With capital gains tax changes looming, what could the future hold for agency M&A?

As M&A advisers, at Green Square we are frequently asked about potential CGT changes and how they might affect business owners. While we can’t predict the future, here’s a simple guide to the current CGT situation and possible change – though remember, this is a general overview and specific tax advice is always recommended.

Historic CGT position

Back in 1997, CGT rates in the UK were based on the individual’s marginal income tax rate, with a top rate of 40% for higher-rate taxpayers.

Ironically, it was the Labour government that introduced taper relief in the 1998 budget, which significantly reduced CGT on business assets. Under taper relief, the longer an asset was held, the lower the CGT rate and, after two years, the effective rate could be as low as 10%.

In 2008, Labour replaced taper relief with entrepreneurs’ relief (now called business asset disposal relief, or BADR), which further reduced CGT on qualifying business sales to 10%, up to a lifetime limit of £1m (later increased to £10m under the Conservatives, but then reduced to £1m in 2020).

Current CGT position

Under the current rules, shareholders who are employees, including directors and founders holding at least 5% of shares for two years (and EMI option holders for more than two years), qualify for BADR.

This allows the first £1m of lifetime capital gains to be taxed at 10%, with the remainder taxed at 20%.

As an example, if a business founded by three shareholders is sold for £15m, with each owning a third (and assuming they hadn’t tapped into their lifetime gain limit), their £5m gain per person would incur £100,000 in tax on the first £1m (at 10%) and £800,000 on the remaining £4m (at 20%), leading to a total CGT bill of £900,000 per person.

Potential changes

Rachel Reeves has not provided any details on CGT changes, but there’s speculation it could be aligned with income tax or a flat 30% rate or tapered based on the length of ownership (as it was in the old days). Here are a couple of possibilities:

1. Worst case: removal of BADR and CGT aligned with income tax

This would be a case of Labour reversing the business growth incentives it had created from 1997 onwards and the shareholders in the above example would each pay £2m at a 40% rate (or £2.25m at a 45% rate) compared with £900,000 currently.

If the first £1m remains under BADR, their CGT bill would be £1.7m at 40% or £1.9m at 45% – still a significant increase from today’s rates.

2. Median case: removal of BADR with a flat 30% CGT rate

Our shareholders would each pay £1.5m. If BADR is unaffected, the bill drops to £1.3m, still £400,000 more than the current rate.

What would we like to see?

As M&A advisers, ideally the current CGT regime would stay as it is, rewarding entrepreneurs for taking risks and creating employment. But that’s very unlikely to happen.

Given changes are inevitable, we’d suggest increasing the 10% BADR lifetime allowance to £3m, with anything beyond £3m taxed at 30%. In the example above, a gain of £5m would result in the same CGT bill of £900,000, but gains over £5m would see higher taxes. A £10m gain would be taxed at £2.8m instead of the current £1.9m. Painful, but not draconian.

When are changes likely to take effect?

Given the £22bn hole in public finances we keep being reminded of, it’s likely that changes will take effect from budget day, October 30. However, there’s a chance they could be deferred until the next tax year, April 6, 2025, allowing time for preparation.

For those close to completing a sale, it’s advisable to aim for closure before October 30. But be cautious of accepting a discounted deal just to expedite the process – it would be quite annoying to find the discount given was more than the ultimate tax increase. Additionally, if completing before October 30, pre-paying CGT on future earnouts to lock in the current rate is worth considering.

For those planning to enter the market soon, we suggest waiting for the budget outcome. While if changes are immediate, you may reconsider selling depending on the new rates, if the changes are deferred, there’s a tight window to close a deal, with six to nine months typically required to find the right acquirer and complete the sale, so you’d have to move fast.

Impact on M&A

The effect of CGT changes on M&A activity will depend on the specifics. A 30% rate with extended BADR could maintain activity for those realizing gains under £5m and, even for those realizing more than £5m, having the first £3m at 10% takes some bitterness out of the pill.

However, aligning CGT with income tax could cause business owners to cancel or delay selling – some might simply opt to keep running their companies in the hope CGT will reduce in the coming years, but we mustn’t overlook the fact that businesses are generally sold based on a multiple of profits. Thus, having a lump taxed at income tax rates today that can be deployed on other uses may still appeal to some.

Internationally, we don’t know of many countries changing their CGT rates at present (although Canadian rates increased in June this year), so we would expect international appetite to remain unchanged or possibly increase between non-UK jurisdictions if UK activity is muted with fewer UK assets available.

There’s also the risk that higher CGT could discourage entrepreneurship altogether. Why risk capital or take loans to build a business if 45% of the gain goes to tax?

Looking back at what happened in 1997 when Labour introduced various incentives to businesses through CGT reductions, we witnessed the following:

An increased incentive to sell: the introduction of taper relief and the eventual shift to lower rates through entrepreneurs’ relief incentivized small business owners to consider selling their businesses as they could pay significantly less CGT.

A rise in M&A activity: lower CGT rates encouraged mergers and acquisitions, particularly for small, privately owned businesses. Business owners saw these changes as opportunities to sell at a lower tax burden, especially as they approached retirement.

Increased private equity interest: lower CGT also made small businesses more attractive to private equity buyers, who could acquire businesses at a favorable tax rate for both sides of the transaction. There’s also talk of the upcoming budget changing the way PE investors are taxed, which could reduce PE appetite substantially if what’s mooted is put into action.

In summary, reductions in CGT from 1998 onwards, particularly through entrepreneurs’ relief, played a significant role in driving mergers and acquisitions of small- and medium-sized businesses.

While we can’t predict the outcome, Labour has consistently stated its support for business and Rachel Reeves has been banging on about driving growth, so we remain hopeful that any CGT changes will be mindful of not stifling entrepreneurship and investment. A return to aligning CGT with income tax would most likely reduce investment and, thus, growth, but we will just have to wait and see.

As an aside, last year the UK government raised £1,095bn in tax and other sources (with £980bn purely coming from tax and duties), so while £22bn sounds scary as a number, in reality it’s actually very small in the grand scheme of things. Maybe, just maybe (and hopefully), this budget won’t be quite as painful as many people think.