One of the key conditions for Entrepreneurs’ Relief on shares or an interest in shares is that the company needs to have been the individual’s “personal company” in the period of a year leading up to either the sale of the shares, or the company ceasing to be a trading company or the holding company of a trading group. For disposals from 6 April 2019, the one-year period is extended to two years. Simple enough, but unfortunately the same can’t be said about the changes to the definition of a personal trading company.
Before Budget day, an individual needed to have 5% of the ordinary share capital and 5% of the voting rights of a company in order for it to be a personal company.
From Budget day, they would also need to be beneficially entitled to at least:
• 5% of the company’s distributable profits
• 5% of its assets available for distribution to equity holders in a winding up.
The new legislation is said to be to combat abuse, where individuals hold shares which do not have such a 5% beneficial entitlement, but are “constructed” to comply with the current 5% tests. However, as explained below, it seems possible that the new rules could result in entrepreneurs’ relief being lost in cases where there is no abuse and no artificially constructed arrangements.
The Finance Bill provides that the new tests are to be defined by the “equity holders” tests in the Corporation Tax Act 2010. These tests look at what the individual would receive if there was a distribution or winding up at the time, but then say that if there are no distributable profits, or no assets for distribution, a hypothetical amount of £100 is to be considered. There are some provisions which apply where some shareholders hold shares with limited rights or temporary rights.
This is potentially problematic for entrepreneurs who hold shares in companies which have decided to use growth shares in order to incentivise employees. This is relatively common in a start-up business, where the aim is to incentivise the employees to build up the company to an exit, and the entrepreneur shareholders can then go on to their next project. Growth shares may give their holders an entitlement to a share of proceeds on a disposal of a company where the proceeds are above a specified hurdle.
The 5% test is applied on the basis of a winding-up, and the value of a company on a winding-up will often be below the sale value, for example where the sale price is based on earnings not assets. However, once a sale is completed, proceeds above the hurdle will cause the growth shares to dilute existing shareholders, and this may cause them to fall below 5% at the last minute, denying their expected entitlement to entrepreneurs’ relief.
HMRC have expressed their view that when option-holders exercise their options on the day of sale, this does not dilute the existing shareholders for the purposes of testing whether the company has been their personal company up to the date of disposal, click here. It may be that they will apply a similar approach to growth shares, since the hurdle proceeds don’t arise until the day of disposal.
The position is unhelpful in that although the Finance Bill has provisions to provide relief to shareholders who have qualified for Entrepreneurs’ Relief but are then diluted below 5% by new investment, those provisions have a commencement date of 6th April 2019.
It does appear that entrepreneurs who currently hold 5% of the ordinary shares in a company, where growth shares are being used for commercial reasons as an incentive, could be put into an uncertain position. It is to be hoped that HM Treasury will listen to representations on this point.
We have been researching the position both for entrepreneur shareholders, and for partners investing in a trading group through a partnership with waterfall or carry provisions, and considering practical ways to deal with this. If you would like to discuss the application of this draft legislation to your own potential exit, please contact us at Trident Tax.