Budget sees important change to entrepreneurs' relief

Napthens - December 5th 2018

November’s budget introduced an important change to entrepreneurs’ relief.

Entrepreneurs’ relief is a key aspect of tax planning for any business owner. Selling capital assets at a profit normally attracts a capital gains tax charge of 28% if you are a higher rate tax payer. If you qualify for entrepreneurs’ relief this reduces the tax charge to 10%. This is particularly relevant for shareholders in private companies.

Until now, qualifying for the 10% reduced rate required you to hold shares which comprise at least 5% of the voting rights and 5% of the ordinary share capital of the company for 12 months. You must also be an officer or employee of the company during that 12 month period. Holding 5% of the ordinary share capital was interpreted as holding 5% of a company’s nominal share capital. So if you had 5,000 shares of £1 each out of a total capital of £100,000 then, even if the other £95,000 was made up of 9.5million shares of 1p, it would meet the test.

November’s budget has changed things so that:

  • the qualifying period of 12 months is increased to 24 months from 6 April 2019, although sales before that date receive the benefit of the 12 month test
  • the 5% test has been tightened up so that from 29 October 2018 it requires you to hold:
    • 5% of the ordinary share capital; and
    • 5% of the voting rights; and
    • an entitlement to 5% of the profits available for distribution (new test); and
    • an entitlement to 5% of the surplus assets on a winding up (new test).

This may impact you in a couple of areas:

  • first, many companies have "alphabet" share classes where shares are designated as A, B, C etc and the company is able to declare dividends on different classes of share at different rates or not at all. There is now a question whether this discretion compromises the requirement for an entitlement to 5% of the profits under the new test. If dividends above 5% have been paid upon the shares as a matter of custom and practice (and particularly during the two year qualifying period for holding the shares) then there is a stronger argument to enjoy the relief, should HMRC object
  • second, some companies have incentivised key people through "growth" or "flowering" share schemes. This is where the existing value of the company is "ringfenced" and a new shareholder (usually a senior executive charged with creating growth) is given relatively low value shares which only accrue value as the company's worth increases above the "ringfenced" value. The concern is that if the return received does not equal at least 5% of the whole value from the first pound then the growth shares will not attract entrepreneurs' relief at 10%. You might look to address the risk by offering a percentage above the ringfenced amount which is well in excess of 5% if that is acceptable commercially or to allow the growth shares to either participate from the first pound or catch up, but this would likely make them more valuable now and more expensive to acquire.

The feeling is that the budget goes further than attempting to cure the mischief of companies trying to create strange classes of share as a means of receiving the relief. Whilst we may see better clarification in the final legislation, do speak to us before putting in place arrangements which deal with alphabet shares or growth schemes. Importantly, there is no requirement to fulfil the 5% test when receiving shares through an EMI share option scheme, so it is worth exploring that structure.

As always, if you'd like further advice on this, or any business matter - get in touch