Entrepreneurs’ Relief: Budget Changes
In his Budget speech, the Chancellor confirmed that Entrepreneurs’ Relief (“ER”) is here to stay, with UK entrepreneurs ‘at the heart’ of the Government’s economic strategy.
However, there were two amendments announced which have some surprising results and could catch existing structures and future planning. The changes can be summarised as:
- a doubling of the qualifying holding period from one year to two years; and
- the imposition of a new 5% economic interest test.
ER introduced in 2008, gives an opportunity to reduce the capital gains tax (“CGT”) liability on qualifying disposals of shares. Provided the conditions for the relief are satisfied, CGT at a reduced rate of 10% applies (compared to the normal rate of 20% for higher rate taxpayers), up to a maximum lifetime limit of £10m of gains.
12 months becomes 24 months
Until the recent Budget, one of the key conditions for ER on a share sale (and other qualifying assets) was that, throughout a minimum holding period of at least 12 months before the sale, the company was the entrepreneur’s ‘personal company’; broadly, requiring the taxpayer to hold at least 5% of the ordinary share capital and voting rights in the company.
The minimum holding period has been increased to two years before the individual becomes eligible to benefit, doubling the current 12-month qualifying period. This change comes into force on 6 April 2019, meaning that individuals will need to satisfy the other conditions for ER throughout the extended holding period for disposals on or after that date. The change means that existing shareholdings will be affected in the same way as new shareholdings, without the benefit of any ‘grandfathering’ provisions to ease the introduction of the extended holding period.
Accordingly, this change presents a trap for those who acquired shares or EMI share options in a personal company between 6 April 2017 and 6 April 2018. Applying the current 12-month minimum holding period, ER will have become available in respect of those shares in the financial year from 6 April 2018 onwards. However, when the new holding period comes into effect on 6 April 2019, those same shares will cease to qualify for ER until the longer minimum period has been met.
The second change is an amendment that had immediate effect, which changed the definition of a ‘personal company’. Pre Budget, an individual was required to hold 5% or more of the ordinary share capital with voting rights. From Budget day (29th October 2018) it is now necessary for the individual to have held an interest of at least 5% of the voting rights and 5% of both:
- the profits available for distribution of the company; and
- on a winding up, the assets of the company available for distribution.
Again, no grandfathering provisions or other concessions apply for existing shareholders. Accordingly, this additional requirement restricts the availability of ER not only for future investors, but also for investors already holding shares that would otherwise have qualified for the relief before the Budget.
Even where an individual appears to satisfy the new 5% test, it will be important to ensure that the condition is being tested against the “full pool” of the company’s shareholders. The starting point is that a company’s shareholders will include all of its ordinary shareholders, but will exclude investors to the extent they participate through loan notes or fixed rate preference shares. However, there are some traps:
- Holders of convertible loan notes, warrants, or other debt securities with ‘equity-like’ features will be treated as equity holders for the purposes of the rules, diluting the economic interests of the ordinary shareholders for the purposes of testing the 5% threshold.
- Similarly, there are certain instruments that, although being commercially perceived as fixed rate preference shares, may nevertheless be treated for these purposes as ordinary equity. For example, a fixed rate preference share where the coupon compounds, if not paid could give rise to an issue.
Other examples of where the new rules could cause issues:
- Private equity buy-outs, for example, key managers of the acquired business will typically participate alongside the sponsor, through a tranche of ‘sweet equity’. For several years, it has been market practice to structure that investment to enable key members of the management team to benefit from ER on a subsequent exit. However, a manager’s equity shares will usually represent less than 5% of the dividend and distribution on a winding up of the company and, accordingly, such managers will no longer be able to claim the relief.
- Start-up businesses who rely on external funding are often structured through non-fixed rate preference shares, meaning that it will need to be taken into account when considering whether an individual shareholder meets the new 5% test. Additionally, those shares usually carry a liquidation preference, such that the managers only participate in the residual distribution once a preferred return has been achieved by the fixed rate preference shares.
- Similar problems may arise for individuals holding ordinary shares with terms, such as growth shares that participate only in future growth of the company, or hold shares that only participate once an economic hurdle has been achieved. An individual holding such shares will generally participate in the economics only once an actual distribution or exit has taken place, meaning that it will be difficult for those entrepreneurs to meet the economic test throughout the minimum holding period.
Due to the changes it is important that shareholders check their shareholding against the new ER conditions, but also the old. We have recently inherited a new client, who had a tax enquiry opened into an historic return. It was thought both shareholders (husband and wife) were office holders. However, for some reason, the husband had not be been appointed an office holder and was never paid a salary. With nothing in place to show that he was an employee, therefore ER was not available for the husband.
Please check your company shareholdings, or alternatively ask Harbour Key.