NAVIGATING THE CAPITAL GAINS TAX MINE FIELD FOR BUSINESS SELLERS IN 2021
Business owners need to balance concerns about impending tax changes with considerations around maximising the value of their businesses before deciding when to sell.
This is quite a long post! For those with less patience, here is the tldr:
Capital Gains Tax is expected to rise in 2021 in many countries including the UK and US
This will affect the after-tax proceeds received by an e-commerce business owner who sells their business after the change
Changes:
US: likely full alignment with income tax rates for gains above >$1m
UK: unclear, wide range of options from very little change to full alignment. Wildcard prediction: an Australian or Canadian style model may be introduced in the UK
Timing:
US: legislation likely to pass in 2021 but take effect most likely in 2022; slim chance that the rules could be made to apply retrospectively for sales from 1st Jan 2021
UK: could be as early as 3rd March, most predict later in the spring or summer
For business owners:
Now is the best time in history to sell an e-commerce business
If the time is right for your business, sell now. Try to get in before the tax change if possible
Even if you miss the window and CGT does change, selling in 2021 will still make sense for many business owners. The current seller’s market, with sky high valuations, may not be around forever. If taxes go up it will not be temporary, this will be the new reality. Selling in a seller’s market will still be the right call
Make sure you execute the sale properly and get the best price for the business: doing a bad job of the sale can cost more than the effect of a tax change
Introduction
For business owners planning an exit, tax is an important consideration. The structure of the sale (stock vs assets) can have an enormous impact on the after-tax proceeds a business owner will receive. But when a change to the tax code is expected, then timing of the sale is also critical.
And while taxation should certainly not be the driving force behind any decision to acquire or sell a business, it can have an impact on decision making. In 2021, with governments across the world having spent enormous amounts to battle the COVID-19 pandemic, there is a general expectation that fiscal authorities will seek to “balance the books”, by reducing expenditure and increasing receipts. And high on the list of targets is capital gains tax (CGT).
Why Capital Gains Tax?
Capital gains tax is seen as a relatively soft target because it has historically been charged at a lower rate than income tax in most countries, and because the nature of the tax is that it applies to gains in asset values.
Rather than taxing income, some argue that taxing wealth (or gains in wealth) has a more direct impact on reducing inequality. On the left, the work of Thomas Piketty and others linking inequality to taxation was already starting to shift macroeconomic policy in this direction, even before COVID-19. And commentators are increasingly predicting that politicians on the right may start to embrace wealth taxes, at least temporarily, given the current scale of government deficits.
While capital gains tax is not the main target of these movements, it is a much easier target for politicians than other wealth tax alternatives, since many of the others ( “mansion taxes” for example) require liquidity that the bearers of the taxation do not necessarily have. Compared to introducing new taxes, and especially compared to raising income taxes, a proposal to “reduce tax breaks” on “high earners” is politically more expedient, hence CGT is widely believed to be on the table.
Simplification
Euphemisms like “simplification” and “alignment” are often used by policy makers in lieu of more blunt terms like “increase”, when the latter term is what they generally mean. In July 2020 the UK’s Chancellor of the Exchequer, Rishi Sunak asked the Office of Tax Simplification (OTS) to carry out a review of Capital Gains Tax. The report was published Nov 2020 and included the recommendations including “More closely aligning Capital Gains Tax rates with Income Tax rates has the potential to raise a substantial amount of tax for the Exchequer”. OTS has recommended that gains made on accrued value in a business should be paid at rates similar to Income Tax rates rather than the lower Capital Gains Tax rates.
Accounting firm Deloitte’s view on the OTS report noted that "the UK has one of the lowest capital gains tax rates in Western Europe (in particular, among nations with no Wealth Tax), so with the current cost of government COVID-19 measures, Capital Gains Tax rates look a reasonable target for some increased revenue raising". However, they viewed full alignment of income and CGT rates as being at “the more radical end of the spectrum”, believing a more moderate approach likely.
Image credit: Adam Schultz
In the United States, incoming President Joe Biden’s team have already announced that they intend to increase CGT to bring it in line with income tax, albeit only for those earning > $1m per year. The language used is again designed to appeal to a sense of fairness: “Asking those making more than $1 million to pay the same rate on investment income that they do on their wages.” Since winning the presidential election and both houses, it’s now very likely that the Democrats will proceed with their plans to raise CGT on gains above $1m to the same rate as income tax (which will be 39.6%).
Aligning CGT more closely with income tax rates would more closely align the UK and US to the CGT rates in the Nordics. Sweden, Denmark and Norway generally levy high rates of capital gains tax, with top rates between 30 and 42 per cent (Iceland being the low-tax exception to its neighbours).
However, if the UK was to pursue full alignment of CGT with income tax rates (up to 45%) it would make the UK more punitive than most other European countries’ current tax regimes. Germany and France levy CGT at 25% and 30% respectively. Germany has quite a low threshold, with tax due on nearly all capital income above the €800 (£700) mark. However, other EU countries such as Greece and the Czech Republic, have lower CGT rates than the UK’s current model, while Belgium and Switzerland levy no CGT on individuals at all.
In The Firing Line
The Conservative UK government had already made changes to one aspect of the CGT system specific to sellers of businesses: in March 2020 the government reduced the lifetime limit eligible for Entrepreneur’s Relief from £10 million to just £1 million. Renaming the system “Business Asset Disposal Relief”, the rules allow entrepreneurs to pay a reduced rate of 10% CGT on the first £1m (previously £10m) of capital gains when they sell a company.
This relief may now be in the firing line again. While it is unlikely to be completely eliminated, rumoured changes could include a change in the threshold percentage ownership required to qualify (from the current 5%), a further a reduction in the lifetime limit, or a change to the tax rate applied.
Hope
In the US it seems certain that the Biden government will proceed with their planned tax changes now that the Democrats hold both houses. In the UK however, the situation is not quite as clear. It should be noted that this is not the first OTS report making radical recommendations on capital gains taxes and the UK Government doesn’t always choose to implement recommendations. This time most people do expect some changes to CGT, although the scale and timing of the changes are still up for debate.
Deloitte’s analysis of the report stated that if the UK was to move to more closely aligning CGT with income tax right now, it would represent a break from other G20 nations – effectively creating a competitive disadvantage for the UK – just as COVID-19 and Brexit are still affecting businesses. The timing is not ideal.
The OTS report itself acknowledged that increasing Capital Gains Tax rates would result in behavioural changes including an impact on people’s willingness to dispose of assets and trigger a tax charge, increasing the extent to which Capital Gains Tax has a “lock in” effect.
The fact that Entrepreneur’s Relief lifetime limit was already slashed by 90% in 2020 may give the Chancellor pause for thought before targeting it any further.
And since “simplification” of CGT was the intention, the government may look to Australia or Canada for a model on which to base its new tax structure. In these countries CGT is charged at the same rate as income tax, but it only applies to 50% of the gain. Changing to a model of this sort would achieve both the alignment and simplification objectives that have been alluded to, and while still netting more tax for the government, the change would not be so punitive.
For entrepreneurs in the UK selling their businesses this would be a substantial change from the current CGT model, but in many cases it would not be such a damaging blow, and would still be seen to be rewarding entrepreneurship. The current UK government seems particularly enamoured with Australian and Canadian policymaking, citing the countries as its benchmarks in policies ranging from immigration to trade. Perhaps they will be influenced by their CGT models also.
Key Dates
So if CGT changes are going to be made, when should business owners expect these changes to occur?
The first realistic (albeit relatively unlikely) date for a change to occur in the UK is Wednesday 3rd March, when the Chancellor will announce the Spring Budget. Given that the country has recently re-entered a national lockdown and is not expected to be completely out of this by March, it is viewed by some as less likely to be the date that the Chancellor will announce aggressive increases in taxation. However, he is no doubt influenced by those in his party with a pressing desire to balance the books more quickly, and may be pushed in the direction that they see as “fiscal responsibility” sooner rather than later.
The Chancellor doesn’t have to wait for a budget to announce a change to CGT, so it could happen at any time after this. Another possible date might be Tuesday 6th April, the first day of the new tax year for individuals in the UK.
Few people believe that there will be no change at all to CGT in 2021. If not in March or April, most expect some fiscal policy changes, likely affecting CGT, to occur during the summer or, as soon as it is politically expedient for the politicians to do so. It is possible that Chancellor Sunak will wait until the Autumn budget or even later in the year, but this is currently deemed to be less likely.
The US situation is more complex. While the new administration’s first 100 days are expected to focus largely on implementing stimulus measures rather than tax changes, and then new tax legislation is likely to take several months. But the new legislation could be applied retroactively, affecting gains made from 1st January 2021 onwards.
While it isn’t likely that the tax initiatives will be in the legislature until later in the year, it’s anticipated that the Biden administration will utilise a process known as budget reconciliation to speed up the process and help it to pass within his first year. But even this approach requires a implementation process before the changes come into place. So it’s considered more likely that the new legislation would not come into effect until the 2022 tax year. The Trump administration utilised the same procedure to pass tax legislation in his first year in office (2017), but almost all of it was not implemented until the following year.
CGT Impact For Sellers of Small Businesses in 2021
Business owners concerned about possible changes to the CGT landscape have to weigh up a multitude of factors, of which tax is only one.
The first is the performance of the business itself: demand will be strongest when the business is growing and more growth is forecast in future. If an account suspension, or a Brexit or COVID-related issue has negatively affected profitability, in some cases it will not be the right time to sell. Better to steady the ship, get back to growth, and sell for a much better multiple rather than selling during distress for a less than optimal price. In some of these cases the owner of the business may be exhausted and want to sell anyway, to take advantage of the buoyancy of the market.
If an e-commerce business is doing well, especially if it is in the specific sector in which there is currently a buying frenzy (Amazon FBA private label businesses), it makes sense to sell now. The sale should be handled as quickly as possible while still being executed properly to ensure the absolute best price, because leaving cash on the table in negotiations can actually outweigh the cost of a higher tax regime. Business owners in this position should do their best to sell before any change in CGT, where possible.
What about e-commerce businesses that are not quite ready to sell yet, or where the sale process will take longer than the expected timeframe for CGT changes? Business owners have to weigh up the situation in a measured way. Firstly, the predicted increases in CGT are not going to be temporary – it’s extremely unlikely that they will rise and then fall again within a short timeframe. So once the changes have occurred there is little point in “waiting” for tax the situation to improve. Therefore these businesses have to weigh up the other factors affecting the outcome: the success of the business itself, and the nature of the M&A market for the business. Is the business doing exceptionally well right now? How confident is the owner that this will continue indefinitely? If the future is looking less than certain, many owners will decide to sell while things are still looking great.
What about the M&A market for the business – are valuations at record highs right now? Owners of Amazon FBA private label businesses are in this situation at the moment, with valuations at sky high levels. How confident is the owner that the market will pay such a high price in future? If there is doubt about this, many will decide to sell now, at the height of the seller’s market. The bravest will hold on, hoping to ride the wave ever higher, but many will choose not to take the risk of the market turning against them.
Conclusion
It’s very likely (and in the case of the USA almost certain) that CGT will rise in many countries in 2021. The exact structure of the taxes and the timing of their introduction will have an impact on which business owners are affected, and by how much. Where this risk can be taken off the table, it should be. Business owners who are in a good position to sell should not delay, and they should do their best to execute the sale properly and get the best result before any change in CGT comes into effect. For businesses who miss the deadline, all is not lost. Depending on the detail of the changes to CGT, the impact may not be as substantial as feared (although the worst case scenario is still possible). Even in the most aggressive case, business owners should weigh up the other factors affecting the sale outcome: primarily the current position of their business, and the current state of the M&A market for their business. Even after a change in CGT, the extremely buoyant market for e-commerce businesses will likely make many business owners to decide to sell sooner rather than later.
At Hahnbeck we have streamlined processes for taking companies to market quickly and achieving the best result. Institutional buyers are in many cases able to move very quickly, and we can get other buyers in the process to meet strict deadlines when needed too. Private label Amazon FBA focused businesses, in particular, are able to be sold very quickly in the current M&A environment. If you need Hahnbeck’s help or advice on this, don’t hesitate to ask us.