Changes to entrepreneurs’ relief announced at the 2018 Budget have now passed into law. How can you minimise the impact, and why might disposals in 2018/19 cause particular problems?
Entrepreneurs’ relief recap
Shareholders disposing of all or part of their shares in a personal company at a gain have long been able to claim entrepreneurs’ relief (ER) in the right circumstances to pay 10% capital gains tax (CGT) on qualifying gains and assets.
For disposals on or after 29 October 2018, the conditions are tougher to meet. To qualify for ER your clients must now satisfy the following conditions for at least one year prior to the disposal:
- the company must be a trading company or the holding company of a trading group
- the individual must be an employee or officer of the company; and
- the individual must hold at least 5% of the ordinary share capital and voting rights.
One of the following new conditions must also be met:
- the individual must be beneficially entitled to at least 5% of the company’s distributable profits, and 5% of its assets available for distribution to “equity holders” in a winding up; or
- in the event of a disposal of the ordinary share capital of the company, be beneficially entitled to at least 5% of the disposal proceeds.
Extension of holding period
For disposals on or after 6 April 2019, the above conditions must be met throughout the two years preceding the disposal. The reason behind this is unclear as it only gives affected individuals an additional five months to meet the two-year condition. If the tax at stake is significant it could lead to affected shareholders reducing the sale price to secure a sale before 6 April 2019.
Pro advice 1. shareholders that began to meet the conditions between 7 April 2017 and 5 April 2018 will not meet the two-year rule when the changes take effect and may want to reconsider the timing of disposal or risk doubling their tax liability. Keep in mind that a disposal takes place for CGT purposes when a contract becomes unconditional, not when the consideration is received. Therefore, delaying payment until the two-year mark will not alter the availability of ER.
Pro advice 2. Shareholders who have incorporated with the aim of securing a sale could lose their relief overnight.
Protection for dilutions
ER has previously been criticised for discouraging growth, for example, individuals may decide not to issue new shares to investors because this would dilute their own holding to below the required 5%. From 6 April 2019 individuals whose shareholding is diluted below the 5% qualifying threshold as a result of a new share issue will be able to obtain relief for gains up to that time.
Affected shareholders will need to make an election for their shares to be treated as disposed of and immediately reacquired at market value prior to dilution. ER is available on the resulting gain.
Dividends and equity holders
Of the two new conditions, the first is the hardest to meet. Shareholders now need to be beneficially entitled to at least 5% of the company’s distributable profits and assets to secure ER. This is to ensure that the relief is only given to individuals with a true economic stake in the business and on the face of it appears to be a reasonable requirement. However, many companies have been set up with alphabet share structures, typically to shift wealth to younger family members as part of succession planning. Significant costs will have been incurred on advice to ensure the share structure of family investment companies is fit for purpose, both to achieve the desired wealth distribution and to ensure it does not fall foul of anti-avoidance provisions.
Dividends. It will be difficult to demonstrate that some shareholders have been entitled to 5% of the company’s distributable profits where dividends have not been voted, so attention should be given to the rights associated with each share class. Shareholders who have not received a dividend where others have (or have received less than 5%) will be affected. The solution is to change the position at least two years before the sale or ensure the second test is met.
Equity holders. To satisfy option one, clients must also demonstrate that they are entitled to at least 5% of the assets available for distribution to equity holders when the company is wound up. Once again, private family companies are likely to lose out here.
Typical succession planning involves a parent lending capital to a company, which is repaid tax free out of distributable profits. Under this test, the percentage share is calculated before the deduction of the non-commercial loan. Where the loans are large, it is likely that the shareholders’ percentage entitlements will be reduced and they could lose out on ER.
If the shareholder is most concerned with reducing their IHT exposure, the optimum position is to die whilst the company is still trading to ensure 100% business property relief rather than sell the business to secure ER and hold cash in their estate.
Due to the concerns expressed about the practical application of option one, the government added an alternative test. To qualify for ER under this test, shareholders must be able to show that they would be beneficially entitled to at least 5% of the sale proceeds if the ordinary share capital was sold throughout the two-year period. This means that even where there are large non-commercial loans or different dividend rights, individuals can still secure ER. It will be important to revisit share structures to ensure ordinary shareholders can show entitlement to 5% of the sale proceeds.
To complicate matters further, option two wasn’t announced until 21 December 2018, and only applies to disposals after this date. Disposals taking place between 29 October and 20 December 2018 will only qualify for ER if the stricter condition for dividends and equity is satisfied.
Defining ordinary share capital
You may be confident that the shareholder’s shares qualify as ordinary share capital (OSC) but now you will have to determine which other holdings count as OSC. If the rest of the share classes are not analysed carefully, your client could lose out. The definition of OSC is “all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits”.
When applying option two you must ignore the labels attached to different shareholdings, e.g. preference shares, and look at whether the associated rights bring them within the definition of OSC. This may increase the hypothetical sale proceeds, potentially decreasing your client’s percentage entitlement.
HMRC has published some examples which do of course come with the caveat that the specific facts and circumstances of each case may differ. It sets out examples of shares that count as OSC, such as:
- shares with no dividend rights
- a fixed rate of 10% non-cumulative
- a preference share with a right to tiered dividends
- a preference share with two alternate fixed rates.
Review the rights attached to each share class to ensure they qualify, and if they don’t restructuring may be needed. The rules changed three times between 29 October 2018 and 6 April 2019, so disposals during this period may be complex. Ensure you are clear as to the correct conditions to be met.