Entrepreneurs' relief - avoiding the pitfalls

Finance Act 2019 introduced significant changes to the eligibility tests for Entrepreneurs’ Relief (ER), particularly regarding the disposal of shares in a trading company. ER is a generous relief that reduces the rate of capital gains tax to 10% on certain disposals of business assets, including shares, by individuals. The new rules impose stricter tests of eligibility, so it is important to consider the capital and debt structures of a business to avoid losing this valuable relief. Alongside the FA 2019 changes, HMRC has released updated guidance following recent tax cases on the meaning of ‘ordinary share capital’.

The new rules

To qualify for ER on the disposal of shares in a trading company, an individual must have owned at least 5% of the ordinary share capital of the company and, by virtue of that holding, be able to exercise at least 5% of the voting rights. A further economic interest measure applies for disposals on or after 29 October 2018 which require the individual to also be beneficially entitled to:

• Condition 1: at least 5% of the profits available for distribution to equity holders and, on a winding up, at least 5% of available assets; or
• Condition 2: at least 5% of the proceeds in the event of a disposal of the whole of the ordinary share capital of the company.

The minimum period throughout which all the qualifying conditions must be satisfied increased from one to two years from 6 April 2019. The extension to the holding period will also affect shares acquired via EMI options.

Changes have also been made to protect relief for entrepreneurs on dilution of their interests where a business needs to issue further share capital to grow. An election is required.

What are the pitfalls?

Condition 1 is measured by reference to ‘equity holders’, which is a much wider definition than ‘shareholders’. Non- commercial loans and preference shares can fall within the definition of ‘equity’ for these purposes. The calculation for company ownership is therefore diluted compared to ownership based only on ordinary shares. A shareholder owning 5% of the ordinary share capital who was eligible for ER before these changes may no longer qualify because of equity investment in the company with preferential rights attached.

Certain types of employee share arrangements such as growth shares or ratchets are now less likely now to qualify for ER as entitlements at the discretion of senior management, or within side agreements or based on future financial hurdles being met must be ignored.

To calculate beneficial entitlement to distributions of profits and assets, the taxpayer will need information from the financial results of the company that cover the two year period before disposal. Given that the company accounts may not be finalised for several months after the year end, the taxpayer may not be able to determine whether or not he qualifies for ER at the date of disposal, except in simple cases where there is only one class of share or the proportionate interests of each class of share are fixed.

Condition 2 is usually the simplest condition to apply. It is based on the shareholder’s beneficial entitlement to proceeds in the event of a hypothetical sale of the whole of the ordinary share capital of the company, at market value. The market value of the company’s ordinary share capital at the date of disposal is deemed to have been the value of the ordinary share capital throughout the minimum shareholding period. Minority discounts are ignored here as well as holdings that do not meet the definition of ordinary share capital.

Particular care should be taken over shares described as preference shares. In the recent case Warshaw v HMRC, ordinary share capital was found to include preference shares entitled to a cumulative dividend that was calculated as a percentage of an amount that was not itself fixed.

In addition to rights inherent in the shares, consideration is given to all circumstances surrounding the shares. It is therefore important to carefully examine Articles of Association, shareholder agreements and any arrangements in place that alter the proportionate interests in the event of an exit, to ensure that the shareholder’s entitlement to proceeds is calculated correctly.

How can Smith & Williamson help?

Our tax specialists can analyse your company ownership and debt structures to advise on your eligibility for this valuable tax relief. Smith & Williamson has a wealth of experience in ER and advising on business exits, whether you are preparing to exit a business or planning for the future.

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.