Tax Basics

One indication that markets are moving again is the start of takeover talks. The latest company to entertain offers from suitors is Cadbury (LSE: CBRY.L - news) (LSE: CBRY), which has an advance from Kraft Foods (NYSE: KFT - news) .

But for those who own shares in a company subject to a takeover bid, what are the tax implications of any deal? To roll out an old tax stalwart, the answer is that it depends. It depends on the amount and form of consideration received in exchange for the shares acquired in the takeover.

There are three main elements normally offered to existing shareholders in the target company, and the deal may include any or all of these elements.

Cash

The simplest transaction is one for cash. In simple terms, the shareholders vote to accept a price per share (which is likely to at least equal market value, or why would they accept the offer?) which is then paid out in exchange for their shares.

You have therefore received an amount of cash for disposing of those shares, and a normal capital gains tax computation ensues. The cost price paid for the shares is deducted from the proceeds received, and the balance is liable to capital gains tax, subject to the application of any available reliefs, such as entrepreneur's relief.

Shares

Another common arrangement is for the purchasing company to issue its own shares in exchange for the shares in the target company. Depending on market values, you might receive, for example, 6 new shares for every share you currently hold, or just half a share. Either way, you are effectively exchanging your shares for different shares.

Now, tax isn't always held out as a beacon of fairness and equity, but it would seem a little unfair to demand cash to settle a tax bill calculated on a capital gain when you have not received any cash with which to pay said liability. As a result, in this situation, the new shares are said to 'stand in the shoes' of the old shares.

This means that any gain is effectively deferred until the new shares are sold, where the original cost of the old shares is applied when computing how much of a gain has been realised.

In most cases, this will be the most advantageous outcome for the taxpayer, but what if you would be entitled to claim entrepreneur's relief, for example?

Entrepreneur's relief on shares requires not only a minimum 5% shareholding, but also that the person disposing of the shares be an officer or employee of the company. Under a takeover arrangement, it is possible that not only would a 5% holding be diluted to a lower percentage amount, but also that the taxpayer would no longer be involved as an officer or employee. This would mean that, although the current gain would have qualified for entrepreneur's relief, the deferred future gain does not qualify and the relief is lost.

In these circumstances, it is possible to claim to disapply the 'standing in shoes' provisions such that the gain, complete with entrepreneur's relief is chargeable now, and the base cost of the new holding will be market value at the date of acquisition (the same as the disposal proceeds for the current gain computation). You still need to find the cash when you haven't received any though

Securities

Securities such as debentures or 'loan notes' can also be used as consideration in a takeover deal. Often the structuring of the loan note will allow the purchasing company to effectively defer payment for a given length of time. Shareholders often like loan notes as well, as they may be able to defer any capital gains arising, or even structure their affairs to avoid capital gains tax altogether.

The tax treatment of a takeover paid in loan notes depends on whether the loan notes are classified as Qualifying Corporate Bonds (QCBs) or not.

QCBs need to fulfil specific criteria, and you should be informed at the time of the takeover if the debentures you receive are QCBs. QCBs are not, themselves, liable to capital gains tax, but as there is still no cash, the current gain can still be deferred. However, the gain is, in effect, frozen at the date of takeover and simply falls back into charge when the QCBs are realised. Note (Stockholm: NOTE.ST - news) that any entrepreneur's relief available on the first disposal is included in the frozen gain such that its benefit is not lost.

Non-QCBs are liable to capital gains tax in a similar way to shares, so non-QCB takeover consideration is treated in the same way as receiving shares.

Dolly Mixture

But what if, as is often the case, the takeover deal comprises two or more elements of consideration?

If you receive both shares and cash, there is no capital gains tax to pay if both of the following apply:

• you receive a 'small' amount of cash (less than £3,000 or an amount less than 5 per cent of the value of your shares in the company -- valued just before the takeover); and
• the cash received is less than the cost of your original shares.

When the new shares are sold the allowable base cost (equal to the original cost) will be the cost of the original shares less the (small) amount of cash received.

If you receive a 'small' amount of cash, but the cash received is more than the cost of your original shares, you will generate a capital gain on the cash received. You can either:

• calculate your Capital Gains Tax in the way described below; or
• calculate your Capital Gains Tax on the difference between the cash received and the cost of your original shares. You must make an election to do this and it will reduce the cost of your new shares to nil on a subsequent disposal.

If you receive more than £3,000 (or 5%) cash you need to allocate a 'cost' to the cash payment as any gain arising on the cash will be chargeable now. You do this by splitting the original cost of the shares proportionally between the cash received and the new shares. So if cash comprised 25% of the value of the offer, you'd allocate 25% of the original cost and so on.

So, now tax is a Picnic and a (Turkish) Delight for any Fools owning shares in the chocolate factory, regardless of any Wispas Boosting the share value!