Monday's Budget contained the surprise announcement that - with immediate effect - the conditions for obtaining entrepreneurs' relief have been tightened.
Entrepreneurs' relief is a valuable relief, reducing the rate of capital gains tax payable on the disposal of shares in a "personal company" from 20% to 10% on up to £10 million of gains over an individual's lifetime. A number of conditions must be met in order to be eligible for the relief; chiefly that the individual was an employee or office holder in a trading company and held at least 5% of the voting rights and nominal capital in that company for a period of at least a year prior to the disposal.
The introduction of further conditions relating to the economics of the shareholding, and also the holding period, means that many people who previously held qualifying shareholdings and could have expected to obtain entrepreneurs' relief on disposal must now restructure (if possible) or pay double the tax.
Astonishingly – especially as there had been no prior indication that HMRC had any issue with how the relief was being used – there is no grandfathering of existing arrangements. Those hoping to obtain the relief should therefore review their share rights to determine if they remain eligible well in advance of any disposal, although application of the new conditions may not always be clear cut.
What has changed?
Before Monday, the individual merely needed to hold at least 5% of the company's ordinary share capital, allowing him or her to exercise at least 5% of the voting rights. Importantly the share capital test was only calculated by reference to nominal capital rather than wider economic tests. With immediate effect, the new conditions require the individual to be beneficially entitled to at least:
- 5% of the company's distributable profits; and
- 5% of its assets available for distribution to equity holders in a winding up.
The minimum period throughout which certain of the conditions (including those relating to the share rights) must be met to be eligible for entrepreneurs' relief is to be increased from one year to two years, with effect for disposals of shares on or after 6 April 2019. There are special provisions for cases where the business ceased before Monday.
A previously trailed relaxation of the rules allows individuals whose shareholding is diluted below the 5% qualifying threshold as a result of a new share issue to obtain relief for gains up to that time, subject to conditions. This applies where the new share issue takes place on or after 6 April 2019.
What arrangements are affected?
Companies where the economic interest follows the share capital and voting rights will be unaffected, save for the need to ensure that the longer holding period is completed. In addition, any disposal by a partner of a part of their partnership share, regardless of whether the 5% thresholds are reached, has always qualified for the relief (assuming the other relevant conditions are satisfied) so partnership arrangements should also be unaffected, again other than the point on the extended holding period from April next year.
However, shareholding arrangements relying on a high nominal value or enhanced voting rights to tip the individual over the 5% threshold will no longer qualify for entrepreneurs' relief.
Another area which could be of concern is ratchet/waterfall arrangements such as those which involve a fixed sum being paid out to preference shareholders before a proportion is paid out on each of the managers shares and the remainder of the shares. Each separate arrangement would need to be reviewed on an individual basis but the distributable profits test could give rise to real issues in many types of waterfall arrangement.
Comment
The changes are stated to be to ensure that the claimant has a true material stake in the business which is characteristic of true entrepreneurial activity (as distinct from simple investment or employment).
However, many provisions of the tax code include requirements for beneficial economic rights over shares and it is therefore hard to escape the conclusion that the original omission of such conditions from entrepreneurs' relief was deliberate. That is not to say that such conditions are necessarily inappropriate in this context, but to introduce them with no warning and no grandfathering will have significant impact on many, and can only damage confidence in the government's express commitment to support entrepreneurship. Moreover, given the typical ratchet/waterfall arrangements commonly used to encourage entrepreneurial activity, it is hoped that the Government will listen to representations to ensure that those benefiting from such arrangements qualify once valuations are (and have been for two years) such that the shareholder would get over 5% of equity proceeds on a notional exit.
It is particularly disappointing that these changes have been introduced with immediate effect and without prior stakeholder consultation.
