Lifecycle of a transaction: structuring an acquisition

This article was originally published in the Tax Journal, February 2025 and is reproduced with permission from the publisher.

 

In the pressured run-up to Christmas, we might have been forgiven for forgetting that 2024 was a year of uncertainty for the UK, filled with a General Election, change in political landscape, and the first Labour Budget in over a decade. Whilst we await the final M&A activity reports, the mid-year statistics suggested that the UK saw a 20% decrease in volume from the same point in 2023. However, as we enter 2025, it is hoped that investors will have greater confidence in the UK market and that the year-on-year increase in deal value continues its previous trend.

In the first of a series considering the lifecycle of a transaction - from acquisition to operation and ultimate exit - this article examines some of the key considerations for a buyer when structuring an acquisition. I have focused on the acquisition of UK real estate, but the principles may be applied more generally.

 

Case study

Fundco, a Luxembourg Fund which holds property rental assets via local special purpose vehicles across Europe, is looking to expand its UK investments and acquire a partially completed mixed-use development in Leeds, known as Property A. The Seller is marketing Property A as an asset sale but, since Property A is owned by a company that has no other material assets, is willing to consider a sale of the shares of the property-owning company. The Seller has started preliminary sale discussions with Fundco. Fundco asks for an initial call to discuss headline points on structuring the acquisition and any key points to consider for the Heads of Terms.

 

Asset versus share acquisition

There are often two key factors to be taken into account when comparing asset and share acquisitions: (1) exposure to historic liabilities; and (2) transfer taxes (there can be other factors too, which are perhaps of more relevance in a non-real-estate context, such as the ability to amortise the acquired assets). In a share purchase, the buyer effectively takes on all historic liabilities of the target company. The extent to which this is acceptable will depend on what the buyer's due diligence exercise has unearthed, and the level of protection the buyer is afforded going forwards, either by way of indemnity from the seller or insurance protection (a topic to be discussed in a subsequent article). By contrast, an asset acquisition would only result in the buyer taking on risks and costs arising directly from the specific assets (and liabilities) it is acquiring - and so there is less exposure to the unknown.

On the tax side, where UK commercial real estate is concerned, an asset acquisition gives rise to SDLT (or LBTT/LTT depending on the location of asset), resulting in a cost equal to (broadly) 5% of the purchase price. Where the seller has opted to tax the property and the transaction does not proceed as a TOGC, VAT will be payable on the purchase price. Although it may be possible to structure the acquisition so that the VAT is only a cashflow cost for the buyer, SDLT (or its local equivalent) is payable on the VAT inclusive price, effectively increasing the SDLT charge to 6% of the purchase price.

By contrast, a share sale would not attract VAT and the UK stamp taxes payable on the transaction should be limited to a 0.5% charge calculated on the price for the purchase of shares in a UK company (or, likely, no UK charge arising on the sale and purchase of non-UK companies). It is therefore not surprising that many high-value UK real estate assets are traded by way of share sales.

A buyer should always consider seeking a price chip for [any] latent gain.

However, where a share acquisition is being considered, a buyer should give thought to whether the target company holds the property at a gain (or profit). If the property is held at a gain (generally referred to as a 'latent gain') then the buyer should note that this latent gain would be triggered if the target company were to subsequently sell the property and that the buyer would effectively be taking on the tax cost that would arise from this potential future gain. A buyer should always consider seeking a price chip for this latent gain. It is preferable for any potential price reduction to be raised at Heads of Terms stage, so the parties are clear on the parameters at the outset. Arguments for/against the appropriateness of such a price reduction can be argued but ultimately, this boils down to a commercial decision (which can be impacted by the tax status of the buyer) and the economics of the transaction.

 

Choosing the acquisition vehicle

Initial points to consider

Key factors in choosing the acquisition vehicle (which may be more relevant where the acquisition proceeds as an asset purchase as the acquisition vehicle will become the property-owning vehicle) and wider acquisition holding structure include:

• the tax status of the ultimate investors (on the buy-side); and
• long-term intentions and likely exit scenario.

For example, thought should be given to the following factors:

• whether any non-UK tax points need to be considered;
• the likely hold-period for the investment;
• whether debt will be required (either to fund the acquisition or at a later stage); and
• whether an exit is likely to be at asset level or further up the structure.

In addition, depending on the tax status of the buyer and its ultimate investors, and the buyer's business plan (principally whether the underlying assets are held for the purposes of trading or investment), it may be possible to structure the new investment to take advantage (either immediately or at a later point in time) of certain UK tax elections or exemptions that operate to minimise overall UK tax costs.

So called 'transparency' and 'exemption' elections may result in any capital gains being taxed solely against investors (rather than against the real estate owning vehicle) so that each investor may be taxed by reference to its own tax status. This can be highly beneficial where the investor is exempt from tax. By contrast, a UK REIT election operates to reduce the effective UK tax rate on both income and capital gains to 20% (and often lower, depending on the jurisdiction or identity of the investors). Where a transaction takes the form of a corporate acquisition (i.e. the purchase of an existing real estate owning vehicle) then these elections may both be appropriate for such vehicles and provide an additional advantage of removing any 'latent gain' within that vehicle.

Key factors in choosing the acquisition vehicle and wider acquisition holding structure include the tax status of the ultimate investors (on the buy-side) and long-term intentions and the likely exit scenario.

The conditions that must be fulfilled to make such elections are detailed, and the purpose of this practice guide is not to delve into the detail of each of these conditions or the benefits of such an election. However, it is important to note that if one of these elections is anticipated, structuring the acquisition in line with the relevant conditions / rules from the start is likely to save time and cost in the future. For example, a UK REIT election requires the REIT company to be resident solely in the UK for tax purposes (CTA 2010 s 528(1)) and, accordingly, this should be factored into any discussions concerning jurisdiction and entity choice. By contrast, some types of exemption election require non-UK tax residence!

Jurisdiction

Historically, holding UK real estate through a non-UK company was often beneficial for UK tax purposes - and therefore where UK real estate is traded through share sales, it is commonly through the sale of shares in non-UK companies. However, changes to UK tax legislation over recent years - predominantly bringing UK non­resident property-rich companies within the scope of UK corporation tax from April 2019 (TCGA 1992 ss 1A-3G and Sch 1A) - mean that the benefits of using a non-UK company to acquire UK commercial property may now be very limited. A non-UK resident company is required to pay UK corporation tax on taxable income profits arising from its UK property letting activities (CTA 2009 s5) and, unless an exemption applies, is subject to UK corporation tax on chargeable gains arising from direct and indirect disposals of UK property (TCGA 1992 s 2B(4)).

A non-UK resident company holding UK property (and carrying on a letting business) is also subject to additional compliance burdens - for example, it will be required to register under the UK's Non-Resident Landlord Scheme (Taxation of Income from Land (Non­residents) Regulations, SI 1995/2902) (NRLS) in order to receive rental income without the deduction of UK income tax. Advisors should also point out any non-tax obligations where UK real estate ownership is concerned ­such as registering on the Register of Overseas Entities or the Trust Registration Service (where relevant).

As noted above, use of a non-UK company as the acquisition vehicle may mitigate UK stamp taxes on a future exit if a subsequent share sale is contemplated. Accordingly, a non-UK incorporated but UK tax resident vehicle may be suitable as an appropriate compromise and offer flexibility on exit (potentially removing the need for transfer taxes to be modelled on exit). Although such companies remain subject to UK corporation tax on income and gains, they should not need to register under the NRLS on the basis that their 'usual place of abode' is regarded as in the UK for these purposes (see HMRC's Property Income Manual at PIM4850) - thereby removing one of the compliance burdens of using a non-UK company as the property-owning vehicle.

Where a transaction takes the form of a corporate acquisition, choice of jurisdiction of the property-owning vehicle will have been pre-determined by the seller. However, where the acquisition is of shares in a non-UK incorporated, and non-UK tax resident company, a buyer can choose to bring the tax residence of the property-holding vehicle onshore post-completion (subject to checking any local tax implications).

For a non-UK company to be treated as UK tax resident, it needs to be centrally managed and controlled in the UK. 'Central management and control' is the place where strategic and policy decisions concerning the company are taken. Practically, therefore, it is important that the majority of the company's directors are UK resident with board meetings predominantly held in the UK.

Entity type

Once the choice of jurisdiction is determined, the type of entity for both the acquisition vehicle and any entities 'higher' in the acquisition structure should be considered. There are a range of entities available, such as partnerships, offshore property unit trusts (OPUTs) and limited companies and the choice of entity is often driven by commercial factors, and whether the acquisition is proceeding as a share or asset acquisition, rather than solely tax.

From a UK tax perspective:

• partnerships (at least UK partnerships and non-UK equivalents) are tax transparent, with profits/losses of the partnership being taxed on the members;
• OPUTs are normally transparent for UK income tax purposes but opaque for capital gains tax purposes, unless certain elections are made to treat these as transparent or exempt (TCGA 1992 Sch SAAA); and
• companies are opaque with profits / gains of the company being subject to UK corporation tax (after any available deductions have been made) - subject to a UK REIT election being made to exempt the company's property rental business profits from UK corporation tax (CTA 2010 s 534) or an exemption election being made to exempt the company's capital gains.

Although tax factors clearly play a significant role in entity choice, commercial considerations often drive the decision.

 

Case study

The Seller and Fundco sign Heads of Terms for Fundco's acquisition of Jersey Propco, the Seller's Jersey incorporated but UK tax resident property holding limited company. Given the transaction is progressing as a share sale, Fundco agreed to increase its offer to reflect the fact that it would not incur transfer taxes on the acquisition (i.e. no SDLT or UK stamp duty), however, its price takes into account a price chip for 50% of the latent gain sitting in Propco.

Given the majority of investors in Fundco are currently overseas pension schemes, Fundco would like to consider the feasibility of having a UK REIT in future - accordingly it confirms that it will use a Jersey incorporated, but UK tax resident company as its acquisition vehicle.

Fundco would now like to understand how best to finance the acquisition, and subsequent development, and any tax points to consider in this regard.

 

Funding an acquisition vehicle solely by way of share subscription is unlikely to give rise to any UK tax costs. However, it may limit flexibility on profit extraction.

 

Funding

There are two basic methods of funding an investment: equity and debt. In structuring such finance, it is crucial to ensure that tax leakage is minimised. The following should be taken into account:

• to the extent that cash is advanced by way of equity (i.e. share subscription), dividends received are not taxable or subject to withholding tax; and
• to the extent that funds are advanced by way of loans (be it intra-group or third party debt):
• the tax deductibility of any interest payments should be maximised; and
• if intra-group interest-free loans are granted, it should be ensured that transfer pricing rules do not operate to impute a tax charge on the lender, without a corresponding deduction being available to offset the imputed tax charge.

Equity

The issue of shares does not give rise to UK stamp taxes and no tax should arise to UK resident companies on receipt of shares via share subscription. Accordingly, funding an acquisition vehicle solely by way of share subscription is unlikely to give rise to any UK tax costs. However, it may limit flexibility on profit extraction ­without steps being taken to reduce share capital, surplus profits would only be extracted by way of the payment of dividends. Although the UK does not impose withholding tax on dividends paid, no UK corporation tax deduction is available on dividend payments. In addition, the ability to pay dividends will depend on company law and investors should be aware of the potential for 'dividend traps' where sufficient distributable reserves prove not to be available (at least where a UK incorporated company is concerned) - therefore restricting the ability to extract surplus cash from the structure.

Debt

Intra-group debt can provide flexibility on profit extraction (as interest/principal can be paid regardless of the level of distributable reserves) and potential tax benefits may arise where interest expenses are deductible against profits for UK tax purposes. Where intra-group debt is preferred over equity, consideration should be given to whether third-party financing is or will be required, and if so, whether additional holding companies should be incorporated into the acquisition structure to create a lending structure acceptable to third party lenders (often referred to as 'structural subordination'). This may necessitate discussion with Finance colleagues as well as potential external lenders. Again, having these discussions early in the process can mitigate the need for a subsequent group re-organisation which can be costly in both time, professional fees, and potential tax charges.

The availability of UK tax deductions for interest expenses is subject to a wide range of UK tax rules. A number of these rules are set out in overview terms below.

Corporate Interest Restriction (CIR) rules

TIOPA 2010 Part 10 and Sch 7A contain the UK's detailed CIR rules which limit the amount of UK corporation tax relief available to 'worldwide groups' in respect of interest and other financing costs. In broad terms, the basic position under the CIR rules is that tax relief for interest expenses is capped at 30% of a group's UK taxable EBITDA profits. An optional group ratio method prevents the CIR rules having an overly restrictive impact on groups that are highly leveraged — but this often operates to permit interest deductions on external debt, whilst restricting deductibility of interest on shareholder debt. The rules apply to each 'worldwide group. For these purposes entities form part of a group if they are treated as part of a consolidated group for the purposes of relevant international accounting standards (or would be so consolidated if such standards had been applied by all entities). The application of the CIR rules therefore requires a detailed understanding of accounting rules and how such rules apply to the relevant group / structure at hand. The CIR rules allow for a minimum tax-deductible sum of GBP2m per annum for each 'worldwide group.

Anti-hybrid rules

The UK's anti-hybrid rules (TIOPA 2010 Part 6A) can deny interest deductions in relation to 'structured arrangements' or arrangements entered into between members of the same 'control group' where there is a 'hybrid entity' or 'hybrid instrument' that would otherwise result in a deduction but no corresponding inclusion in the taxable income of the recipient, or result in a double deduction for tax purposes. The rules are wide-ranging and can apply where payments are funded from the UK which give rise to a UK tax deduction and no corresponding tax payment elsewhere in a group structure.

Transfer pricing

To ensure interest deductibility, large companies / groups need to be compliant with the transfer pricing obligations set out in TIOPA 2010 Part 4, but on a wider scale, all companies should be cognisant of the arm's length principle. Transfer pricing rules require that transactions between related parties are on arm's length terms, i.e. that the amount of profit / deduction recognised for tax purposes is what it would have been had the same transaction been carried out by unrelated parties. For these purposes, consideration must be given to interest rate, quantum of debt, and, amongst others, the debt terms. Where intra-group debt is advanced between two UK companies (or two UK tax resident companies), the impact of the UK's transfer pricing legislation is reduced. This is because if one company were to be denied a UK tax deduction on part of the interest it pays, then the company receiving that interest should avoid a UK tax charge on the receipt (i.e. a compensating adjustment may be claimed (TIOPA 2010 s 182). In such a case, the net tax impact should be nil - and it is noted that as part of its UK Corporate Tax Roadmap, the Government has proposed to consult further on reforms to the UK's rules on transfer pricing, including the potential removal of UK-to-UK transfer pricing.

Unallowable purpose rules

UK legislation contains provisions that deny tax relief for interest in relation to any debt that is for 'unallowable purposes', i.e. for a purpose which is not among the commercial purposes of the debtor company. There are also rules which deny interest relief if the loan is part of a scheme or arrangement, the sole or main purpose of which is to obtain a reduction in tax liability by bringing a loan relationship debit into account. The unallowable purpose rules have been the subject of recent scrutiny by HMRC and by the courts (JTI Acquisitions Company (2011) Ltd v HMRC [2024] EWCA Civ 652; BlackRock HoldCo 5, LLC v HMRC [2024] EWCA Civ 330) and in this context careful consideration should be given to the purpose/rationale of any intra-group loans before they are put in place. Attention is drawn to HMRC's recently published guidance in their Corporate Finance Manual at CFM38100.

Withholding taxes

Where intra-group debt is concerned, particularly where interest-bearing debt is advanced to UK incorporated or UK tax resident companies and/or where that debt is secured on or funded by UK real estate, it is important to ascertain whether UK withholding tax may be due on interest payments made. The payment of 'yearly' interest (i.e. interest on a debt capable of subsisting for longer than 364 days) will, potentially, be subject to UK withholding tax if the interest has a 'UK source' (ITA 2007 s 874). In determining whether an interest payment 'arises' (i.e. its 'source' is) in the UK (and is therefore potentially subject to deduction of UK withholding tax), HMRC and the courts have confirmed that a multi-factorial approach should be taken (Savings and Investment Manual at SAIM9090). Taking a prudent approach and assuming that UK withholding tax will apply to interest payments on intra-group debt advanced to a UK tax resident company which generates its income solely from UK rental profits, there are a number of exemptions - under both UK law and treaties to which the UK is a party - that can apply to reduce to remove the obligation to withhold. The UK has a large Treaty network which often operates to minimise withholding taxes on interest payments between entities resident in Treaty states, and there are a further raft of domestic exemptions (such as the quoted Eurobond exemption where debt is listed) - and so it is often possible to structure debt funding without the need to deduct and account for UK withholding tax on interest payments. That said, care needs to be taken to ensure that any relevant procedural formalities are satisfied prior to payment of any interest to ensure that the business is not inadvertently exposed to a withholding tax obligation and related interest and/or penalties.

 

Case study

Fundco is keen to ensure flexibility in its structure going forwards, particularly with a combination of third-party finance and intra-group debt to help fund Jersey Propco's ongoing development of Property A. Accordingly, Fundco considers the following acquisition structure suitable.

Looking forward

Once the acquisition structure is broadly determined, a buyer should focus on the funding mechanics, ensuring that it can acquire the target in the most cost-effective (including tax efficient) manner, subject to key transfer pricing considerations.