Perhaps unsurprisingly for such an innovative asset class, search funds can experience some challenges from a tax structuring angle. We highlight five critical tax structuring points that can significantly enhance your outcomes before executing a deal.

Once a searcher has identified a target business and started the acquisition process, it is vital they consider the options to achieve an optimal structure from both a tax and commercial perspective. The structure should consider the various parties to the transaction, including the objectives and preferences of the searcher, investors, selling shareholders and any third-party lender.

A poorly structured acquisition can lead to unintended tax consequences for the key stakeholders and therefore change the commercial reality of the deal.

The tax structuring report is a key component in the transaction process and is often the basis on which the lawyers draft the legal documents to execute the transaction. It is also possible that the senior lender would request to rely on the tax structure report prior to a drawdown of funds. In this article we outline five critical tax structuring points a searcher should take advice on prior to executing their deal.

1) Tax treatment of searcher equity

The key tax issue for the searcher in respect of their equity subscription is whether HMRC could assess any value to income tax on either acquisition, vesting or on a future disposal of the searcher’s shares. To the extent that the searcher has not paid market value for their shares, the searcher will be assessed to income tax on the discount, leaving the searcher at an immediate cashflow disadvantage. This problem tends to arise in cases where the searcher has not incorporated the search vehicle or structured the capital rights appropriately before identification of the target business. Tax structuring solutions can be explored to defer payment for the shares until a future liquidity event or adjust the commercial terms to make the transaction compliant with the safe harbour conditions set by HMRC.

To incentivise the searcher, it is common for the searcher to be offered enhanced capital rights (‘ratchet’) on a future exit if certain performance metrics are achieved. Without appropriate structuring the additional value attributable to the equity received from the ratchet could be subject to income tax (including employer withholding) rather than a capital receipt. Careful structuring of ratchet arrangements can mitigate this risk.

2) Structuring preferences of third-party lenders, investors, and selling shareholders

Each stakeholder will have their own preferences and objectives for the acquisition. It is important that these are considered early on to ensure they can be accommodated. For third-party lenders their main objective is often to achieve appropriate structural subordination such that in the event of a liquidation of the target business the lender gets priority in the waterfall.

The investors are often tax resident outside the UK and will want to understand to what extent, if any, UK withholding taxes could apply in future to the sale of their shares, distributions from the structure or interest returns.

For selling shareholders required to reinvest a proportion of their sale proceeds into the acquisition structure (e.g. shares or loan notes) they will often want to achieve tax deferral on this consideration to avoid a dry tax charge (i.e. have a tax liability without the cash to settle it). Careful structuring of legal documents can ensure tax deferral is achieved for the any reinvesting shareholders.

3) Transaction costs

The value of professional fees invoiced by advisors (legal, tax, corporate finance, due diligence providers) to the acquisition vehicle can be significant. Absent any further structuring the company would not be eligible to recover the input VAT on certain deal fees that are eligible for recovery, representing a permanent tax cost of the structure. Appropriate structuring can help provide a structure which maximises the availability of input VAT recovery for eligible deal costs but whether this is worthwhile is likely to depend on the size of the deal.

4) Consideration structure

It is common for the consideration structure of a search fund acquisition to incorporate some element of deferred consideration or earn-out to sellers where some or all the sellers are individuals who will continue to be employed by the target business following acquisition. In a search fund context this tends to be employee manager/shareholders who have acquired their equity stake in the target via an employee incentive scheme, while the original founders exit entirely.

There is often tension between the commercial desire to use an earn-out to incentivise these managers by making the payment conditional on the seller’s personal performance or continued employment with the business and the seller’s aim that their earn-out to be taxed in the same way as their cash proceeds i.e. capital gains tax rather than income tax. If HMRC assert that the earn-out represents remuneration, rather than further sale proceeds for their shares, the earn-out is subject to income tax through PAYE. Absent any contractual allocation to the contrary, any employer NICs due on the earn-out payments will be suffered and represent a cost for the purchaser.

5) Shareholder acquisition finance – debt or equity?

Another important decision is whether the preferred capital to finance the acquisition should be funded through shareholder debt or equity. Structuring the preferred capital as equity has the advantage of being simple to implement and avoids withholding tax concerns on repatriation of funds from the acquisition structure but the preferred return is not tax deductible and requires the company to have sufficient distributable reserves. The payment of interest may also attract withholding tax obligations but there are options available to manage this risk. The make-up of the investors and overall commercial aims will determine what the optimal debt/equity structure should be.

Conclusion

As illustrated above, there are numerous tax issues to consider when making an acquisition through a search fund vehicle. It is vital that you have a tax adviser on board with the experience and expertise to guide you through the process as smoothly as possible.

Search funds: a complete guide

We've created a series of articles exploring the key things you need to know about search funds, an innovative and growing asset class which can provide a great outcome for all parties involved when utilised correctly. Read more here.

How can Buzzacott assist on a Search Fund acquisition?

The Corporate Finance Team at Buzzacott have great experience providing financial due diligence and transaction advisory services to searchers looking to make acquisitions. We view the due diligence process as establishing whether the target is a company you want to acquire and the transaction advisory service as using learnings from the diligence process to negotiate the best possible deal. This is typically achieved through making adjustments at the enterprise to equity value bridge stage, establishing a cash requirement or identifying additional debt items.

The Buzzacott tax team also have experience in both performing tax due diligence to identify potential issues in the company and structuring the deal/acquisition vehicle so that it works most efficiently from a tax perspective. This is often invaluable in cases where a Search Fund has multiple different investors, often based in a variety of countries. Get in touch via the form below.