The Finance Act 2019 has confirmed new limitations on the availability and operation of Entrepreneurs' Relief. Employee shareholders and private equity investors need to be alive to the changes and their impact on share disposals or on structuring new investments.
What changes are being made to ER?
Entrepreneurs' Relief ("ER") operates to reduce the rate of capital gains tax ("CGT") on disposals of certain business assets and shares from 20% to 10%. There are a number of conditions which must be satisfied before a shareholder can make a qualifying claim for ER, including that the business must be the shareholder's ‘personal company’.
Key changes are:
- a tightening of the definition of a personal company;
- an extension of the minimum share holding period; and
- new rules where an individual's shareholding has been diluted.
Do these changes mean it will be harder to qualify?
The changes mean that shareholders will have to hold shares for longer, some existing shareholders may cease to qualify and it is more difficult to establish that the conditions are met.
How do I know if I will qualify?
To satisfy the new personal company requirements to qualify for ER, an individual must hold:
- 5% of the ordinary share capital;
- 5% of the voting rights; and
- either (the additional tests): i) be entitled to both 5% of profits available for distribution and assets available for distribution in a winding up; or alternatively ii) in the event of a disposal of the whole of the ordinary share capital of the company, the individual would be entitled to 5% of the disposal proceeds.
The final limb of the test (paragraph ii) was intended to ease evidential problems for disposing shareholders, especially where companies had different classes of shares with different rights such as alphabet shares, growth and preference shares.
The alternative test is easier to apply and likely to be relied on more frequently by shareholders particularly in circumstances in which their disposal was as part of the sale of the company's entire issued share capital. The changes are to address perceived avoidance to ensure that shareholders qualify for ER only where they have a genuine economic interest in the company.
From 6 April 2019, individuals will need to demonstrate they have met the qualifying conditions for at least two years at the date of disposal (currently one year), meaning that shareholders now need to consider their position at least two years in advance of any potential transaction to ensure their position is protected.
Dilution of shareholding
In some good news for owner managers, from 6 April 2019, individuals who no longer hold a 5% interest in a company will still be able to claim ER where the reduction in shareholding is due to the company issuing shares to raise capital for the purposes of its trade. The shareholder will need to elect for this treatment to apply.
This change is to address the problem of founder shareholders losing eligibility when shares are diluted on a fundraise, and this being a perceived bar to further growth of the business.
ER would be preserved up until the point of the dilution of shares, at which point the chargeable gain is crystallised (and a further election is made so that tax is not payable until disposal), but going forwards, ER would not be available for the future growth on those shares.
What do I need to do?
Obtaining and preserving entitlement to ER is now more difficult, making it imperative that shareholders and businesses obtain expert tax advice. Shareholders need to consider their position at least two years in advance of any potential disposal (and ideally at the point of investment) to ensure their position is protected.