May 20, 2019
In the lead up to the Budget at the end of October, there was a lot of murmuring about whether the Chancellor would abolish Entrepreneurs’ Relief. He hasn’t done that. But he has changed the rules to narrow the relief. The consequences are, unhelpfully, not clear and could be broader than was perhaps intended. Here’s what you should know about.
Entrepreneurs’ Relief allows individuals to pay capital gains tax at 10% when they sell shares in a company. Conditions must be satisfied to claim the relief. These include that the shares must be either ‘qualifying EMI shares’ or shares in the individual’s ‘personal company’.
Two new ‘economic interest’ conditions have been added to the definition of ‘personal company’.
The changes to the definition of ‘personal company’ mean that an individual must not only hold at least 5% of the ordinary share capital in a company, and be entitled to exercise at least 5% of the voting rights by virtue of that holding, but they must also:
These changes apply from 29 October 2018. Anyone who sells shares on or after this date, and who would like to claim Entrepreneurs’ Relief, needs to consider the new tests. This is unless they acquired their shares by exercising qualifying Enterprise Management Incentive scheme options.
These new conditions also need to be satisfied throughout the period of 12 months ending with the date of the share sale. This will increase to 24 months where shares are sold on or after 6 April 2019.
Rather than writing new legislation for the economic interest tests, existing legislation has been adapted. The current draft legislation is similar to what might happen if you try to make a jet-ski by bolting a motorbike to a surfboard: It’s ugly, doesn’t seem to work as intended, and detailed instructions are required in order to use it.
Unfortunately, HMRC has yet to provide any guidance on how the economic tests should apply in practice. This has not prevented tax practitioners from speculating on the problems that might arise.
The potential application of the new rules to ‘alphabet shares’ has caused the most debate. Alphabet shares are different share classes which allow a company to vary the rate of dividends for each class or only declare dividends on certain classes and not others. The rights of alphabet shares are drafted in a number of ways, but the practical effect tends to be that each class of share only receives a dividend where the company chooses to declare a dividend on that class.
Some tax practitioners and lawyers have been quick to point out that this ‘discretionary right to a dividend’ could cause problems when applying the first of the two new economic tests. They argue that a discretionary right to a dividend does not give a shareholder a beneficial entitlement to any part of a company’s distributable profits.
This would mean that the holders of alphabet shares would not have a beneficial entitlement to at least 5% of a company’s profits available for distribution, and Entrepreneurs’ Relief would not be available on a sale of their shares.
This interpretation could lead to the situation where no shareholders would be entitled to Entrepreneurs’ Relief if a company’s ordinary share capital is solely comprised of alphabet shares. As a tax team at PKF Cooper Parry, we’d be disappointed if this was the case. However, we think it’s too early to be able to offer a business-wide view either way. Further guidance is required before attempting to apply the tests.
It’s worth remembering that HMRC estimate that fewer than 1,000 individuals will be affected by the changes. Alphabet shares are not uncommon in trading companies. So, it seems unlikely that HMRC intended that individuals with alphabet shares who qualified for Entrepreneurs’ Relief before the Budget are now no longer entitled to it. If the draft legislation does deny alphabet shareholders the relief, then perhaps we’ll see more changes before it officially becomes law next year.
Until guidance has been published by HMRC (and any amendments made to the draft legislation), taxpayers should refrain from trying to ‘second guess’ how the rules might apply. Doing so might lead to costly or unnecessary or ineffective changes being made to shareholding arrangements. However, the approach and timing of any action will be tailored depending on circumstances and so please do not hesitate to get in touch to talk through your individual position.
As soon as we know more, we’ll provide an update.
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