Entrepreneurs' Relief - Filling the gap
In our previous post on this subject following the Autumn 2018 Budget, we considered the changes to the qualification criteria which must be met so that individuals can benefit from the reduced capital gains tax rate on gains made following the sale of their shareholding in a trading company.
As a quick recap, the changes introduced:
- An extended holding period for shares of two years will apply to disposals with effect from 6 April 2019; and
- With effect from 29 October 2018, new 5% tests were introduced in relation to the shareholding so that in addition to having to hold 5% of the ordinary share capital of the company entitling the individual to exercise at least 5% of the voting rights, individuals must also be beneficially entitled to 5% of the distributable profits and 5% of the company's assets available for distribution to equity holders on a winding-up.
HMRC's policy objective in implementing the new tests was to ensure that the claimant of the relief could demonstrate a "true material stake" in the company because such an interest "is characteristic of true entrepreneurial activity" (HM Treasury, Autumn 2018 Budget, Entrepreneurs' Relief: definition of a 'personal company', pg127).
The difficulty with the new 5% test, though, is the application of the rules to determine who an "equity holder" is for the purposes of the relief. The legislation to determine an equity holder is complicated, requires detailed analysis of complicated share structures (including debt instruments and preference shares) and was never designed to apply to individuals investing in the entrepreneurial environment. Moreover, because the reference is to "equity holder" rather than to "ordinary shareholding", structures such as alphabet shares and growth shares which are common place in private companies could be ineligible for relief under this test.
In recognition of the concern surrounding the application of the new test, an alternative test was introduced on 21 December 2018 with effect from 29 October 2018. The impact is that individual shareholders must comply with the original 5% requirement in relation to ordinary share capital and voting rights and then be beneficially entitled to either i) 5% of the distributable profits and 5% of the company's assets available for distribution to equity holders on a winding-up; or ii) at least 5% of the proceeds in the event of a disposal of the whole of the ordinary share capital of the company.
As a means of proving a "true material stake", the new alternative test is simpler to apply. An individual will have to show that:
- In the event of a hypothetical sale of the whole of the company, they will be beneficially entitled to 5% of the ordinary share capital of the company. This is an easier task that does not require taking into account debt instruments and preference shares; and
- The amount to which the individual is entitled in the event of such a sale is the amount of the proceeds to which it would be reasonable to expect the individual to be beneficially entitled.
An important impact of the change is that it may enable individual shareholders to be able to dispose of their shareholdings before the new holding period for shares becomes effective. If a shareholder can show that they comply with the original 5% rule and the new alternative test in relation to the disposal proceeds and they have held those shares for a period of 1 year, the relief may be available to them. Certainly, it does help assist in deal structuring to know that alphabet shares are not entirely persona non grata and growth shares can continue to be a valid and workable method of incentivisation in the entrepreneurial environment.