Nichola Ross Martin's Tax Consultancy

This a quick guide for advisers for more detailed consideration of the issues see our guide to Selling the business: deferred consideration and earn outs

Loan stock: QCBs or non-QCBs?

Loan notes are structured as qualifying corporate bonds (QCBs) or non-qualifying corporate bonds (non-QCBs).

• When a seller exchanges his shares for QCBs or non-QCBs providing that the right conditions are met, he may be able to defer his capital gain until the disposal of the loan note. 
• The rules allow the loan note is treated as a security so you have in effect a share for share exchange.
• Following changes made in the second Finance Act of 2010 it is no longer to possible to claim Entrepreneurs' Relief (ER) on deferred gains.

QCBs

• QCBs are not chargeable to CGT so when shares are sold in exchange for QCBs any gain is calculated as if it is chargeable at the time of the exchange. The gain becomes chargeable when the QCB is redeemed, disposed of, or ceases to qualify as a QCB.
• Up until 23 June 2010 ER could be claimed to reduce the gain on an exchange of share for QCBs - providing the qualifying conditions for ER were met at the time of the exchange.
• For QCB exchanges made on or after 23 June 2010 ER will no longer apply to deferred gains. To avoiding losing ER the individual can make an election to treat the date of exchange as if it were a disposal. This will mean paying CGT before the QCB is redeemed.
• The election must be made by January 31st following the end of the tax year.

Non-QCBs

• A gain can be deferred on a share for non-QCB exchange so that it will crystalise when the security is redeemed or disposed of or ceases to qualify as a security.
• A gain so deferred is reduced or eliminated if the loan note turns into a bad debt.
• A further roll-over can be possible if non-QCB loan notes are exchanged on a subsequent take-over.
• There is no ER when a non-QCB is disposed of, however, you may elect to crystalise your gain in the year of the exchange - as for QCBs.

Loan note summary

The most common method of making loan notes into non-QCBs is to include a clause affecting redemption conditions. Any changes made to a loan note after issue (i.e. removing a foreign currency redemption provision or allowing conversion into share capital) is counted as a conversion, and this will crystalise any gain at that point.

Earn out example: Company Ltd is valued at £10 million by Mr Buyer, he offers Mr Seller £8 million cash up front, and the balance to be satisified by an earn out.
Mr Seller insists that the earn out is supported by the issue of £2 million in convertible loan notes in order to provide him with some security and comfort. The parties agree terms of conversion so that 50% will be convertible in one years' time if a certain level of sales is achieved, and the balance is convertible one year later if a second sales event is achieved. 

Conversely, the earn out could be structured in just cash terms without loan notes, or by substituting convertible shares instead. It all depends on the attitude of the parties, the advice given and what they agree.

Small print:

Section 116(10) TCGA 1992 - Reorganisations, conversions and reconstructions

Sect 169R TCGA 1992 (as amended by Finance (no 2) Act 2010 reorganisations involving acquisitions of QCBs