Entrepreneurs Relief – Key changes to note
Entrepreneur’s Relief (ER) is a very valuable Capital Gains Tax (CGT) relief for business owners which gives a preferential rate of 10% tax on qualifying gains from disposals, as opposed to the standard 20% higher rate of CGT.
The Finance Act 2019 introduced a number of key changes to ER including tightening up of the qualifying criteria.
In this article, we recap the rules and take a look at the changes which apply to disposals since 6 April 2019, with the following gains qualifying for the relief, subject to a lifetime limit of £10m:
- the disposal of shares and securities (for example loan notes) in a personal trading company
- a material disposal of any business operated as a sole trader or partnership, and
- subject to certain conditions, assets owned personally but used in a company or partnership. These are known as associated disposals (covered later in this article).
Disposals can arise on the sale, gift or winding up of the business.
New qualifying criteria
To qualify for the relief, sole trade and partnership businesses must now be owned throughout the two years prior to disposal, rather than the 12 months qualifying period since the rules were introduced.
The new rules for shares and securities are more complex. In order to qualify, the following conditions must be met by the company and shareholder throughout the two years prior to disposal:
- the shareholder must be an employee or office holder of the company
- or another in the same group
- the company must be a trading company or holding company of a trading group
- for Enterprise Management Incentive (EMI) Share Option Scheme shareholders: the EMI option must have been granted at least two years prior to disposal
- for Non-EMI shareholders: the shareholder must hold at least 5% of the ordinary share capital and 5% of the voting rights. They must now also meet at least one of the following tests:
- beneficial entitlement to at least 5% of the distributable profits and, on winding up, to 5% of net assets, or
- in the event of disposal of the whole ordinary share capital, beneficial entitlement to at least 5% of the total proceeds.
Tax planning with alphabet shares
Alphabet shares are a commonly used tax planning structure as they allow flexibility in terms of dividend payments. However, when the Chancellor initially announced the rule changes back in October 2018, there was uproar amongst the tax profession, fearing that previously qualifying alphabet shares would not meet the new rules due to their discretionary nature.
The good news is that the Government listened to concerns and added the alternative dilution test; alphabet shares can therefore still qualify for the relief as long as it would be reasonable to expect that they would be entitled to at least 5% of the disposal proceeds in the event of the disposal of the whole ordinary share capital.
Dilution of shareholding
Another welcome update to the rules is the availability to ‘bank’ ER on shares if the 5% criteria are no longer met due to the issue of new shares in the company. This will be particularly useful for founder shareholders seeking outside investment from venture capitalists or other sources.
An election can be made to bank the relief on qualifying shares. The CGT can either be paid at that point or an election can be made to defer the tax payment until a subsequent disposal of the shares.
Company ceases to trade
A disposal can still qualify for the relief as long as the criteria were met throughout the two years prior to the cessation of the trading and the disposal date is within three years of cessation.
Gains on disposals of personally owned assets used in a partnership or company can also qualify for relief. The disposal must coincide with a material disposal and withdrawal from the business.
The asset must have been used in that business during the two years prior to this disposal/cessation of the business and been owned by the individual for at least three years.
If the individual has previously charged rent for use of the asset, the gain eligible for ER will be restricted on a just and reasonable basis. There are also restrictions if the asset had not been used in the business throughout the individual’s ownership or if only part of the asset had been used in the business.
Making a claim
The usual time limit to claim ER is the first anniversary of 31 January following the year of disposal. For example, if you sold your business during the 2019/20 tax year you would have until 31 January 2022 to make a claim.
The key point to remember is that the qualifying period has been extended to two years from the 12 months previously.
Act now in order to take advantage of the full tax relief
This doubling of time limit for qualifying holdings, together with restrictions on specific share classes does mean careful consideration and review of existing share structures is strongly recommended. As with any tax relief, planning is essential because as Benjamin Franklin famously said “By failing to prepare, you are preparing to fail.” ER offers a very attractive tax rate and with the extended qualifying period in order to be able to make a claim, it can be very frustrating to find that your tax bill will be doubled when a sale process starts, when action could have been taken beforehand.
This article is a part of the UHY Hacker Young “Prosper Magazine” Third edition of 2019. Read the full magazine here.