An update on the below has been published here.
The recent Budget announced changes to the entrepreneur’s relief (ER) legislation. These changes could potentially impact upon the ability to claim this relief and to access the 10% rate of capital gains tax on share disposals. As a result, any companies with different classes of share in issue, including “alphabet shares”, or preference shares / ordinary shares with preferential rights, should review the position to see if their shareholders will be impacted.
For an individual selling shares, in order for ER to be available, the company must have been the individual’s “personal company” throughout the relevant qualifying period (currently one year ending with the date of disposal and increasing to two years from 6 April 2019).
The Budget has introduced, effective from 29 October 2018, changes to the definition of personal company. These changes were unexpected by the profession and were not the subject of prior consultation.
The definition previously required that, to potentially obtain relief, the individual held at least 5% of the ordinary share capital, and that this holding of ordinary share capital entitled them to exercise at least 5% of the voting rights. Ordinary share capital is defined as “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.”
The recently published Finance Bill narrows this definition, by adding two further 5% tests relating to profits available for distribution and assets available in a winding up. Only rights that the individual has from the holding of ordinary share capital are taken into account in assessing the 5% test. If they have any of these rights arising from any other type of share or instrument, these would not count towards meeting the 5% test.
The Finance Bill sets out that a company is a “personal company” if the individual –
- holds 5% of the ordinary share capital of the company, and
- by virtue of that holding –
- may exercise at least 5% of the voting rights in the company,
- is beneficially entitled to at least 5% of the profits available for distribution to the equity holders of the company, and
- would be beneficially entitled, on a winding up of the company, to at least 5% of the assets of the company available for distribution to equity holders.
The definition of equity holders includes a person who holds ordinary shares or is a loan creditor of the company (generally banks will be excluded from this) in relation to a loan other than a normal commercial loan.
In the past, it was usually quite easy to determine whether a company was the personal company of an individual. However, with the new definitions, it will in many cases be a significant exercise to determine what the “profits available for distribution to the equity holders” or “assets of the company available for distribution to the equity holders on a winding up of the company” actually are.
It will be necessary to first establish who the equity holders are, which will mean considering:-
- For each type of share, whether this is an ordinary share, or whether this is a restricted preference share; and
- For each loan creditor, whether this is excluded by virtue of being a normal commercial loan.
The definitions for each are complex and satisfying these criteria will not always be easy to determine.
These tests will need to be considered throughout the two year period (post 5 April 2019) up until disposal, and it could be possible for them to be met some of the time, but not all of the time, without any changes to the individual’s own holding. Indeed, it could be difficult for a minority shareholder to assess whether his own shares qualify or not, as there may be insufficient information available to him; especially to determine what the loan creditors have been throughout the qualifying period, and which of these does or does not constitute a normal commercial loan.
There are a number of examples which may be caught, which do not on the face of it appear to be the target of the legislation:-
A Venture Capital investor insists on preferential share rights
It is common practice that a VC, when investing in a company, might invest in a new class of share, which gives them a preferential right in relation to dividend rights and assets in a winding up, equivalent to the amount of capital that they have contributed. This ensures, in effect, that they will get their investment back before other ordinary shareholders receive anything. However, growth essentially still accrues to all ordinary shareholders in their equity ratios.
Early on, where the VC investment swamps the company’s balance sheet, it seems likely that all other shareholders would become ineligible for ER.
As the company’s balance sheet grows, then some other shareholders would slowly return to qualifying status, but two years would be required from when the mathematical test is met by an individual shareholder before they would be ER qualifying.
The smaller the individual’s holding, the more the balance sheet will need to grow before ER qualifying status would be achieved again. A shareholder with exactly 5% of the ordinary share capital would never retrieve their ER qualifying status, as long as the preference right exists.
On the face of it a variation in the structure, where the VC holds both normal ordinary shares and a separate fixed rate preference share, might work better for ER.
We commonly see various arrangements where separate classes of ordinary share have been brought into existence, allowing directors to dictate upon which class of share a dividend should be paid.
It is possible that these shares may not therefore be “beneficially entitled to at least 5% of the profits…”, as they do not have any actual entitlement (as it is at the discretion of the directors).
As such, the holders of such shares would appear to lose their entitlement to ER.
It would seem that the holder of an ordinary share that sat alongside such shares could also lose ER; again, they are not entitled to 5% of the profits, as the directors may choose to pay them all on other classes of share.
HMRC stated that the new rules are not intended to impact upon family companies; but such companies commonly use Alphabet shares for reasons which are not tax motivated.
Newco may acquire Target company under an MBO where an element of consideration is deferred using loan notes issued by Newco to the vendor. The management team might own all the ordinary share capital of Newco, or the vendor might also receive some consideration in the form of shares in Newco.
It would not be uncommon for the loan notes to be convertible into share capital if Newco defaults on redemption of the loan note. Such conversion rights would seem to prevent the loan notes from being a “normal commercial loan” again potentially impacting upon ER.
No doubt there will also be other situations that are caught.
The changes introduced with effect from 29 October 2018 have the ability to adversely impact upon the availability of ER. More than ever, advice should be taken as early as possible to determine whether ER is likely to be available on a share disposal.