Entrepreneurs’ relief (ER) and its predecessors (taper relief and retirement relief), have existed since the introduction of capital gains tax in 1965 to recognise the contribution of family owned and entrepreneurial businesses to the UK economy, by rewarding the key stakeholders with a lower capital gains tax liability on a disposal.
On 29 October 2018 (Budget day) additional conditions were introduced which changed the way in which ER operates – the changes were designed to prevent abuse of the rules and restrict relief to those entrepreneurs who have a genuine economic stake in their business.
The ‘personal company’ test
Shareholders must meet a number of conditions in order for a sale of their shares to qualify for ER, one of which is the ‘personal company’ test. The changes to this test originally announced in October 2018 would have adversely affected a large number of business owners, many of whom would have been prevented from claiming ER.
Following lobbying by the professional bodies and representations from accounting firms such as RSM, the Government tabled an amendment to Finance (No.3) Bill 2017-19 on 20 December 2018 in respect of the proposed changes to the definition of ‘personal company’ for ER purposes.
The new alternative test
The amendment is a welcome change and should go a long way to resolve the uncertainty for clients affected by the two proposed new conditions which have effect from 29 October 2018, requiring the person disposing shares to be beneficially entitled to:
- 5 per cent of the profits available for distribution to equity holders; and
- 5 per cent of the assets available for distribution to equity holders on a winding up.
The amendment announced on 20 December adds an alternative test to these two new tests. This is that the shareholder must be beneficially entitled to:
- 5 per cent of the proceeds if there were a disposal of the whole of the ordinary share capital of the company.
This test should be of assistance to many clients who will not meet the distributable profits and assets on a winding up tests.
Why is this important?
There was previously concern about how the 5 per cent distributable profits test would be applied and whether shareholders in companies with multiple share classes would qualify for relief. The amendment clarifies that ER should continue to apply in cases where an individual holds a material economic interest in the company but the company directors have discretion over which classes of share receive a dividend.
Similarly, as the new test is assessed by reference to the sale proceeds attributable to ordinary shareholders, concerns around the concept of ‘equity holder’ (which can include holders of loan notes with an above market rate return or which are capable of conversion into ordinary shares) should fall away.
However, there are still cases where shareholders who consider themselves to hold an economic interest of 5 per cent will fail to qualify even under the new alternative test, with shareholders holding growth shares or shares in companies with Articles of Association containing complex ‘waterfall’ provisions (where bands of consideration are allocated in differing proportions) particularly at risk.
When do the changes apply from?
The revised personal company tests apply for share disposals on or after 29 October 2018. However, for the purposes of restricting ER when goodwill is transferred to certain close companies, the effective date for the new proceeds of disposal test is 21 December 2018.
HMRC is working on guidance on the changes that will be published as soon as possible.
The application of the ER rules to proposed transactions can often be a complex exercise that calls for up front specialist professional advice. For more information, please get in touch with Helen Relf or Chloe Ellis.