Entrepreneurs’ Relief – Post Budget 2018
Entrepreneurs’ Relief is a tax relief that applies to the sale of certain qualifying business assets and which operates so as to apply a rate of…
Entrepreneurs’ Relief is a tax relief that applies to the sale of certain qualifying business assets and which operates so as to apply a rate of Capital Gains Tax of 10% on up to £10 million of gains.
In relation to disposals of shares and securities in a company by individuals, the requirements in order to qualify for Entrepreneurs’ Relief are that the company is the “individual’s personal company” throughout the period of 12 months ending on the date of disposal.
Two key changes were made to the qualifying conditions for Entrepreneurs’ Relief in the 2018 Budget, namely:
- For disposals on or after 6 April 2019, the requirement to have held the business assets or shares for 2 years (rather than 1 year as currently); and
- The requirement, in relation to the disposal of shares in an individual’s personal company, to hold shares which have the right to at least 5% of the profits available for distribution (dividends) and company’s assets on a winding up. This change came into effect immediately and applies to all relevant disposals of shares after 29 October 2018.
It quickly became apparent that the changes, which were intended to combat perceived tax avoidance, largely in private equity backed companies where employers and managers have been issued special classes of shares that confer 5% of the voting rights but not a 5% share in the underlying economic interest in the company, operated in a far wider range of circumstances than was intended. In particular, that the changes would adversely affect a number of common structures and arrangements where an entitlement to 5% of the profits and assets could not be demonstrated.
For example, where a company has multiple classes of shares with a discretion for the board to pay dividends on one class but not the others or to declare different dividends on each class of shares (so called “alphabet share” structures) no individual shareholder would be able to demonstrate that they be hold shares that are entitled to at least 5% of the profits available for distribution (as the distribution of profits is discretionary).
Following lobbying by the tax profession, amendments have now been tabled to the proposed legislation so as to introduce an alternative test to ensure that the “changes operate as intended, by allowing claimants to use their entitlement to the sales proceeds of the company as evidence of their economic stake, in circumstances where their entitlement to the profits and assets of the company cannot be demonstrated”.
Sale of shares – a summary of the new qualifying requirements
In summary, as a result of the changes, on the sale of shares in a company by an individual they must throughout the 1 year up to the date of disposal for disposals before 6 April 2019 or throughout the 2 years up to the date of disposal for disposals on or after 6 April 2019:
- be an officer or officer or employee (full or part time) of the company or, if the company is a member of a trading group, of one or more companies which are members of the trading group;
- hold shares that represent at least 5% of the “ordinary share capital” of the company (by nominal value); and
- by virtue of that holding exercise at least 5% of the voting rights in the company; and
- EITHER (or both) the following conditions are met:
- by virtue of that holding be beneficially entitled to at least 5% of the profits available for distribution to the “equity holders” of the company and, on a winding up, be beneficially entitled to at least 5% of the assets so available; OR
- in the event of a disposal of the whole of the ordinary share capital of the company, be beneficially entitled to at least 5% of the proceeds.
What we essentially now have is a requirement to hold 5% or more of the economic rights in the company (whether profits and assets or sale proceeds) in order to qualify for Entrepreneurs’ Relief.
The changes to extend the holding period to 2 years from 6 April 2019 will mean that it will more important than ever to get the share capital structure right well in advance of any disposal. If, for example, intending to give directors and employees an equity stake in the business it will be important to do so well in advance of (and at least 2 years prior to) any proposed sale so as to enable them to be able to qualify for Entrepreneurs’ Relief (and, if possible, to do so via an Enterprise Management Incentives (EMI) scheme – see below). The changes to require the shares to confer a 5% “economic interest” in the company will also mean that particular care is required where a company has more than one class of shares. It will be more important than ever for all business owners to check that the relevant qualifying requirements are (and will continue to be) met and not to simply assume that Entrepreneurs’ Relief will be available on a later sale of their shares so that a 10% capital gains tax rate will apply. Any changes to the capital structure (whether involving issuing new shares or creating new classes of share) will also require an assessment of the impact on the Entrepreneurs’ Relief position of the existing shareholders.
A couple of common situations that, despite the changes, may still be affected are:
Any companies that have multiple classes of shares with a discretion for the board to pay dividends on one class but not the others or to declare different dividends on each class of shares will mean that, the first “economic ownership” test is not satisfied. This is because no class of shares or individual will hold shares that are entitled to at least 5% of the profits available for distribution. It will therefore be imperative to ensure that in such circumstances the relevant shareholders are entitled to 5% of any sale proceeds (and would be throughout the 2 years prior to the actual sale).
With growth shares the articles will usually provide that the first £x is returned to the other shareholders so that the growth shares will not entitle the holder to at least 5% of the assets of the company available for distribution to equity holders on a winding up of the company. If similar provisions apply on a sale (and the allocation of sale proceeds) this may mean that neither of the two alternative 5% economic ownership tests are met.
Investment backed companies
Similarly, it is common for investors to require preferential rights to dividends or assets on a winding up and on a sale which may mean that the other shareholders do not, in all cases, have a right to 5% of the surplus assets on a winding up or 5% of the sale proceeds.
Enterprise Management Incentives (EMI)
One other point to note is that per the draft legislation while shares issued on the exercise of Enterprise Management Incentive (EMI) options will, in relation to disposals on or after 6 April 2019, be subject to the extended 2 year holding period (which includes the period during which the EMI option was held) EMI shares will not be subject to the new 5% holding requirements.
This is likely to lead to an increased use of EMI options to deliver shares to key directors and employees.
Other changes - dilution
Another more welcome change was made, in order to remove any disincentive to further capital fund raising, so as to allow shareholders who drop below the relevant 5% thresholds as a result of a “commercial issue of shares” (which does not unfortunately include as a result of the exercise of share options) to essentially make a claim banking their ER up to date they dilute below 5% and to also elect to postpone paying the tax on that banked gain until a later disposal of the shares.
The claim and any election to defer (which are both irrevocable) must be made within 1 year of the 31 January following the end of the tax year in which the shareholder is diluted so if, for example, diluted below 5% in August 2019 (2019/20 tax year) the individual will have until 31 January 2022 to make the claim and elect to defer.
So where are we now?
The introduction of the alternative 5% minimum “economic ownership” test looking at the entitlement to sale proceeds rather than profits or assets available for distribution is a welcome one and will ensure that the changes are of more limited impact than would otherwise have been the case.
It is however still important to check whether or not you are impacted and, if so, what steps can potentially be taken to restore the ability to qualify for Entrepreneurs’ Relief going forward (bearing in mind that, if affected, the shares will have to be held for 2 years post any changes before they can qualify again for Entrepreneurs’ Relief). This will require a mixture of corporate and tax advice.
Weightmans has a dedicated team of corporate and tax specialists who can assist you with this process and help to identify whether or not there is an issue and, if so, implement any required corrective actions to re-establish or preserve relevant shareholders entitlement to Entrepreneurs’ Relief. If you have any queries or would like to discuss please contact Haydn Rogan on 0161 2140517 or email email@example.com.