Entrepreneurs Relief from 6 April 2019
Capital Gains Tax » November 11, 2019
Finance Act 2019 bought in some additional conditions and changes to entrepreneurs relief. Looking through these changes it seems that they are have been implemented to try and reflect the true nature of entrepreneurship and remove some barriers that previous rules inadvertently created. These changes in the most part appear more generous to genuine entrepreneurs.
A number of changes to entrepreneurs’ relief were introduced by FA 2019 and these have been covered in by Pete Miller in Changes to Entrepreneur’s Relief 22 January 2019 and by Kevin Slevin in Entrepreneurs’ relief conditions for personal companies 21 November 2018. As a recap the following changes were introduced:
- tightening up the definition of a personal company for the purposes of a disposal of shares or securities ― applies to disposals that take place on or after 29 October 2018
- increasing the minimum qualifying holding period from one year to two years ― applies to disposals that take place on or after 6 April 2019 (except where the business ceased before 29 October 2018)
- protecting the entitlement to entrepreneurs’ relief when there is a dilution of the individual’s shareholding ― applies to share issues that take place on or after 6 April 2019
This article is going to take a company and run through how the new entrepreneurs’ relief rules will work in practice through worked examples.
The company we will be following is called Tulips Ltd. They have 4 management shareholders Danny, Raheem, Sarah and Rashmi. Their current shareholdings is as follows;
| Tulips Ltd | A £1 Ordinary Voting Shares |
| Danny | 36% |
| Raheem | 28% |
| Sarah | 20% |
| Rashmi | 16% |
| Total | 100% |
Tulips Ltd is a trading company and the management shareholders have all worked for the company for over 2 years. The value of the company is approximately £7.5 million. The shareholders are thinking about selling the company or undertaking a funding round to generate more cash into the business. They are keen to understand how these possible actions will impact their entitlement to entrepreneurs relief.
What’s the position today if they do nothing?
We should first establish if the shareholders are able to claim entrepreneurs’ relief in the current position they are in pre sale or funding round.
Finance Act 2019 introduced two economic tests. Shareholders are only required to meet either of the 2 new tests. These tests must be met for the 2 year period leading up to the event (sale/dilution etc).
New economic tests
This is the original economic ownership test, which is written in as the new s169S(3)(c)(i), TCGA 1992. This requires the seller shareholder to be beneficially entitled to at least 5% of:
- the profits available for distribution to the company’s equity holders, and
- the company’s assets available for distribution to its equity holders on a winding-up.
For these purposes, the legislation applies a modified version of the ‘economic-ownership’ conditions used for the corporation tax ‘group relief’ rules found in Chapter 6, Part 5, CTA 2010.
‘Equity holders’ would typically cover:
- all the ordinary shareholders (which includes some types of preference shares but excludes ‘restricted preference shares’ and
- loan creditors (except most bank borrowing and other commercial loans – see s160 to s164)
If Tulips Ltd receive an offer of 7.5 million to purchase the company. Using the above first economic test all of the management share holders would be entitled to entrepreneurs relief providing all other conditions have been met, as they meet the 5% requirement.
| Tulips Ltd | A £1 Ordinary Voting Shares | Entitled to ER? |
| Danny | 36% | ✓ |
| Raheem | 28% | ✓ |
| Sarah | 20% | ✓ |
| Rashmi | 16% | ✓ |
| Total | 100% |
Unfortunately, the original proposed ‘economic interest’ test created considerable uncertainty, especially for owner-managed companies that had alphabet share structures. There was a justifiable view that many standard ‘alphabet share’ scheme arrangements would not qualify under the new economic test. (See Readers’ forum: Alphabet conundrum Directors’ share arrangements and entrepreneurs’ relief 27 November 2018)
Fortunately, after consultation with the various professional bodies etc, HMRC announced a revised alternative ‘economic test’ on 21 December 2018 – the ‘original’ economic test has not been removed or amended, and can still be used in straightforward cases.
Therefore, for disposals taking place after 28 October 2018, shareholders must satisfy the 5% ordinary share capital/voting rights requirement and one of two ‘economic interest’ tests.
If Tulips Ltd was structured with alphabet shares there is an argument that under the first test, whether a particular class of shares receives a dividend is at the discretion of the directors. Unless the articles give a particular class of shares a right to dividends nothing prevents the directors from distributing all the profits to one class of share or another.
If Tulips Ltd had an alphabet share structure the possible outcome under the first economic test would be;
| Tulips Ltd | A £1 Ordinary Voting Shares | B £1 Ordinary Voting Shares | C £1 Ordinary Voting Shares | Entitled to ER? |
| Danny | 36% | ✕ | ||
| Raheem | 28% | ✕ | ||
| Sarah | 20% | ✕ | ||
| Rashmi | 16% | ✕ |
Therefore in cases of companies with alphabet share structures the second economic test is likely to be used more commonly. This alternative test requires the individual in question instead to be beneficially entitled to at least 5% of the proceeds in the event of a disposal of the whole of the ordinary share capital of the company. It is intended to allow individuals to use their entitlement to sale proceeds as evidence of their economic interest in the company, in circumstances where entitlement to the profits and the net assets of the company cannot be demonstrated.
Using the second economic test
| Tulips Ltd | A £1 Ordinary Voting Shares | B £1 Ordinary Voting Shares | C £1 Ordinary Voting Shares | Entitled to ER? |
| Danny | 36% | ✓ | ||
| Raheem | 28% | ✓ | ||
| Sarah | 20% | ✓ | ||
| Rashmi | 16% | ✓ |
One of the key things to note is that when looking if entrepreneurs’ relief will apply on sale using either test is understanding the potential sale structure of the company and the position of any investors.
We will now move back to the ‘simpler’ company structure where all the management share holders have A ordinary shares. Danny, Raheem, Sarah and Rashmi are all management shareholders and as we can see from Fig 1 based on their shareholdings they would (in principal) all qualify for entrepreneurs’ relief either of the economic tests.
Investment and Preferential Claims
Tulip Ltd have received investment from Daffodil Ltd. Daffodil Ltd have invested £2.5 million into Tulip Ltd which has diluted their total shareholdings from 100% to 25%.
The management share holders checked that their shareholding did not drop below 5% and are confident they would all remain entitled to entrepreneurs’ relief on disposals of the shares and they would like you to confirm the same.
The investment would have the following effect on the shareholding
| Shareholders | A £1 Ordinary Shares nom value | B £1 Ordinary Shares nom value | Ordinary & Voting Shares % | Entitled to ER? |
| Daffodil Ltd | 2,500,000 | 25% | ||
| Danny | 2,700,000 | 27% | ✓ | |
| Raheem | 2,100,000 | 21% | ✓ | |
| Sarah | 1,500,000 | 15% | ✓ | |
| Rashmi | 1,200,000 | 12% | ✓ | |
| Total | 7,500,000 | 2,500,000 | 100% |
As we can see, as all of the management shareholders holdings have been diluted from their original holdings (see fig 1) but they do remain above 5%, therefore, at first glance they would still be entitled to claim entrepreneurs’ relief.
However Daffodil Ltd have a preferential claim for the first £7 million of proceeds on a sale.
This is where advisors need to be particularly careful when it comes to advising on the new 5% tests. As this example shows, where there is a preferential claim we may not be able advise our clients on if entrepreneurs’ relief is available until we know the potential proceeds of the company.
There will be a different entrepreneurs’ relief position for the management shareholders if Tulips Ltd is sold for £10 million versus £20 million
Sale for £10,000,000
Sale proceeds which the management shareholders will be entitled to is £3,000,000. Being £10,000,000 less the £7,000,000 preferential claim. When determining if entrepreneurs’ relief would be available we need to calculate whether
the seller shareholder are beneficially entitled to at least 5% of:
- the profits available for distribution to the company’s equity holders, and
- the company’s assets available for distribution to its equity holders on a winding-up.
Or
The seller shareholder to be beneficially entitled to at least 5% of the proceeds in the event of a disposal of the whole of the ordinary share capital of the company.
We therefore, need to work out what each shareholder is entitled to as a percentage of the whole company on sale.
| Shareholders | Relevant sale proceeds % | Relevant sale proceeds of (£3m) | % of proceeds (£10m) | Entitled to ER? |
| Danny | 27% | 810,000.00 | 8.10% | ✓ |
| Raheem | 21% | 630,000.00 | 6.30% | ✓ |
| Sarah | 15% | 450,000.00 | 4.50% | ✕ |
| Rashmi | 12% | 360,000.00 | 3.60% | ✕ |
| Total | 75% | 23% |
Looking at the percentage of total proceeds column we can see that under this scenario Sarah and Rashmi would cease to be entitled to entrepreneurs’ relief as their entitlement on sale is below 5%.
Sale for £20,000,000
Sale proceeds payable to management shareholders £13 million being £20 million less the £7 million preferential claim
| Shareholders | Relevant sale proceeds % | Relevant sale proceeds £ | % of proceeds (£5m) | Entitled to ER? |
| Danny | 27% | 3,510,000.00 | 17.55% | ✓ |
| Raheem | 21% | 2,730,000.00 | 13.65% | ✓ |
| Sarah | 15% | 1,950,000.00 | 9.75% | ✓ |
| Rashmi | 12% | 1,560,000.00 | 7.80% | ✓ |
| Total | 75% | 9,750,000.00 | 23% |
Using the same tests as in Fig 6, the above table demonstrates, that if the sale price was £20,000,000 then all the management shareholders would remain entitled to entrepreneurs’ relief.
When the sale price increases all the management shareholders are now entitled to entrepreneurs’ relief. This is a an interesting planning point.
We will now need to be explaining to clients that even if after investment they retain their 5% holding if there is a preferential claim on sale this will potentially impact the availability of entrepreneurs’ relief on the sale of the company.
Dilution of a shareholding
The above scenario looked at the position if Daffodil Ltd invested money into the company which did not dilute the shareholders holding below 5% but their preferential claim on sale would potentially impact the entrepreneurs’ relief claim of 2 of the management shareholders.
It is also common for private equity funding to create dilution problems for existing entrepreneurs’ relief-eligible shareholders, where the external investment dilutes their ownership percentage below 5%. Pre 6 April 2019, individuals in those circumstances would cease to qualify for entrepreneurs’ relief completely.
We will now look through the impact of Daffodil Ltd investing £60,000,000 into the company with no preferential claim on exit. The company value pre investment remains £7.5 million.
| Shareholders | A £1 Ordinary Shares nom value | B £1 Ordinary Shares nom value | Ordinary & Voting Shares % | Eligible to claim ER Pre 6 April 2019? |
| Daffodil Ltd | 60,000,000 | 89% | ||
| Danny | 2,700,000 | 4.00% | ✕ | |
| Raheem | 2,100,000 | 3.11% | ✕ | |
| Sarah | 1,500,000 | 2.22% | ✕ | |
| Rashmi | 1,200,000 | 1.78% | ✕ | |
| Total | 7,500,000 | 60,000,000 | 100% |
If this had been done Pre April 2019 Danny, Raheem, Sarah and Rashmi would not be eligible to claim entrepreneurs’ relief on a subsequent disposal of the shares.
Finance Act 2019 now brings some assistance to these shareholders as the changes broadly allow shareholders to crystallise entrepreneurs’ relief on chargeable gains that arise before external investment dilutes their ownership percentage below 5%. The opportunity to capture the entrepreneurs’ relief gain arises immediately before the share issue is made. It is worth noting that the minority discounts that typically apply for fiscal share valuation purposes are switched off here.
This crystallisation is achieved by the individual making an irrevocable election to treat the shares as having been disposed and reacquired immediately before the share issue. The deemed disposal takes place at market value of the shares at that date.
The election to make the notional disposal must be made by the first anniversary of the 31 January following the tax year of the share issue (ie by 31 January 2022 for notional disposals in 2019/20). The election to defer the notional gain must be made within four years of the end of the tax year in when the gain arises (ie by 5 April 2024 for notional disposals in 2019/20).
Looking at the Fig 8 using the post 6 April 2019 rules the shareholders entitlement position changes and all the management shareholder are entitled to elect to capture their ER charge immediately before the dilution.
| Shareholders | A £1 Ordinary Shares nom value | B £1 Ordinary Shares nom value | Ordinary & Voting Shares % | Eligible to claim ER Post 6 April 2019? |
| Daffodil Ltd | 60,000,000 | 89% | ||
| Danny | 2,700,000 | 4.00% | ✓ | |
| Raheem | 2,100,000 | 3.11% | ✓ | |
| Sarah | 1,500,000 | 2.22% | ✓ | |
| Rashmi | 1,200,000 | 1.78% | ✓ | |
| Total | 7,500,000 | 60,000,000 | 100% |
The value of the company pre equity funding round is was 7.5 million, after the funding round where £60,000,0000 was invested into the company, all of the management shareholders will drop below 5% ordinary share capital holding.
If the shareholders wish to keep their entrepreneurs’ relief entitlement they will make a s169SC TCHA 1992 election. This relief only applies on share issues undertaken for genuine commercial reasons and with the shares issued wholly for cash consideration. The gains will be captured as below:
| Shareholders | Danny | Raheem | Sarah | Rashmi |
| % of £7.5 million deemed sale | 36% | 28% | 20% | 16% |
| Deemed Sale Proceeds | 2,700,000 | 2,100,000 | 1,500,000 | 1,200,000 |
| Less negligible base cost | (-) | (-) | (-) | (-) |
| Capital Gain @ 10% | 270,000 | 210,000 | 150,000 | 120,000 |
The gains will be taxable at the entrepreneurs’ relief rate of 10% assuming they have enough value left in their lifetime allowance. However, paying tax at 10% on a deemed disposal is usually undesirable as a dilution of their holdings does not give rise to any cash realisation.
Fortunately a new s169D TCGA 1992 provides an irrevocable supplementary election that enables shareholders to defer taxing their qualifying entrepreneurs’ relief gain until a subsequent actual disposal of the relevant shares. Crucially though, this deferral election does not remove the requirement to meet the other conditions for entrepreneurs’ relief on the final disposal, it simply allows the 5% personal company test to be regarded as met on the final disposal. If, for example, Rashmi was planning on leaving the company in a year (before the final disposal) she should consider the possibility of paying the tax charge pre dilution at 10% rather then on a subsequent disposal when the gain would likely be taxed at 20% as she would cease met the officer of the company test.
| Shareholders | Danny | Raheem | Sarah | Rashmi |
| % of £7.5 million deemed sale | 36% | 28% | 20% | 16% |
| Deemed Sale Proceeds | 2,700,000 | 2,100,000 | 1,500,000 | 1,200,000 |
| Less negligible base cost | (-) | (-) | (-) | (-) |
| Capital Gain @ 10% | 270,000 | 210,000 | 150,000 | 120,000 |
| S 169SD TGCA 1992 election to defer CGT | ||||
Summary
- Where investors have a preferential claim on exit it may not be possible to advise shareholders of their entrepreneurs’ relief eligibility until a proposed sale price has been agreed.
- If there is a dilution of share holdings through investment, if the shareholders wish to capture the gain and then defer the gain until the final disposal of the shares it’s critical to advise them that the deferral only applies to the 5% economic test conditions and all other entrepreneurs’ relief conditions must continue to be being met on final disposal for entrepreneurs’ relief to apply.