The good news for those business owners who were listening to the Budget speech on 29 October was that the Government is committed to keeping capital gains tax (CGT) relief for entrepreneurs. This is despite coming under pressure to abolish the favourable entrepreneurs’ relief (ER) which was expected to cost the Exchequer an eye watering £2.7bn in 2017-18 – far more than originally anticipated.
ER provides a 10 per cent rate of CGT (half the main CGT rate) on lifetime gains of up to £10m for individuals selling qualifying business assets – for example, shares in their personal trading company.
Changes to the holding period
There were, however, some ‘tweaks’ to the rules which at first sight, seemed relatively harmless – for example, an extension of the qualifying period from one year, to two years to support longer term business investment. This was relatively easy to foresee and not unreasonable, on the basis that most genuine entrepreneurs will own the business that they have founded or grown for at least a two year period. It is worth noting that this change applies to disposals on or after 6 April 2019 – which gives a small window of opportunity for anyone who currently meets the one year qualifying holding period requirement but who will want to sell before they meet the new two year qualifying period test. Advisers are already rolling up their sleeves in readiness for a flurry of business sales in the run up to the end of March 2019.
Changes in the qualifying tests for shareholders
Further changes to the qualifying conditions were set out in the Budget documents to tackle misuse of ER and to ‘address an identified abuse of the current rules’. Again, this sounds fair enough, but it is these changes that have caused concern since Budget day as the wide-ranging ramifications have emerged.
The changes relate to the ‘personal company’ test, which must be met by individuals who want to claim ER on a share sale. For a company to qualify as a ‘personal company’ a shareholder now needs to hold 5 per cent of ordinary share capital and voting rights and be beneficially entitled to 5 per cent of available distributable profits and 5 per cent of the assets available for distribution on a winding-up.
Where a business has one share class, this may not sound complicated, as one would assume that they will typically participate in dividends and net assets pro rata.
However, even small businesses often have multiple share classes. Where there is more than one share class, careful thought needs to be given to whether an individual is beneficially entitled to 5 per cent of distributable profits. If the Articles of Association are silent on this point, or state that dividends are at the discretion of the board, is the condition met? We need to know what HMRC’s approach to this will be and how it will apply the new test. Clarity is clearly needed.
The net asset test creates further complexity. This new provision will undoubtedly impact companies with certain types of share incentives, such as growth share plans or private equity type share structures with ratchets and ‘waterfall’ arrangements, where the net assets are not divided pro rata between shareholders.
A word of warning
For those that think there is an easy fix and rush to amend the company’s Articles of Association, a word of warning is needed. If the share rights are changed to grant fixed rights to dividends and net assets, this may well result in an increase in value of relevant shares and consequently an income tax charge under employment related securities legislation may arise. Arrangements specifically designed to secure ER may well also fall into the territory of the general anti-abuse rule (GAAR). Tax advice should be sought before acting.
What are the options now?
To ensure that the new conditions are met, shareholders will need to closely monitor their position over a two year period prior to disposal.
It is notable, however, that the 5 per cent tests do not apply to shares acquired under an enterprise management incentive (EMI) plan, so this is likely to become an increasingly popular way to deliver equity and incentivise management teams.
For business owners with an exit on the horizon, it may now be worth considering whether a sale to an employee share ownership trust is feasible, an option which can deliver a zero rate of tax on sale.
In the meantime, for those with the luxury of time to plan ahead, it may be possible to implement share structures which do not fall foul of the new rules from the outset.
For those on the brink of a sale, urgent advice should be sought.
For more information please get in touch with Helen Relf.