:

  • Does the target have formal TP policies and are these appropriately documented for both legal (intercompany agreements) and transfer pricing purposes?
  • Is the allocation of profit aligned to the economic activity that produces those profits? In particular, it is important that value creating activities are not characterised as routine or low cost plus functions
  • How have the TP policies been implemented operationally? For example, has the correct cost or sales base been utilised when calculating recharges?
  • How will any debt introduced as part of the transaction be priced?
  • Will any post deal integration steps or other changes to the business model require adjustments to the TP policies? This can also be an opportunity to review and improve the TP policies.

6. Tax residence and overseas permanent establishments

UK groups should be able to demonstrate that management and control of UK entities is exercised from the UK to ensure that the target company(s) are treated as UK tax resident. We have seen instances where UK entities could be treated as tax resident in an overseas jurisdiction as a result of the Directors living outside of the UK. These risks are particularly relevant as Covid lockdowns begin to lift. While tax jurisdictions may be willing to accept that Directors could not travel to the UK for board meetings during lockdown, they will expect to see a pattern of decision making in the UK both prior to and after travel restrictions were lifted.

Irrespective of the above, employees based overseas can give rise to a taxable presence of a company in an overseas jurisdiction. This is relevant where groups have implemented remote working policies or have hired employees overseas to meet talent needs.

A careful assessment, of the individuals’ activities and their relationship to the business of the company as a whole, will be necessary, as many European countries apply a low threshold for creating a permanent establishment.

7. Stock options

Many companies incentivise key staff using stock option plans. In the UK, the most popular type is an Enterprise Management Incentive (EMI) scheme. This is highly tax-efficient both for the employee and the employer. However, there are numerous conditions that must be met – both at grant and on an ongoing basis. The UK tax authorities apply these rules prescriptively and even a minor failure can result in employees losing the tax benefits they had expected. The payroll costs associated with the exercise of non-qualifying options can be significant, as can the costs of remedial work. The need to file UK Employment Related Securities is often overlooked and can lead to penalties.

Care also needs to be taken where an acquisition triggers a UK Corporation Tax deduction on options exercised pre-deal. This may crystallise a tax loss pre-acquisition that could be extinguished if there are (or have been) major changes to the trade.

8. Value added tax (VAT)

VAT is the UK’s sales tax. The VAT rules can be highly complex, particularly in relation to cross-border trading, property transactions and where companies make supplies that are only partially subject to VAT.

Any errors in VAT returns (which are usually filed quarterly) can give rise to a complex disclosure process plus payment of underpaid tax, interest, and penalties. It can also increase the risk of detailed VAT investigations by HM Revenue & Customs (HMRC).

9. Contractor employment status

Problems arise where individuals are effectively operating as employees but have been treated as independent contractors, with their wages not put through the payroll. This is often seen in the context of non-executive directors where payments are made that have not been subject to UK payroll or social security deductions or where consultants have been incorrectly treated as independent contractors.

This will now become more of a widespread risk as, with effect from April this year, the UK off payroll worker (‘IR35’) rules have been extended. Broadly these rules shift the obligation to correctly apply and withhold payroll taxes to the company paying a contractor’s personal service company. Groups will face greater scrutiny as part of the tax diligence process.

10. Post deal integration

Particular care needs to be taken that any changes to the business post-acquisition do not result in any ‘exit’ taxes from the UK e.g., if assets such as intangibles are migrated to the US (whether intentionally or ‘deemed’ under transfer pricing rules). The UK has a number of anti-avoidance rules that can tax or recharacterise such transactions. Changes to the UK operations can also extinguish valuable tax assets (e.g., NOLs) and/or crystallise deferred gains. These aspects should form part of the modelling prior to completion.

Would you like to know more?

If you would like to discuss any of the above, or how it relates to your specific situation, please get in touch with your usual Blick Rothenberg contact or James Dolan using the form below or via his profile page.

Contact James