Following the 2018 Autumn Budget, anyone planning to claim Entrepreneurs’ Relief against their Capital Gains Tax bill needs to urgently review their position to ensure they still qualify.
Tax Partner Paul Morris explains.
Shareholders in companies with different classes of shares – alphabet shares, for example – could find themselves in the soup.
Such shares will not qualify for relief on disposal unless they broadly have a right to 5 per cent or more of every dividend declared and also the Company’s assets on a winding-up.
Entrepreneurs’ Relief (ER) is valuable because it halves the rate of Capital Gains Tax (CGT) from 20 per cent to 10 per cent on disposals of shares in a company on up to £10m of lifetime gains.
Before the Autumn Budget, for ER to apply an individual had to meet three key conditions for a 12-month period prior to the date of disposal of shares:
That has now changed with effect for disposals of shares on or after 29 October 2018.
Two new restrictions have been introduced in Schedule 15 of the Finance Bill published on 7 November 2018. Although they are subject to Parliamentary approval before becoming law, and could therefore change, this article assumes they will become law as is.
For disposals of shares on or after 29 October 2018, the individual must now meet two extra tests (in addition to the three mentioned above):
The changes pose potentially serious issues for companies that have more than one class of share. This might include companies that have undertaken management buy-outs (MBOs) in the past, have Private Equity (PE) Investment, or have implemented other share arrangements involving multiple share classes (e.g. for example, A & B shares to pay differential dividends or growth share schemes etc)
The new tests look at the “beneficial entitlement” of the shares to profits available for distribution, i.e. dividend. Such rights are usually set out in the Company’s Articles of Association.
A common feature of private company Articles, where there are multiple share classes in issue, is the ability of the Board to declare dividends on any class of share as it may choose from time to time, potentially to the exclusion of other classes (i.e. Board discretion).
Where this clause exists, and unless each shareholder holds the requisite percentage of every single class, it would appear difficult to say that the shareholder has the ‘beneficial entitlement’ to 5% of any dividends declared (as a dividend could be paid one class but not others, or vice versa) .
If this is how the new rules are applied, the outcome could be that no shareholders will meet the conditions for ER, including Founder shareholders – even if they may hold the majority of the shares and equity value of the Company.
A similar rule now looks at the entitlements of ‘equity holders’ to receive at least 5% of the Company’s assets on a notional winding-up.
Rather than focusing solely on the rights attaching to “ordinary shares”, the new rules consider the amounts that would be payable to “Equity holders”.
This widened definition may bring certain Preference shares or Loans into the equation in considering entitlements of ‘Equity holders’ on a winding-up. This could again be an issue for many Private Equity backed businesses.
If Preference shares or Loans do fall within this criteria, then it could mean that other shareholders may not then meet the requisite percentages of the Company’s assets on the notional winding-up.
Coupled with these extra tests is an additional hurdle in that for disposals of shares on or after 6 April 2019, the qualifying period of 12 months is doubled to 24 months.
That means that if you need to make any changes to your arrangements now to meet the two extra tests mentioned above, you will have to wait 24 months (not 12) to ensure all five tests are met for the qualifying period for a post April 2019 disposal.
Shares derived via EMI (relevant EMI shares) do not need to meet the 5 per cent tests, so growth share arrangements may still be structured and be eligible for ER where EMI can be used.
The 1 year holding test for the EMI option/shares will however extend to 2 years from 6 April 2019.
The danger with EMI shares is that where such shares are of a separate class, their existence could affect the entitlement to ER for other shareholders. This could result in a situation whereby the employees are eligible for ER on sale, whereas Founder shareholders do not qualify.
The Finance Bill has also introduced a new positive measure for disposals on or after 6 April 2019.
Where an existing sole trade or partnership business has incorporated into a LTD company, the ER holding period in relation to the shares in the new company can be extended, taking account of the ownership period over which the previous business was owned – such that the shares in the new company could qualify for ER on day one.
This may be useful where a business needs to be incorporated prior to an onward sale within a short period of time.
However, for the relief to apply, the Incorporation needs to have transferred the “whole of the business and assets” (except cash), and the shares have been issued in exchange (effectively as consideration).
Another positive change in the Finance Bill assists those whose shareholdings fall below the 5 per cent qualifying threshold as a result of new shares being issued by the company for new funding. This measure has effect for shares held at the time of fundraising events which take place on or after 6 April 2019.
Where such new funding takes place (where the new share issue is for cash, subscribed for genuine commercial reasons), an individual whose holding is diluted to below 5 per cent can “elect” to crystallise a notional disposal and reacquisition of shares to create a gain against which ER can be claimed.
For shares, the notional consideration is based on the value of the shares, assuming the ‘whole company’ had been sold at that time – potentially avoiding any adjustment for minority discounts/ size of holdings.
An individual may also elect to defer the gain to the point of an actual future disposal of the shares, to potentially avoid a dry tax charge.
As stated above, these provisions apply for share issues post 5 April 2019.
This is a potentially useful relief for early stage investors in companies that may subsequently seek to raise further funds from external investors or private equity, which could naturally result in dilution below the 5% limits.
Firstly, it is vital that no decisions are taken without first obtaining appropriate professional advice based on a review of the existing arrangements or plans in place. The arrangements already in place may meet the new conditions, but equally may not.
The changes announced in the Budget taking effect on 29 October 2018 are subject to the 2018 Finance Bill receiving Royal Assent, which will probably be in March 2019. Should the rules be enacted as drafted, then they will be effective from 29 October 2018 and this could mean that certain shareholders ceased to qualify for ER on this date.
Where shares have ceased to qualify, it may be possible to make changes to share rights under the Articles to seek to restore the ER position. However, as there will have been a gap in the ER history, those shares will then need to be held for a further 2 years for ER to be restored – given that the new 2 year holding period will come into effect from 6 April 2019.
HM Revenue & Customs (HMRC) do provide an ER pre-clearance procedure in relation to material uncertainties arising from legislation, so it may be possible in some cases to clarify the treatment of company share structures with HMRC once the legislation is finally enacted, probably around March 2019. HMRC may also issue some guidance on these rules in due course.
In the meantime, there is a considerable amount of uncertainty as to what the new rules mean and how HMRC will seek to apply them in practice. As with all such considerations, professional advice is essential before undertaking any action, or before refraining from acting.
If you would like to discuss how these changes affect your plans to dispose of your shares, please contact a member of our Business Tax team.