In his Budget speech on 28 October, the Chancellor announced the widening of qualification conditions for shares in a ‘Personal Company’ to qualify for Entrepreneurs’ Relief (ER). With immediate effect, where a company has multiple classes of shares ALL its existing shareholders may have lost ER if the shares do not rank pari passu.
From Budget day, (in addition to the current requirements to hold 5% or more of the issued ordinary share capital and votes), shareholders must also be entitled to at least 5% of the distributable profits and assets on a winding up of a company. Failing either of the two new tests (or any of the current requirements) means ER is lost.
The problem for ‘alphabet shares’ is that whether a particular class of shares receives a dividend is usually at the discretion of the directors. Unless the Articles give a particular class of shares a right to dividends, nothing prevents the directors from distributing all the profits to one class of share or another. Consequently, no share class may carry an entitlement over the distributable profits, resulting in ALL shares failing that arm of the new test.
It therefore appears that, as the legislation is currently drafted, no alphabet shares will be eligible for ER on disposal unless the Articles rank all share classes pari passu or give a right to a proportion of every dividend declared.
Mr A owns 50 A Ordinary Shares and Mr B owns 50 B Ordinary Shares. The shares rank equally in voting power and assets in a winding up. There are no other shareholders.
The Articles permit dividends to be voted independently between the two classes of share.
Following the Budget announcement, it now appears that neither shareholder will qualify for ER, as they have no absolute right to receive at least 5% of the dividends. This is the case even if, historically, actual dividends have been paid equally between them.
Even if a shareholder was able to take steps to restore relief, as the new rules are already in effect there will be a gap in the qualification period and the shares will need to be held for another 2 years before again qualifying for ER.
A further complexity is that, when considering if an individual is entitled to 5% of the distributable profits/assets on a winding up, the draft legislation uses a definition that covers more than just ordinary share capital. It is therefore possible that an individual could hold more than 5% of the ‘economic’ value attributable to ordinary shareholders, but still fail to qualify based on the company having other instruments in place that fall within the definition of ‘equity’.
For example, it is also likely to affect shareholders where the company has:
- Growth shares (where the shares benefit only on a proportion of an uplift in value)
- Low or nil dividend paying shares
- Ratchet share structures
- Shares with different par (nominal) values
- Convertible securities, preference shares and certain financing arrangements with shareholder loans
- Shareholder or investment agreements referring to restrictions on voting or dividend rights
- Private equity/VC investors (which may include some of the above features).
Indeed, the ER status of shareholders in any company that has more than one class of share, or any debt other than normal commercial bank finance, could be affected by the new rules.
Great care is needed to understand what a client’s ordinary share capital is, as there are cases where taxpayers own 5% of votes but do not own 5% of ordinary share capital – measured on nominal capital. The CIOT recently published a helpful technical note on what may constitute ordinary share capital.
Advisers may wish to carry out a review of clients’ share and debt structures to see if these new rules deny ER for anyone. This should include considering the effect of warrants, options, and other rights of equity holders, such as certain loans and convertible instruments. It may be that changes can be made to mitigate the impact of the new rules.
Where there are EMI options, the impact of both of the above changes should be considered. Although EMI shares themselves will be unaffected by the changes to the Personal Company qualification described above, if those EMI shares are of a different class, their existence could affect ER entitlement for other shareholders.
As intimated above, a further change will apply from 6 April 2019 that extends the minimum period that share ownership and working role requirements that must be met, from 12 months to 2 years. Whilst the change is unlikely to affect a founding or longstanding shareholder, it could make ER more difficult to achieve for management equity awards and EMI option shares, where awards would have to pre-date an exit by two years (as opposed to just one). This means a longer-term view will be required.
In the absence of HMRC guidance on the subject, the above summary is based on our understanding of the draft legislation. We expect representations to be made to HMRC on some of the apparent shortcomings of the new law.
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