Tax Issues for Smaller E

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Tax Issues for SmallerEP Companies

• Gordon Aird
• Piper Consulting Limited
• 01444 441798
• gordonaird_at_aol.com

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Agenda

• Corporate structure
• Development - Allowances and deductions
• Sale of success -Deferred consideration etc
• Capital gains relief/exemption in disposals

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Corporate structure

• Suppose you have more than one success, or
• You want to sell only part of the business
• Substantial shareholding exemption requires one
  company to sell another
• Exempt business for shares swap gives new shares
  to shareholders of company disposing of the
  business
• JV company rules for taper relief give a
  shareholder company trading status
• Get a Holding company and an Operating subsidiary

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Farm out

• Acquiring party assumes work obligation in return
  for the interest
• Tax free transaction if the transfer relates to
  an undeveloped area and the consideration
  consists of an obligation to undertake
  exploration or appraisal work in an area which
  is, or forms part of, the licence area in
  relation to the licence disposed of (S.194 TCGA
  1992)
• Undeveloped area means that for no part of the
  licensed area has a programme of development
  beenapproved by the Secretary of State on or
  before that time (S196(1))
• There is therefore no tax free farm out on a
  brown field site or on a development

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Development Carry

• Only tax free on a non-statutory basis where
• Field interest given by owner to developer and
• Developer recovers cost of development (and
  interest equivalent) out of hydrocarbon sales and
• When the development cost account reaches zero
• The interest reverts to the owner.
• This is very rare
• Anything else is a taxable sale

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Deferred consideration

• When a discovery is sold with unknown upside, it
  is understandable that the seller wants to keep
  a piece of the action, and this is often done
  by a price adjustment formula or creation of a
  royalty.
• The tax effect can be catastrophic

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Deferred Consideration

• Capital
• Ascertainable e.g. Further XX million after Y
  bbls produced from effective date.
• Taxable at disposal without discount, risk of
  contingent event not occurring or fx adjustment.
• Not Ascertainable e.g. X of future cashflow gt Y
  million (includes value of right to royalty
  revenue)
• Taxable at disposal on risked value of right to
  future payment
• Deferred Consideration can give high PV tax bills
  on asset sales. Corporate deals with SSE
  unaffected.
• See statutory exempt transactions Shares/Carve
  out?

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Deferred Consideration

• Revenue e.g. NPI or Royalty
• S.125 ICTA 1988 makes these not deductible by the
  payer, but taxable in the hands of the recipient.
• If the payments can exist in more than year, they
  can be caught by this section as annual
  payments made in return for moneys worth
  which was not taxable income in the hands of the
  recipient.
• These reverse annuity rules can be highly
  damaging to economics.

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Existing Asset Acquisition

• Totality of tax effect of deal is what matters
• NPV of tax cost to seller v NPV of tax benefits
  available to buyer
• Understand counterparty position

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Asset deal

• Financing Ring Fence deductible
• PM /Drilling
• Buyer - 100 CAs how fast can you use these?
• Seller 1) Reduce pool 25 DB effect OR
• 2) Immediately taxable
• Licence/Reserves
• Buyer No tax benefit until subsequent sale
• Seller Capital Gain cash tax bill
• Asset deal usually has tax leakage these days

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Corporate deal

• Financing Ring Fence NOT deductible
• Nothing happens inside company - Buyer stands in
  shoes of Seller
• Seller
• Corporate Substantial Shareholding exemption?
• Individual Taper relief?
• Possibly very little tax effect at all on
  transaction

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Capital Gains - Taper relief

• Gives individuals a 75 reduction in the taxable
  gain after two years on business assets which
  have always been business assets
• Shares in a trading company or holding company
  of a trading group can be business assets
• trading includes being in business with a view
  to acquiring or starting to carry on a trade,
  provided that the company starts to carry on the
  trade as soon as reasonably practicable in the
  circumstances
• HMRC accepts that EA on a promote licence can
  constitute trading provided the intent is not
  only to sell the licence

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Taper relief (cont)

• If the shares are qualifying, business asset
  taper relief is available on a sale by an
  individual where
• The company is unlisted or
• The individual was an officer or employee or
• The individual had at least 5 of the votes
• So if you want individual, non employee
  investors,
• do not get the company listed, as that costs the
  investor 30 tax on sale
• AIM is not a listing for this purpose
• TSX(V) and similar are listings for this purpose

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Substantial Shareholding Exemption

• 100 exemption from CT on gains
• Available to companies which have owned 10 or
  more of the share capital for at least one year
• Sold company must be a trading company or holding
  company of a trading group at sale (same
  definition as taper relief)
• Selling company must be a trading company or a
  member of a trading group during the qualifying
  period and immediately after the sale
• You need more than one company to use this!

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Joint Venture Companies

• When a trading company for SSE BATR
• has 5 or fewer shareholders who between them
  hold 75 or more of it, it is a JV company and
• Shareholders companies are all deemed to not hold
  shares but to carry on part of the trade of the
  JV company
• The shareholder companies are therefore
  qualifying trading companies for SSE and BATR
• Shareholder companies can therefore be sold and
  the seller get the benefit of SSE or BATR

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Statutory tax free exchanges (1)

• Share for share

Individual Or Corporate Shareholders
2
Bigoil
1

• Promote shareholders give their shares
  inPromote to Bigoil
• Bigoil gives Promote shareholders Bigoil shares
  in exchange

Promote Licence Company
Provided the exchange is for bona fide commercial
reasons and not for tax avoidance, this is
regarded as no transaction at all. Clearance
available.
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Statutory tax free exchanges (2)

• Business for shares

Individual Or Corporate Shareholders
2
Bigoil
1

• Promote gives its business to Bigoil for no
  consideration
• Bigoil gives Promote shareholders Bigoil shares
  in exchange

Promote Licence Company
Provided the exchange is for bona fide commercial
reasons and not for tax avoidance, this is
regarded as no transaction at all. Conditions
complex. Clearance available.
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Objectives

• Buy assets with minimum tax loss in transaction
  probably corporate deal
• Farm out interests on a tax free basis or do a
  tax free exchange
• Dont go for a royalty which gives you an
  immediate tax bill and no cash to pay it. Make it
  something better
• Qualify for SSE when selling any entity
  containing a licence interest. This allows you to
  keep the upside by contingent deferred
  consideration without an immediate tax bill.
• Qualify for Taper Relief when selling personal
  shares in top company
• 10 tax on the whole deal!

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Impact of Finance Act 2003

• Finance Act 2003 destroyed the founder
  shareholder argument
• Shares and securities will be employment related
  if
• The right or opportunity is by reason of
  employment (including a former or prospective
  employment) of person acquiring the shares or any
  other person
• The right or opportunity is deemed to be by
  reason of employment if it is provided by a
  persons employer or a person connected with the
  employer

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Impact of Finance Act 2003

• Scenario
• Alan and Brian form a company (NewCo) in which
  they are the sole shareholders and directors with
  the help of a bank loan
• They grow the company and in 2 years NewCo is
  acquired by BigCo. Alan and Brian receive cash
  and shares in BigCo
• Two years later they sell their BigCo shares
• Tax under FA 2003
• The founder protection has been removed
• New deeming rules mean that both NewCo and BigCo
  shares are employment related securities
• Employment income tax and NIC charges likely to
  arise

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Pitfall under Finance Act 2003

• If Managements employment related securities
  are restricted then income tax may arise under
  Finance Act 2003
• Securities will be restricted if
• Restrictions under any contract, agreement,
  arrangement and
• Restrictions reduce the market value
• Generally, management equity will be regarded as
  restricted securities

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Pitfall under Finance Act 2003

• Restrictions include
• Forfeiture or transfer for less than market value
  (e.g. as a bad leaver or on bankruptcy)
• Restrictions on sale or sale proceeds (e.g.
  certain time period must elapse before Management
  may sell the shares, or first refusal rights)
  and
• Any provision under which the disposal, retention
  or exercise of a right conferred by the
  securities will result in a disadvantage on
  Management or a connected person

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Pitfall under Finance Act 2003

• Example
• Actual market value 80p per share
• Unrestricted market value 1 per share
• Choices
• Pay nothing for shares No tax/NIC on
  acquisition but income tax/NIC on 100 of
  proceeds (assumes forfeiture risk lasts less than
  5 years)
• Pay 80p per share Income tax/ NIC on 20 of
  proceeds
• Pay 1 per share Capital gains tax on 100 of
  proceeds
• Pay 80p per share AND income tax/NIC on 20p per
  share Capital gains tax on 100 of proceeds

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The road to capital

• Elections
• Elect to disregard all restrictions and pay tax
  on acquisition on unrestricted market value
• all growth subject to capital gains tax
• Elect to disregard specific restrictions and pay
  tax on acquisition on a value between actual
  market value and unrestricted market value
• greater proportion of growth in value subject to
  capital gains tax

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The road to capital

• MoU
• Memorandum of Understanding between the British
  Venture Capital Association and the Inland
  Revenue
• Sets out safe harbour for managers of a company
  financed by venture capital/provider equity
  provider (VC)
• If the safe harbour applies Inland Revenue will
  accept that the price paid by Management for
  their shares is unrestricted market value
• Result Growth in value subject to capital gains
  tax not income tax

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The road to capital

• MoU Key Conditions (no Ratchet)
• Management acquire ordinary shares
• Leverage provided by the VC is on commercial
  terms
• Management pay the same price for ordinary shares
  as the VC
• Management acquire their shares at the same time
  as investors
• Management and VCs shares rank pari passu
• Management fully remunerated via separate
  employment contract

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Carl P King

• Deloitte's (partner, employer solutions)
• cpking_at_deloitte.co.uk or 0207 007 3987
  direct/07785 394246 mobile