Business owners under the bus

The 2016/17 budget came and went without too much concern from tax payers, given they were all expecting a much harsher tax collection regime. The media in their quest to sell their advertising have concentrated on the effects to their readership because, let’s face it, they need to attract as many interested eyes as possible. I have looked, and seen nothing about how business owners, big or small have been affected. There is nothing I can find, written about how as of now, business owners have become a lot poorer, at the stroke of a pen.

First some history

When capital gains tax (CGT) was introduced in October 2001, there was a lot of panic in the business community about what was perceived to be a crippling tax on the sale of a business. Those fears were reduced to a certain extent by a few apparent concessions from SARS:

  • Businesses could have their businesses valued by a competent authority as at October 2001, which valuation could be used as a base from which the gain would be calculated.
  • Businesses could use their actual acquisition or establishment costs as the base.
  • There was a prorata base for calculating the gain as  well

When the selling event occurred, the business or the owner, could work all three calculations, and use the most beneficial one for his payment of CGT. Crucially, only a portion of the gain was then taxed – 20% for individuals at their marginal rate and 50% for companies at the corporate rate.

That was all good and well. Business owners looked at their valuations, thought about what they could get for their businesses, and realised that the tax payable would be negligible. So they moved on. CGT was relegated from a panic to a mere irritation.

A few years later, business sellers were receiving a bit more on the sale than they had expected, but the CGT tax although payable, was also very bearable.

Something like this: A business selling for R1.2M, with a base rate of R1M, had a gain of R200k. For companies selling the business in an asset deal, the applicable CGT was 50% of R200k = 100k, taxed at 30% (as the corporate rate was then), meant a total CGT of R30K was payable. But for the company owner to get the money into his own pocket, he would have to pay secondary tax on companies of 12.5%. That works out to another R146,250 going to the tax man. The owner walked away with R1,023,750, having paid almost 15% of his selling price to SARS. The CGT implication was dwarfed by, and therefore lost against, the much larger STC.

If the business owner chose rather to sell his shares in the company in the same deal, the tax would have worked out like this: The gain of R200k would have 20% subjected to the CGT, so R40k, and assuming he was at the top tax bracket of 40%, the tax payable would have been R16k or 1.3% of the selling price of the shares.

If the seller was over 55, the first R900k of the gain was not subject to any CGT, and for this example, no tax would be payable.

So why then did business owners not go for the equity deal, rather than the asset deal?

Some essential practical background

In years gone by, business owners were more (how should I put this?) “interested in making profits than doing their paperwork properly”. This left a potential problem of risk in the company (or usually, the close corporation) housing the business. If the owner sold the company as a whole (ie, the shares or equity in the company) the new owner could find himself having to deal with a bunch of skeletons, which often came with crippling price tags. He would then be faced with the prospect of suing an untraceable seller.

So the buyer would prefer to move the assets, the goodwill, the customers, the supplier contracts, the staff, and whatever else as required, into a new company (Newco).

The seller found favour in this arrangement as well, because he knew that almost every bit of paper he had signed on behalf of the company in the past, included a clause tying himself up to the deal in his personal capacity, jointly and severally with the company.

The deal was protected by a clause in the insolvency act – section 34, and some advertising that was done in the press, which nobody ever read.

For many years, that was the way of dong things. I would tell buyers and sellers: “Consider the pros and cons of whether to do the deal as an asset deal or as an equity deal. Then just do the asset deal”. It was the accepted wisdom amongst all professionals in the industry… Despite the extra tax payable. Only in exceptional cases was the equity sale route taken.

Buyers forced sellers to go with the asset deal. Sellers were comfortable with the 15% tax, and took comfort in the protection the structure gave them.

It gave us at Suitegum the idea to launch PrepareYourBusinessForSale™, allowing business owners to take the risk out of the sale of their businesses, gain more value, and save tax. At the same time controlling the inevitable due diligence process, to give greater comfort to the buyer of the business.

Time marches on

Let’s move on by 11 years. You all know about the magic of compound interest –  the greatest force known to man, and all that? Well it turns out that it is not only relevant to interest on interest compounded on your savings bank account.

2016-03-02_11-27-02

The same principle holds for other growth indices, most notably felt through the effects of inflation. But even more pertinently to this conversation, the concept holds for the value of businesses. It holds to such an extent that those valuation exercises done in 2001 on businesses which are being sold today, are of almost no consequence at all in reducing the CGT payable.

If your business is older than 15 years, chances are that shareholders have changed in that time, making calculations awkward, the original base value number is useless in mitigating the effect, and your business value has grown enormously.

So I am going to do what most people do, and base the rest of this on the single selling price. Your accountants and tax professionals can tidy up the bits and bobs for you.

Along came a bus

Our small (and not so small) business owners – you know the cornerstone of employment opportunities in South Africa – merrily went about their business of keeping their heads above water, and helping the economy on the way.

But then a bus appeared out of nowhere.

In 2012 a change was made to two taxes; you guessed it, CGT was one, but the other one was dividends tax.

  • The gain subject to CGT was moved from 20% to 33.3% for individuals
  • More importantly, for companies, the rate moved from 50% to 66%
  • The old secondary tax on companies was replaced with dividends tax, and the rate was pegged at 15%
  • Let’s not ignore the effects of geometrical growth in business values

Back to our business which was valued at R1M in 2001. By 2012, this business was quite likely worth R10M.

An individual selling his shares for R10M would have his gain of R9M having 33% or R3M taxed at 40%, so would have to pay CGT of R1.20M, or 12% of the selling price. That is quite a difference from the previous 1.3%!

Pity the guy who sold his business in an asset deal: R9M gain having 66% or R5.9M taxed at 28% or R1.7M. His company would be left with 8.3M. To get that into his own hands, he would have to declare a dividend, and pay that tax. So he would have a little south of R7.1M to take home to his long suffering life partner. That is total tax of 29%, which is significantly higher than the guy selling his shares.

At that point we had the attention of those who thought about spending a small amount each month to get their businesses prepared properly for their eventual exits! And PrepareYourBusinessForSale™ started to make a difference.

The bus is reversing

That bus which did such a good job of wiping out a chunk of the small business owner’s well earned wealth?

Well it has now been put into reverse. Not, you understand, to undo the damage previously done, but rather, to finish off the job!

Look at what has happened in the 2016/17 budget.

  • Dividends tax has remained the same, thankfully.
  • CGT on companies has been increased to affect 80% of the gain.
  • CGT on individuals has been increased to 40% of the gain.
  • Business values have grown significantly, only because of the hard work of their owners (mostly).

Our old friend, the business which was valued at R1M way back in 2001, is now worth R15M. Well, because that’s the way the compounding geometrical growth curve rolls.

For the asset deal… A gain of R14M… 80% of this is R11.2M. Taxed at 28% is R3.1M, leaves R11.9M. After dividends tax, the owner can walk off with R10.1M. So a total of R4.9M is paid in tax. That is 33%. Thank you for playing!

For the “more risky” equity deal… The owner of the company sells his shares for R15M, with a gain of R14M, 40% of which is subject to CGT (R5.6M) at 40%, making R2.2M payable to the treasury (15% of the selling price).

What could you do with an extra R2.7M in your pocket?

Anyone?

There is another benefit to the equity deal for a shareholder older than 55: The first R1.8M is now not subject to CGT. That relief is not available for the asset deal.

The point is

The point is that CGT was introduced to us in a fundamentally innocuous manner, with a cynical eye on where it would take us in the future. The future has arrived. Please don’t suggest that there is no wealth tax in South Africa. It is right there.

For companies selling businesses, the rate has moved from something which was hardly worth talking about, to something which is quite astounding, given that for the business to have reached this sort of valuation, it had to spend years paying lots of taxes already. Thank you for that. Those retiring shareholders who get all their money out… I hope you spend it before you die, because if you don’t you’ll be posthumously handing a lot more over to SARS.

For individuals selling their shares, things look a lot less generous to Mr Gordhan, or whoever happens to be minister of finance by the time you read this. But that approach has its risks for both buyer and seller. The good news is that the PrepareYourBusinessForSale™ program mitigates that risk for both sides, and for a fraction of the extra tax you would pay otherwise.

The imperative, ladies and gentlemen, is to sell your business by way of an equity deal. That means you sell your shares with the balance sheet intact. There are some other interesting tax advantages to this approach which you may want to investigate with us, once you have signed up for the PrepareYourBusinessForSale™ preparation.

Some salt for those wounds, Sir?

To add insult to injury… If you want to keep up your BEE score card at its current level, the new codes dictate that there’s a small requirement in that you may have to sell a bunch of shares, and pay CGT on the gain, following the sale of those shares. Oh how they like milking this particular cow!

Heads up everybody: I am not a tax professional. Every single business is different. In our PrepareYourBusinessForSale™ program, participants’ accountants and tax practitioners are engaged with closely, in determining an appropriate strategy for each participant, because there is no “one size fits all” solution. The examples used here are for illustrative purposes only.

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