Entrepreneur’s Relief (ER) is a highly valuable relief from capital gains tax (CGT) allowing individuals to secure a 10 % tax rate on disposals of qualifying shares, up to a lifetime limit of £10 million of qualifying gains. To ensure the relief is targeted as the Government intends, there are certain conditions to be met before it can be claimed.
The main requirements for a disposal of shares by an employee to qualify for ER on disposals on or after 6 April 2019 are as follows:
- Throughout the two years ending with the date of the disposal the company is the individual’s ‘personal company’
- Throughout the two years ending with the date of the disposal, the company is either a trading company or the holding company of a trading group (although relief under separate rules may still be available where a company has ceased to trade within the last three years), and
- The individual is an officer or employee of the company or (where the company is a member of the trading group) of one or more companies which are members of the trading group.
A company is an individual’s ‘personal company’ if they have the following rights:
- Share rights
- At least 5% of the ordinary share capital of the company is held by the individual (by reference to the nominal value)
- At least 5% of the voting rights in the company are exercisable by the individual by virtue of that holding, and
- Economic share rights
- The individual will either have a right to 5% of the company’s distributable profits and 5% of the assets available to equity holders on a winding up, or
- The individual would be beneficially entitled to at least 5% of the sale proceeds had the whole of the ordinary share capital of the company been sold on the day of the disposal.
In determining whether the ER conditions are met:
- A ‘holding company’ is a company with one or more 51% subsidiaries and
- A company or group is a ‘trading company’ or ‘trading group’ if it carries on trading activities and does not carry on other activities to a substantial extent (and as a rough rule of thumb more than 20% is substantial).
The rules above under the heading “economic share rights” were introduced with effect from 29 October 2018 to ensure that ER is only claimed where an individual has a true material stake in the business. As part of the October 2018 changes, the period over which the ER conditions need to be met was increased to two years for any disposals arising on or after 6 April 2019. For disposals prior to 6 April 2019, the qualifying period was one year.
For a shareholder with a 5% ordinary share holding who acquires additional shares and sells them six months later, relief can be claimed on the gains arising on all of the shares. The requirement is that the company is the shareholder’s personal company throughout the qualifying two-year period. The particular shares or securities disposed of do not have to be held throughout that period.
Entrepreneurs’ relief complexity
With such specific qualifying conditions, it is no surprise that difficulties can arise in meeting all the ER tests. Key points that need to be determined for any taxpayer are:
- Which shares constitute ordinary shares?
- How to determine whether a shareholder has 5% of the relevant rights in the two years prior to sale
- How to treat debt and preference shares issued by the company/group
- What impact share exchanges and share reorganisations will have on eligibility.
Where a company has a number of different share classes with varying share rights, the risk that employee shareholders will not qualify for ER is considerably increased.
For example, a recent ruling at the First Tier Tribunal has cast more doubt on the long-held understanding of what ‘ordinary share capital’ means. In Warshaw v HMRC, the Tribunal ruled that preference shares could form part of the ‘ordinary share capital’ of a business where they carry a right to dividends that is cumulative and compounding if preference dividends are not paid on time. If this interpretation is confirmed, it could affect the entrepreneurs’ relief claims of many business owners. However, the ruling relies on a highly technical interpretation of the definition of ‘ordinary share capital’ and, therefore, could be seen as against the ‘spirit’ of the legislation as well as HMRC’s interpretation of it. For this reason, this ruling may yet be overturned in a higher court. Individuals who own ordinary shares in companies that have also issued preference shares should seek advice on their personal position.
Enterprise management incentive (EMI) schemes
EMI plans are the most generous form of tax-advantaged discretionary option plan. Options may be granted up to a limit of £250,000 per employee. However, EMI is only available to smaller companies with gross assets of less than £30 million and fewer than 250 full time (or full-time equivalent) employees that meet certain ‘trading activities’ tests.
The rules governing whether a shareholder qualifies for ER further increase the attractiveness of shares received through an EMI option plan. Broadly, ER can be claimed if:
- The EMI option was granted more than two years prior to the disposal of the option shares, and
- In the 24 months prior to disposal the option holder is an officer or employee within the group and the company is a trading company or holding company of a trading group.
There is no requirement for the company to be the individual’s personal company (ie no 5% holding tests). Where option holders exercise within 90 days of cessation of employment, the 24-month period is applied to the date of cessation so leavers may still benefit from ER. Read more on EMI.
Claiming entrepreneur’s relief
A claim for ER must be made on or before the second 31 January falling after the end of the tax year in which the qualifying disposal is made (ie the time limit for amending an individual’s personal self-assessment tax return).
Takeovers and dilution events
On a company takeover involving a paper for paper exchange, employees can choose to crystallise a gain qualifying for ER rather than allowing the normal ‘no disposal’ rules to operate. An employee may choose to do this if the new shares do not qualify for ER because, for example, the acquiring company is not his personal company. However, this will mean incurring a ‘dry’ tax charge (albeit at a low rate of 10%) as they will not have received cash because of the exchange.
Where shareholders would cease to meet the 5% test because of dilution of their personal shareholdings (perhaps on a takeover or other corporate event), they may be able to make an election to deem a disposal of his shares and crystallise ER immediately prior to that dilution event. This election must be made by the first anniversary of 31 January following the tax year in which the deemed disposal takes place.
If an election is made, the taxpayer would be subject to CGT at ER rates on the notional gain, which would give rise to a dry tax charge as no actual disposal takes place. The individual may make a further election to defer the gain until an actual disposal of the shares takes place. This election must be made within four years of the end of the tax year in which disposal takes place. If a deferral election is made, the shareholder must continue to meet all other conditions for ER (ie the rules other than the 5% test) until the ultimate disposal.
How we can help?
It is important that equity arrangements are reviewed well in advance of a transaction to understand whether shareholders can expect to benefit from ER. We can help with this including reviewing whether shareholders should qualify for the relief.
For help and advice on tax implications of using share plans and changes in corporate capital structures, please contact Andy Goodman or Matthew Emms.
Share plans and incentives