Entrepreneurs’ relief was introduced for disposals of qualifying business assets taking place on or after 6 April 2008. The relief has now been available for over 10 years and is one of the most efficient tax reliefs available to UK entrepreneurs. The relief only applies to individuals or trusts and is not available to companies or personal representatives. The relief has to be claimed (i.e. it is not automatic) and is reported to HMRC on the tax return for the year in which the disposal takes place.
Where the necessary conditions for the relief are met, capital gains are taxed at a rate of 10% – half of the normal main rate. Entrepreneurs’ relief may apply to a disposal of business assets, certain disposals of trust business assets or disposals of qualifying shares. The latter is the subject of this blog.
It should be noted that there is a lifetime limit for an individual of gains qualifying for entrepreneurs’ relief of £10 million. Any gains which exceed this amount are taxed at the main rate of capital gains tax (i.e. 20%). A husband and wife / civil partners each have their own lifetime limit of £10 million; this gives the opportunity for planning where significant gains are expected to be made by a “couple”.
Entrepreneurs’ relief in respect of share disposals
For an individual selling shares, in order for entrepreneurs’ relief to be available, the following conditions must be met throughout the one year period up to the date of the share disposal:-
The company must either be a trading company or the holding company of a trading group;
The individual shareholder at issue must have been an officer or employee of that company or another company in the same group;
The company must have been the individual’s “personal company” during the period. This is defined as a company in which the individual not only holds at least 5% of the ordinary share capital (HMRC regard this as determined by nominal value as opposed to by the number of shares in issue) but also is able to exercise at least 5% of the voting power by virtue of that shareholding. For these purposes, ordinary share capital is defined as all share capital of a company other than shares which only entitle the shareholder to fixed rate dividends.
Entrepreneurs’ relief is also potentially available where a company ceases to trade (such as where it disposes of its business), the conditions above are met in the one year period up to the cessation and the shares in the company are disposed of within 3 years of the date of cessation. Such a disposal could be via a company liquidation, but the impact of the anti-phoenixing rules and the transactions in securities legislation needs to be considered in such circumstances.
Where shares are acquired by the exercise of an Enterprise Management Incentive (‘EMI’) option, there is no requirement that the company must be the shareholder’s personal company for entrepreneurs’ relief to be available. The date that the option was granted must be at least one year before the disposal (or cessation of trade) and throughout that year the trading/holding company and officer/employee requirements must be met.
Potential problem areas
There are several potential areas where problems can and do arise with entrepreneurs’ relief claims.
Need to be an officer or an employee – this is often overlooked by shareholders who do not have a day to day involvement in the company’s trade, or by family shareholders who would otherwise qualify. No relief is available if this condition is not met.
The trading requirement – the company (or group) must be carrying on a trade. The legislation defines a trading company as a company which carries on trading activities and which does not carry on other activities to a substantial extent. This means, for example, that shares in a property investment company will not qualify for entrepreneurs’ relief. A particular difficulty may arise with companies which are carrying on a trade but which are either holding significant surplus cash or have made investments with such cash. Such circumstances need to be considered carefully on a case by case basis to determine if entrepreneurs’ relief may be available. It is possible that the holding of cash on deposit does not amount to an activity and thus may not prevent entrepreneurs’ relief from being available especially if the cash has merely been retained for future use in the trade. However, the holding of investments could amount to a non-trading activity, thus jeopardising entrepreneurs’ relief, particularly if the company managed the investments itself.
Shareholding ‘dilution’ problem – shareholders must hold at least 5% of the ordinary share capital and 5% of the voting rights. However, problems can arise where shareholders have been diluted by other classes of ‘ordinary’ shares. Unexpected dilution can arise in a number of other ways, for example, as a result of the exercise of employee share options. As above, the definition of ‘ordinary share capital’ is extremely wide and variable rate preference shares constitute ‘ordinary shares’ for entrepreneurs’ relief purposes. Where the company has more than one class of shares, the owner managers/key shareholders should regularly monitor their shareholdings to ensure they have not been diluted below the critical 5% ordinary share capital/voting rights threshold.
Share exchanges – often, when shares are sold in a private company, part of the consideration may be shares in the acquirer. Such share exchanges, if structured appropriately, result in no capital gain on the share exchange with the new shares being treated as acquired at the same time and for the same price as the original shares. A difficulty may come when these new shares are sold, as the entrepreneurs’ relief conditions may not apply to this sale. In these circumstances, the legislation allows for an election to be made to treat the share exchange as taxable, with entrepreneurs’ relief thus potentially available. This election may accelerate the timing of tax payments, with potential cashflow issues, but can reduce the overall amount of capital gains tax ultimately payable.
Possible future developments
The Treasury has recently released a consultation document setting out proposals which aim to ensure that individuals who no longer hold a 5% interest in a company, due to a dilution caused by the company issuing shares to raise capital for its trade, may still be entitled to claim entrepreneurs’ relief. Whilst these proposals are not yet law, and may indeed be amended, the intention is for these new rules to take effect from 6 April 2019. The proposed changes will not fully address the dilution problem as set out above.