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…

Background

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.

The changes to Entrepreneurs Relief

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 therefore applies to all relevant disposals of shares after 29 October 2018.

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 Entrepreneurs’ Relief up to the 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.  

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: 

    1. 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;
    2. hold shares that represent at least 5% of the “ordinary share capital” of the company (by nominal value); and
    3. by virtue of that holding:
      • exercise at least 5% of the voting rights in the company;
      • be beneficially entitled to at least 5% of the profits available for distribution to the “equity holders” of the company; and
      • be beneficially entitled to at least 5% of the assets available for distribution to the “equity holders” of the company on a winding up.

What we essentially now have is a requirement to hold 5% or more of the economic rights in the company in order to qualify for Entrepreneurs’ Relief.

Certain loans and preference shares will also have to be taken into account in applying the new 5% tests which introduces further complexity and uncertainty in applying the new rules.

The impact

The changes to extend the holding period to 2 years from 6 April 2019 are not expected to have a huge impact but will mean that, if intending to give directors and employees an equity stake in the business, it will be important to do so well in advance of 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).

It is the changes to require the shares to confer a 5% “economic interest” in the company that will have a potentially far wider impact. These changes are 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.

The draft legislation to enact these changes could however mean that any company that has more than one class of shares will need to review whether or not they are affected.

A couple of common situations that may be affected are:

Alphabet shares 

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, on a strict interpretation of the legislation, none of the shares in the company (even those held by the founders or majority shareholders) will qualify for Entrepreneurs’ Relief. 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.

Growth shares

Similarly 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.  

Investment backed companies

It is common for investors to require preferential rights to dividends or assets on a winding up 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.

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.

So where are we now?

The legislation to implement the changes is still in draft form and a number of representations have already been made to HMRC (who do not appear to have appreciated the extent of the potential impact of the changes) requesting the legislation to either be amended or for HMRC to issue clarification as to how it will be interpreted and applied. It is hoped that a response will be announced shortly.

It is however important to start considering now whether or not, if no further clarification or changes are forthcoming, you will be 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 and implement any required corrective actions to 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 haydn.rogan@weightmans.com.

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