Entrepreneurs’ Relief (“ER”) is a relief against capital gains tax available to U.K. individuals who sell their businesses, provided certain conditions are met. If the conditions are met, the rate of capital gains tax paid on the sale of the business (or business assets) is reduced from 20 percent to 10 percent.
ER was introduced as the successor of Business Asset Taper Relief to reward entrepreneurs for the risks taken when establishing or investing in businesses.
U.K. chancellors have come under increasing pressure to reduce or abolish this tax relief as it is seen by some as rewarding those wealthy enough to be entrepreneurs. Many anticipated that this relief would be scrapped in the last Budget, but the Chancellor instead opted to tighten the qualifying conditions for ER to be available from April 6, 2019.
Qualifying Conditions up to April 5, 2019
To qualify for ER, several conditions must be met. Broadly, these are:
- the company must be the individual’s “personal company” i.e. the individual must own at least 5 percent of the ordinary share capital and votes of the business; and
- the individual must be an officer or employee of the company (or a company in the same trading group); and
- the company must be a trading company or the holding company of a trading group.
Prior to April 5, 2019, these conditions had to be met by the individual throughout a 12-month qualifying period either up to the date of disposal of the business or the date the business ceases.
If selling the whole business or all the assets, it is straightforward to claim ER: the individual would need to meet the one-year qualifying period. Where assets that were previously used in the business are disposed of after the business is ceased, they will have to meet two additional eligibility conditions:
- the assets must have been used in the business for one year; and
- the asset must be sold within three years of the business ceasing.
Qualifying Conditions Post April 6, 2019
There are two changes which impact ER.
Firstly, the qualifying period will need to be met for 24 months prior to disposal, i.e. the qualifying period has been extended from one to two years. This measure is effective from April 6, 2019. There are grandfathering provisions in place so that if an individual’s personal company or business (or holding company of a trading group) ceased to trade before October 29, 2018, then the existing one-year qualifying period will continue to apply.
Secondly, there is an immediate change to the definition of the “personal company” from October 29, 2018. Essentially, the 5 percent ownership rules are tightened to ensure that the individual must now, in addition to the above, be entitled to at least:
- 5 percent of the company’s distributable profits; and
- 5 percent of its assets available for distribution to equity holders in a winding up.
This measure is designed to ensure that, along with legal entitlement, individuals hold a true economic interest in the business. Equity arrangements must be carefully considered before undertaking any group restructuring or granting of equity to ensure that if ER is sought to be relied upon, the new criteria apply. Particularly, preference shares, alphabet shares or “growth shares” need to be reviewed to determine whether the disposal of such interests qualifies for ER.
It is likely that the introduction of these new rules will mean that it is now harder for entrepreneurs to claim ER, thus ensuring that the spirit of the legislation is adhered to.
Removal of Disincentive for External Investment
In the Autumn Budget 2017, the Chancellor announced an extension to the ER conditions for individuals who may previously have lost their entitlement to the relief due to a dilution of their holding following a restructuring of the company shares. Finance Bill (No.3) 2018 introduced two elections, which allowed individuals to “bank” ER on certain disposals before their 5 percent shareholding became diluted:
1. An election to treat the individual’s holding of (or interests in) shares or securities in a company as having been disposed of and immediately reacquired at market value prior to dilution, giving rise to a chargeable gain on which they can claim ER.
2. A second election to defer the gain until an actual disposal of (or interests in) the shares or securities.
The effect of the above is that ER is not lost up to the “dilution” of the shareholding. It is important to note the anti-avoidance provisions, which mean that the share issue which results in the dilution should have been made for “genuine commercial reasons” and not for the purposes of avoiding tax.
Before the introduction of the targeted anti-avoidance rules commonly known as “Phoenixing Rules,” two opportunities existed:
- To convert distributions chargeable to income tax to capital gains on winding up a business, and then access the ER relief, assuming the above conditions were met, further reducing the overall tax charge; and
- To claim ER on multiple disposals and therefore fully utilizing, as much as possible, the lifetime allowance of 10 million pounds ($13.1 million).
The Phoenixing Rules were introduced to counter the situation of taxpayers selling their existing businesses, extracting dividends in a capital form and banking ER only to start up shortly thereafter another business in the same trade.
There are four conditions that must be met for the Phoenixing Rules to apply, and broadly these are:
- Condition A: The individual receiving the distribution on winding up or liquidation had at least a 5 percent interest in the company immediately before the winding up; and
- Condition B: The company was a close company at any point in the two years ending with the start of the winding up; and
- Condition C: The individual receiving the distribution continues to carry on, or be involved with, the same trade or a trade like that of the wound-up company at any time within two years from the date of the distribution; and
- Condition D: It is reasonable to assume that the main purpose, or one of the main purposes of the winding up, is the avoidance or reduction of a charge to income tax.
The last of these conditions, Condition D, is a motive test. This means that usually taxpayers must prove that their intention was not to avoid or reduce a tax charge for Phoenixing Rules not to apply.
- Growing businesses, or businesses in distress who seek to raise funds by bringing an investor on board, may inadvertently lead to a shareholding being diluted to such an extent that the minimum threshold for ER for other shareholders is breached. It is therefore important to plan when the company is raising funds and issuing new equity. Tax planning advice should be sought to ensure that the conditions for ER are not breached and that the available elections are utilized.
- It is important to note that spouses and civil partners have 10 million pounds lifetime allowances for ER purposes as well. This potentially doubles the relief.
- If you owned your business or qualifying shares for 12–24 months and intended to retire or otherwise exit your investment, then you should consider doing so prior to April 6, 2019, when the qualifying period is extended to 24 months. This may involve placing your business in Members’ Voluntary Liquidation (“MVL”).
- Solicit tax planning advice in advance when you are looking to retire or exit your owner-managed business to ensure that you maximize the ER opportunity. Subject to the Phoenixing Rules, a blended tax advisory and liquidation solution is often optimal.
ER is still a very beneficial tax regime, particularly for business owners as—if the qualifying criteria are met—owners can halve their capital gains tax bill when distributions are received through MVL. However, the qualifying rules have now been tightened. The main changes to the conditions to qualify for the relief are the definition of personal company and the extension of the qualifying period from 12 to 24 months.
A helpful change to the ER rules is the ability for taxpayers to “bank” their tax relief before a shareholding is diluted because of fundraising through equity issuance.
Although taxpayers could claim the ER multiple times—subject to the lifetime allowance limit—strict rules were introduced to block selling and restarting the same business within two years. However, these rules have a motive test so that genuine circumstances are not affected.
Marie Barber is Managing Director, Regulatory Tax Advisory at Duff & Phelps, U.K.