[co-author: Graham Nicholson]*
Changes to Entrepreneurs' Relief
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Entrepreneurs' Relief – new requirement for entitlement to 5% of profits and assets available for distribution to equity holders
The UK Budget 2018 proposes key changes to the scope of Entrepreneurs' Relief ("ER") which would mean that the reduced capital gains tax rate of 10% will no longer be available where an individual is beneficially entitled to less than 5% of both distributable profits and company assets on a winding up. Existing ER planning should, therefore, be revisited in light of these proposed changes.
We consider below in more detail what these proposed changes will mean in the context of both existing and new structures.
When does ER apply under current law?
ER broadly enables certain employees and directors of trading groups to benefit from a reduced capital gains tax rate of 10% on gains (up to a lifetime limit of £10 million) on disposals of shares in the trading company (or the holding company of the trading group) for which they work.
ER will, however, only apply to the extent that the relevant company qualifies as the relevant individual's "personal company". Under current law, this means that the individual must hold at least 5% of the company's ordinary share capital and be entitled to exercise at least 5% of the voting rights. There is, however, no specific requirement for the individual to hold shares giving a 5% economic entitlement. As such, it has in the past been common practice for management shares to be issued with weighted nominal capital and voting rights in order to satisfy the 5% ordinary share capital and voting right thresholds even where an individual holds less than 5% economically.
UK Budget 2018: proposed changes
In UK Budget 2018, it is proposed to introduce two new tests to the definition of "personal company" (in addition to the existing 5% ordinary share capital and voting rights tests), which will also require the individual to be beneficially entitled to at least:
(a) 5% of the company's profits available for distribution to equity holders; and
(b) 5% of the company's assets available for distribution to equity holders on a winding up.
The term "equity holders" is widely defined and includes not only holders of ordinary share capital in the company, but also certain loan creditors (broadly non-bank lenders issuing loans which are not normal commercial loans, eg convertible loans, loans accruing interest above a reasonable commercial return, or results-dependent loans). However, as a general rule, holders of non-convertible fixed rate preference shares and loan notes which give no more than a reasonable commercial rate of return should not be treated as equity holders, although the terms of the relevant instruments would need to be reviewed on a case by case basis.
The proposed new tests would apply for all disposals of shares on or after 29 October 2018, even where the shares in question were acquired before this date, and would need to be met, in addition to the existing tests, throughout the minimum qualifying period (currently one year, but proposed in UK Budget 2019 to increase to two years for disposals on or after 6 April 2019).
What does this mean for existing and new structures?
Assuming that the Budget proposals are implemented in their current form, management will no longer be able to satisfy the 5% holding requirement through weighted nominal capital and voting rights, and will need to hold a genuine economic interest of at least 5%.
This applies for both existing and new structures. We would, therefore, recommend that any relevant ER planning for existing structures should be revisited in light of the proposed changes.
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Entrepreneurs' Relief – dilutions following new share issues
As announced at Autumn UK Budget 2017, the UK government will legislate in Finance Bill 2018-19 to allow individuals whose shareholding is ‘diluted’ below the 5% qualifying threshold for Entrepreneurs’ Relief as a result of a new share issue on or after 6 April 2019 to obtain relief for gains up to that time.
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Entrepreneurs' Relief – extension of minimum qualifying period
Under current rules, the qualifying conditions must be met for 1 year. It is proposed to extend this to two years for disposals on or after 6 April 2019. This will apply to management who hold shares or EMI options.
*Counsel Knowledge Lawyer
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