July 19, 2019

Entrepreneurs’ Relief

Introduction

This valuable tax relief can result in a tax rate of 10% on the sale of a business or the sale of shares. A gain on selling a business or shares is liable to capital gains tax and for higher rate taxpayers the rate of capital gains tax is 20%. This means that Entrepreneurs' Relief can halve the tax charge. However, there is a lifetime limit of £10m. This could be relevant on a single transaction if the value was high enough or to a series of disposals that cumulatively exceeded the threshold. Recent changes to the conditions for the relief to operate make it worthwhile revisiting the circumstances in which the relief will be available.

Businesses and shares

Within the single relief, there are effectively two fairly distinct sets of rules: one set for business sales and one set for share sales. What they have in common is a requirement that the business or shares have been owned for a minimum of 2 years before the sale. The terms of the relief are adapted for shares or assets held by trustees.

Business sales

The business asset form of the relief requires that the whole or that a part of a business is sold or liquidated. For a sale of part of a business to qualify, the test is broadly that there is a viable section of the business that would still be recognisable even when separated from the whole.

Extensions of business sale reliefs

This relief for business sales is extended in two ways:

  1. The first extension is to assets used in the business but only sold after the business has ceased to be carried on by the individual - provided that the gap between the business ceasing and the asset sale is no more than 3 years.
  2. The second extension is relevant on the sale of a business by a partner or on the sale of shares in a company. Assets personally owned by the partner or a shareholder for at least 3 years and which have been used by the partnership or the company for at least 2 years before can benefit from the relief.

Share sales

The share asset form of the relief is available on shares or securities being sold or the company being liquidated. For the two years beforehand, the company must have been a trading company or a company that heads a trading group of companies. During the same period, the individual must have been an employee or director of the company or a group company. An employee or director does not have to work for any minimum amount of time to benefit from the relief and non-executive directors also qualify.

There is a period of grace for a company that has ceased to trade when the shares are sold or the company liquidated: relief is still available provided the sale or liquidation occurs within three years.

If an individual owns a business and then transfers it to a company, the pre-incorporation period can now count towards the two years. Similarly, an individual may receive new shares on a reorganisation or reconstruction and the period of ownership can take account of the ownership of the former shares.

Because of the trading requirement, a property development business can qualify but a property development investment business would not qualify. Relief is available, though, for a furnished holding letting business.

Minimum ownership condition

There is a further minimum ownership condition for shares. The minimum ownership condition is that the individual holds at least 5% of the company's ordinary shares and voting rights in the company. In determining whether an individual holds 5% of the company's ordinary shares, the test is applied to the company's nominal share capital. Because the definition of ordinary shares is so wide, the existence of even worthless deferred shares can skew whether an individual has 5% of the ordinary shares in the company. Similarly, jointly held shares can be a problem because each individual is treated as owning a proportionate part of the joint shareholding. If that proportionate part is less than 5%, relief is not available even if the joint holding is above 5%.

The further minimum ownership condition does not apply to shares acquired on exercise of options granted under the tax-favoured EMI scheme.

Although the minimum ownership condition does not apply to shares acquired on exercise of EMI options, the options themselves must have been held for at least two years before the shares are sold or the company liquidated.

Change to minimum ownership condition

To prevent perceived abuse of the relief by using special shares, the minimum ownership condition has been supplemented by a further 5% test focusing on true economic entitlement. This further test can be met in one of two ways:

  1. The individual must be entitled to 5% of the profits and assets on a winding up; or
  2. The individual must be entitled to 5% of sale proceeds if the entire company was sold.

Crystallising relief on dilution of interest

In the past, the opportunity for relief has been lost if additional capital was introduced that diluted the interest of existing shareholders. It is now possible to elect to crystallise a tax charge and so take advantage of the relief at the point the shareholder's interest falls below 5%. The tax charge benefitting from the relief will be calculated by reference to the gain accrued up to the share dilution.

Only any subsequent increase in value will not qualify for the relief. A further election may also be made to pay the crystallised tax charge only when the shares are ultimately sold.

Takeover issues

On a takeover of a company, shareholders who roll over their shares into shares or loan notes of the bidder need to consider carefully the impact on the effect the exchange will have on the relief. An election may be made to "bank" the relief at the time of the exchange even if this means paying tax earlier than it would have otherwise been due.

If an earn-out forms part of the consideration, the relief may not be available on the earn-out proceeds.

However, restructuring the earn-out may enable the relief to apply after all.