HOMEPAGE NEWS MEDIA CENTER
13 Jun 19

As many start-up/scale up businesses receive some form of private equity investment, recent changes in legislation relating to Entrepreneurs’ Relief may have a big impact on the net cash available to shareholders on a disposal or exit.

There have been some changes to the qualification rules for Entrepreneurs’ Relief (‘ER’), which will affect business owners hoping to get the lower rate of 10% capital gains tax (‘CGT’) on a disposal of their shares or business interests. 

The new qualifying conditions for disposals of shareholdings (of trading companies) are as follows:

  • There is now a two-year qualification period increased from 12 months previously.
  • In addition to the 5% voting rights/5% share of assets on a winding up there is an alternative test of 5% of the sale proceeds. This resolves an issue surrounding alphabet shares that was an inadvertent product of the proposed changes.
  • There is a new dilution relief, effectively preserving ER entitlement to date when new, usually private equity, investment is made diluting existing shareholders below 5%. This is done by triggering the gain and deferring the tax charge until the subsequent actual disposal.

Two years not 12 months

From 6 April 2019 the qualification period has been extended to two years. This includes straightforward disposals as well as disposals (such as distributions on winding up) after that date where the trade ceased before. This is, however, unfair to such cessations before the announcement of the changes on 29 October 2018, where the new rules were not envisaged. So, cessations prior to that date only need 12 months qualifying ownership, even if the actual disposal occurs after 6 April 2019.

Personal company test

This test now requires the individual to hold:

•        5% ordinary shares/5% voting rights, plus

•        5% dividends/assets on a winding up (as available to equity holders) or

•        5% proceeds of sale of whole of ordinary share capital.

These tests apply for all disposals after 29 October 2018. However, the third test was not added until 21 December 2018 and not related back to October. Therefore, there is a danger that a disposal between 29 October 2018 and 21 December 2018 will not have the benefit of the third test.

The third test rescues alphabet shares where the was arguably no ‘right’ to dividends.

It also removes another problem posed by the equity holders test, in that loan notes and preference shares count towards the 5% assets on a winding up rule.  Now this is also irrelevant provided that sufficient interest in the sale proceeds of the ordinary shares is held.

This assumes the preference shares are not treated as ordinary shares.  There are a number of occasions where they could be (essentially where their return is dependent on the company profits, including certain types of cumulative preference share).

Care also needs to be taken when additional investment is made, usually by PE investment. Certain ‘Growth Share’ schemes and ‘Waterfall’ arrangements can cause a loss of ER where it may otherwise be expected to apply.  If the qualification is value-related, then ER should be preserved as long as the qualification happens at the point of disposal; however, if it is time-related then there could be an issue. Changing the rights to ensure qualification may be possible, but require careful and early planning.

Dilution relief

As mentioned above, if new share issues cause existing shareholders to be diluted to below 5%, they may elect to crystallise their gain, at ER rates, and defer the payment of that tax until the actual disposal of the shares.  Any subsequent uplift in value would be charged at the usual non-ER rate.  Whilst this is an important and useful relief, it should be borne in mind that the election can have a negative effect if the company loses value greatly after the dilution.

There are also issues with the new rules where Enterprise Management Incentive (EMI) options are exercised on sale diluting existing shareholders, and with ‘company purchase of own shares’ arrangements.

If you have any questions raised by the above, please do not hesitate to contact Trevor D'Sa tdsa@haysmacintyre.com.