Getting ‘Aheads’ of Yourself
A good set of heads of terms can really improve the efficiency of any transaction. However, a corporate heads is not the same as a property heads and – for it to have the purpose that it is intended to have – it needs to deal with key corporate topics as well as property items.
Whilst lawyers are often only involved once a set of heads have been agreed, we can add real value (for minimal cost) to heads for a corporate property transaction. In particular, we have often seen the situation (from both perspectives) where one side receives corporate advice on the heads and another does not. This can lead to one side starting off the transaction at a significant advantage.
Is the price right?
The heads will always state a purchase price but is that the agreed value of the property or the agreed price for the target company? They may be two different things. Whilst the starting assumption would be that – for this type of transaction – the target company does not trade and has no assets other than the property, it is rare for a target company to be 100% ‘vanilla’.
A well drafted heads will therefore make it clear that the price stated is the price for the shares in the target company and for the offer to be made on a ‘cash free, debt free’ basis (or similar). The headline agreed price will therefore adjust upwards for any cash in the business and downwards for any liabilities. Typically, the parties will agree an estimated ‘net asset value’ (‘NAV’) based on agreed accounting policies and principles with the actual net asset value to be agreed or determined (and a balancing payment made as against the estimated number) around 3 months following completion by reference to a set of completion accounts.
Having completion accounts provides the buyer with a very useful protection that if, having acquired the target company, there are unexpected liabilities, it can seek an immediate £/£ price adjustment. Whilst warranty protection might also provide the buyer with recourse, its ability to claim under the warranties will be subject to limitations such as de minimis, disclosure etc. For this reason, buyers usually favour a completion accounts model and it is a common feature of corporate real estate transactions.
For completion accounts, the specific accounting policies are key and it is therefore crucial that someone with an accounting background (whether internal or external) is involved to shape the required policies.
Finally, it is crucial from the purchaser’s point of view to state that the value of the property is fixed in the completion accounts (avoiding the seller seeking to argue that they should benefit from any increase in the property’s value between the date terms are agreed and the date the transaction documents are signed).
Mind the Gap!
A standard commercial property acquisition heads will stipulate that exchange takes place within a fixed period of the heads (perhaps 20 days), a 10% deposit being paid on exchange, and completion to follow a prescribed number of days afterwards.
Whilst corporate deals can (and do) work this way, having a gap on a corporate deal is not routine. If there is a split exchange and completion, there is an inherent risk around what happens in that period. As this ultimately goes to whether the contract can be terminated or not, the issues are often contentious and inevitably result in additional costs being incurred as they are negotiated. There is no ‘market standard’ or generally accepted way of resolving these points. One of the first questions on the buy side will therefore be to assess whether there is a reason why a gap is needed (such as a third-party consent that cannot be obtained prior to an exchange) and, if possible to explore whether one can be avoided.
The issues that often arise on a corporate transaction where there is a gap include:
- Interim period covenants. The extent to which the buyer should be able to have negative and positive control over what happens in the target company between exchange and completion versus the need for the seller to have operational freedom to run the business. For a genuine property SPV the seller should be prepared to agree a pretty fulsome set of restrictions whereas for a real estate trading business such as hotels or care homes, this will be trickier. Generally, the longer the gap period the more reluctant the seller is likely to be to accept restrictions. Also, what is the consequence of the seller breaching one of those restrictions? The buyer will want to be able to terminate the contract whereas the seller will want to limit such termination rights to core matters only that fundamentally affect the buyer’s go/no-go decision.
- Warranties and disclosure. In any corporate transaction, the buyer will require various warranties to be given about the business and shares being sold. There is not really an equivalent of these on a pure property deal. The warranties are subject to matters that the seller discloses. Where there is a gap, the buyer will want those warranties repeated at completion but would prefer the seller not to update its disclosures because the buyer is already contractually committed to the deal at that stage. The seller will argue that they need to protect themselves by updating disclosures because events may happen even over a short gap period that can render the warranties untrue when repeated. This often ends with a dispute about how significant a newly disclosed matter has to be to trigger a termination.
- Material adverse change (MAC). Even if the seller complies with all the covenants in its control, circumstances can occur which mean that the buyer might not want to complete. These should cover damage to the property but also potentially adverse changes in the financial position of the company. The buyer will want to seek as broad a ‘MAC’ clause as possible whilst the seller will want to resist any risk of the deal falling apart, arguing that ‘risk should pass at exchange’.
An overseas element
Although the property may be located in the UK, the target company might not be. Depending on the tax and structuring favoured by the seller at the time the target company was set up, an offshore jurisdiction might be involved such as Luxembourg, Jersey, Guernsey, Isle of Man or BVI.
If the target company is non-UK then legal issues in the country of incorporation will need to be considered and local law advice taken, including due diligence in that jurisdiction. The completion mechanics may also be more complicated e.g., in many European jurisdictions a notary needs to be involved.
If the seller is incorporated outside the UK then the buyer will typically ask the seller’s local lawyers to issue a legal opinion to confirm the seller’s power and capacity to enter into the deal.
Please see also the ‘Taxing matters’ section below.
As clean as can be
On a corporate real estate deal, the starting expectation is that the target company should own no material assets other than the property. In addition to property due diligence, corporate legal due diligence is required to confirm that the target company is clean and also to verify the seller’s ownership. This should be a relatively swift and controlled process. Some of the things that should be checked include:
- Employees. Does the target company have any employees or liabilities in respect of employees? Even if the target company has no employees there can often be individuals working for third parties exclusively/predominantly at the property such as security guards etc where such individuals might potentially transfer to the target company by operation of TUPE in certain circumstances.
- Contracts. Are there any agreements in place between the target company and third-party service providers, consultants, managers etc? If so, confirmations and waivers should be obtained from all such parties that there are no amounts outstanding or any claims against the target company.
- Title and corporate history. Can the seller’s ownership of the target company be confirmed and do any third parties have any claim on the shares or the property? Are the target company’s corporate records and filings in generally good order?
In addition to legal due diligence, if a corporate is to be acquired it is important to perform both tax and financial due diligence.
The insurance option
One of the key areas of protection for the buyer of any business is the set of warranties that it gets about the activities, ownership and operation of the target company as well as tax indemnities that typically cover pre-completion tax liabilities. Traditionally the seller will give these warranties and tax indemnities. However, over the last 10 years there has been a gradual trend towards the development of warranty insurance (known as ‘W&I’) and it has now become the norm for corporate real estate transactions of a certain value to be W&I backed (in part driven by institutional and private equity sellers that want to wind up their funds within what would normally be a warranty period window).
If W&I is to be involved, the buyer needs to be aware of:
- Costs. Whilst premiums have come down in recent years, W&I insurance undeniably does involve additional cost encompassing premium, taxes and insurer costs. The question of whether those costs should be borne by the buyer or seller (or shared) is often a keenly negotiated commercial point. The buyer’s legal costs are also likely to be higher as it will be necessary to manage the W&I process and negotiate an insurance policy alongside the agreements with the seller.
- Process. The insurers will need to be satisfied that the buyer has undertaken a thorough due diligence (‘DD’) process if they are to provide a comprehensive level of cover. This will entail legal corporate, property, tax and financial reporting being undertaken (selected internal financial and operational DD may be ok if done by someone with expertise of the subject matter). Once all reports are available, they will be provided to the insurers who will raise underwriting questions on the content of the reports (legal, tax and financial). Only at the end of this ‘underwriting process’ will the insurer confirm what warranties/tax indemnities are/are not covered.
- Timing and commitment. As will be seen from the above, carrying out the necessary reporting on a W&I deal might take longer than on a non-W&I deal. Whilst the buyer might (on a non-W&I deal) take a view that it will take a risk and not carry out due diligence on certain areas, such an approach will not be accepted by an insurer and will lead to exclusions of cover. The process to handle the insurer’s questions and negotiate with them on the cover can also take time and is subject to capacity constraints in the insurance market. Note also that the insurer will not begin underwriting work until the buyer has signed a costs undertaking to agree to be liable for the insurer’s fee if the deal doesn’t happen. Many buyers are understandably reluctant to commit to these fees too early in the transaction whereas the seller will want to be sure that the timetable is not delayed by the insurer starting work too late in the process.
- Ease of negotiating with the seller. Traditionally negotiating the warranties and the tax indemnities, the limitations on the seller’s liability and the general disclosures take a lot of time. However, on a W&I deal this process should be much simpler as the seller should be able to accommodate a sensible and market standard set of buyer protections without increasing the seller’s risk profile. The seller should also be able to live with very few limitations on liability in the share purchase agreement – the limitations are instead negotiated via the W&I policy. The buyer will however want to put a marker down that if there are exclusions in the W&I cover – particularly non-standard ones that arise from the seller’s stewardship of the target company – the buyer may look to the seller to plug those gaps.
As mentioned above, the opportunity to pay stamp duty rather than SDLT is often one of the factors in favour of a corporate purchase. However, it must be borne in mind that SDLT liabilities can arise in the target company itself, in addition to the stamp duty due on the share acquisition. For example, if the target company acquired the property from another group member and did not pay SDLT because it claimed SDLT group relief, this relief may be subject to “clawback” on acquiring the target company, as the group relationship between the target company and the transferor member of the seller group will be broken. In addition, there is the risk that the target company may be liable for SDLT on a deferred basis if, for example, the property was acquired subject to an overage agreement under which future consideration becomes payable. It will be necessary to address these risks through due diligence and contractual protections.
The target company may also be registered for VAT. Due diligence should be carried out to check the validity of the target company's VAT registration (and whether VAT compliance has been properly carried out), or if unregistered, to assess whether the target company might be subject to mandatory registration. Similar checks should be carried out to assess whether the target company has opted to tax the property for VAT purposes, whether HMRC permission was required for such an option and whether any option to tax was properly notified to HMRC. It will also be necessary to confirm whether the target company's property is a “capital item” for the purpose of the VAT capital goods scheme and if so, the amount of previously recovered VAT input tax which is potentially subject to clawback by HMRC. Lastly, if the target company is a member of a VAT group, arrangements should be put in place to de-group the target company at completion, settle any VAT liabilities due to or from the representative member of the seller’s VAT group and if necessary, register the target company with a “stand-alone” VAT registration or include it in the buyer’s VAT group.
If the target company has debt outstanding to the seller, arrangements will no doubt be put in place to refinance this debt at completion. Repayment of the debt should not give rise to tax issues for the target company and if the buyer takes on the obligation to procure that the target company repays this debt post-completion and reduces the purchase consideration accordingly, this will reduce the stamp duty burden associated with the transaction. If the buyer procures the repayment by funding the target, this funding should be clearly documented as either a loan advance or a share subscription, to avoid the risk that the new funding might be taxable in the hands of the target. Care should be taken if debt owed to the seller is to be written off or acquired by the buyer as part of the transaction, as in certain circumstances, this could give rise to a taxable credit in the hands of the target under the corporation tax loan relationship regime.
If the target company is a property investment company, the capital allowance and chargeable gains position should be assessed. While an election under section 198 Capital Allowances Act 2001 will not be necessary, as it is the shares of target company rather than target company's property that is being purchased, the tax written down value of the property in the hands of target company should be determined. In addition, the history of any capital allowance elections made by the target company should be checked. Turning to chargeable gains, as a taxpayer in its own right, the target company will be potentially liable to corporation tax on chargeable gains on any future disposal of its property and this liability will be calculated by reference to the target company’s base cost in the property. It is, therefore, important to ascertain what this base cost is, so any “latent” capital gain can be quantified and taken into account when setting the level of consideration. If the property was acquired by the target company from a member of the seller’s corporate group, this acquisition would probably have taken place on a tax free “no gain/no loss” basis. While breaking the group relationship in the six years following target’s acquisition of the property could potentially result in a clawback of this relief, where the shares of the target company are sold, the resulting tax liability now usually falls on the seller.
On the other hand, if the target company was a property trading company, chargeable gains and capital allowances are less relevant and it should be borne in mind that there is no equivalent to chargeable gains group relief for property held on trading account. The result of this is that any post-acquisition reorganisation involving moving the property out of the target company to another member of the buyer’s group may be expensive. A corporation tax charge might also arise in the target company if it appropriates the property from trading stock to fixed assets.
In relation to non-UK resident companies, it should be noted that since 2019 corporation tax on chargeable gains will be levied on a property company even where that company is not resident in the UK and this charge can also be levied on the owner of such a company when the time comes to dispose of the shareholding. If the target company is a non-UK resident company, its base cost in the property may have been eligible to be uplifted to market value on 5 April 2019 (or 5 April 2015, for residential property) and in such a case, contractual assurance should be sought that the target company was indeed non-UK resident at the relevant time. When acquiring a company incorporated and/or resident in a jurisdiction other than the UK, it is also worth taking advice from local tax counsel.
While the above points are probably the main tax issues to be considered in planning the acquisition of a property company, there are many others which may be relevant in the context of any particular transaction. For example, withholding taxes on cross-border payments, NIC/PAYE (e.g., does the company employ any security personnel?) and the potential application of the construction industry scheme might all have to be taken into consideration, covered by due diligence and appropriately dealt with in the transaction documentation.