McEnroe and Another: tax implications of contracts

The Upper Tax Tribunal recently confirmed the 2022 decision of the First-tier Tribunal in the McEnroe and Anor case. The judgment emphasised that when selling shares, it is crucial for the sale and purchase agreement to state clearly if the buyer is taking on any third-party bank debt related to the shares and, if so, how the debt is to be discharged. Complications may arise in relation to Capital Gains Tax (CGT) and stamp duty if the debt has been included in the calculation of the sale price but is not clearly identified and distinguished from the price payable for the equity in the share purchase agreement (SPA). This case highlights the importance of precise and transparent drafting, especially in relation to the pricing aspects.

The background

In the McEnroe case, two individual shareholders, each owning 50% of the issued share capital of the target company, agreed to sell their shares for consideration of £8 million (as provided for in the shares consideration clause in the SPA), subject to adjustments for working capital and an earn-out. Of this £8 million, £1.1 million was used by the buyer to settle the target company’s bank debt, resulting in the sellers receiving a net total of £6.9 million.

HMRC assessed the two individuals to CGT on the basis that they each received £4 million for the shares, rather than £3.45 million (being the net proceeds received by each seller after the bank debt had been accounted for). The taxpayers appealed.

The First-tier Tribunal, noting the clear wording of the consideration clause and the absence of any reference in it to the bank debt, held that the entire £8 million, rather than the net “after debt” amount of £6.9 million, was the consideration for the shares.

The Upper Tribunal agreed, highlighting that although another part of the SPA referred to the discharge of the bank debt, it did not specify how this discharge would occur. The taxpayers claimed that the company being sold owed money to the buyer on account of settling the bank debt and argued that this amount should be taken into account in adjusting the working capital, giving an actual share price, therefore, of £6.9 million. However, the Tribunal rejected this argument.

The importance of clear drafting

The issues in this case could have been avoided by substituting £6.9m for £8m  in the consideration clause and providing, separately, for the buyer to put the target in funds to enable it to discharge the buyer’s £1.1 m bank debt. This could have saved each shareholder at least £50,000 in CGT. The sellers may have assumed that as they only received £6.9m, the additional £1.1m should not be considered part of the sale price of the shares for CGT purposes. The case highlights the error of that misconception and makes clear that the tax treatment of any transaction is based on the legal rights and obligations of the parties as set out in the transaction documentation, and not simply on the flows of money or actual receipts or payments without regard to those rights and obligations.

While the buyer’s tax position wasn’t considered, for CGT purposes, the buyer’s acquisition cost for the shares would clearly also have been £8m and the amount of the stamp duty chargeable to would (or should) in the light of the ruling have been based on £8m consideration, rather than £6.9m, resulting in an additional £5,500 stamp duty liability.

The McEnroe case demonstrates the critical need for precise drafting to ensure that the rights and obligations of the parties are set out clearly and conform with their respective commercial intentions and expectations. Failing to get the drafting right can lead to significant and undesirable tax consequences for all parties involved.

If you have questions about tax consequences arising from a contract, please contact Michael Fluss.