We last detailed some key changes to the Entrepreneurs’ Relief (ER) regime announced in the October Budget in our article Entrepreneurs’ Relief: The Net Tightens for Owner Managers. Since then, there has been significant lobbying on one of the changes, resulting in the government proposing a welcome amendment to the Finance Bill in late December.
The Bill is still going through the Parliamentary process so could be subject to further change, but the main debate stages in the House of Commons are now concluded.
The Budget contained three changes to the ER regime worth noting:
- The holding period will increase to 2 years (from 12 months) for disposals taking place on or after 6 April 2019.
- Where individuals are diluted below 5% as a result of a fresh issue of shares for cash, it may be possible to make an election to “bank” the ER accrued up to the time of dilution and also to elect to defer that tax until the shares are actually sold. This will apply for qualifying share issues taking place on or after 6 April 2019.
- On Budget Day (29 October 2018), it was announced that with immediate effect, in relation to a sale of shares, the selling shareholder must hold 5% of the economic rights in the company (in addition to the nominal capital and votes, which were previously the only requirements).
The Proposed Amendment
The proposed amendment to the Bill is in relation to change 3 above – the ‘economic rights test’ – and will, if adopted, address what has been deemed an unintended and undesirable consequence of the updated ER regime. The tabled proposal is that an individual will meet the 5% economic rights test (which, as with the other conditions for ER, must be met throughout the qualifying period up to and including the date of sale) if either:
- he or she is entitled to at least 5% of both the company’s profits available for distribution and assets on a winding up (the test announced in the Budget); or
- on a sale of the whole of the ordinary share capital of the company, he or she would be beneficially entitled to at least 5% of the proceeds available to the holders of ordinary shares (the new proposed alternative test).
The main concern with the test announced in the Budget was that shareholders who would previously have been expected to qualify for ER without difficulty, may in fact fall foul of the 5% economic rights test because their shares (albeit well over 5% of the ordinary shares in the company) rank behind other shares on liquidation, or because the shares in question were growth shares and rank behind other classes. Similarly, there was a concern around “alphabet shares”, as arguably no class has an entitlement to 5% where there is discretion over dividends.
The new alternative economic rights test (looking at proceeds on an exit) means that an individual with a genuine 5%+ economic stake in the value of the company should be able to qualify for ER, even if he or she would fail on the entitlement to dividends and assets on a winding up test. In practice, this is going to be the test shareholders will rely upon most often to qualify.
However, care will still need to be taken in identifying the “ordinary share capital” of the company for the purposes of this new test, particularly around the detailed rights attaching to preference shares and whether this makes them ordinary share capital or not. If preference shares count as ordinary share capital, the ordinary shares in question would need to be entitled to 5% of the amounts payable to all ordinary shares, including the preference shares (which is obviously harder to meet than if you exclude the preference shares from this computation).
Although the introduction of a new test has allowed many to breathe a sigh of relief, it still has complexities and many of the strategies employed in pre-Budget planning will still fall foul of qualification for ER under these new provisions. To give an example of this, it was quite common for an individual to hold an economic stake in the business below 5%, but still seek to qualify for ER by virtue of the shares having weighted nominal value and voting rights above 5%. However, this would no longer meet either strand of the economic rights test.
It is encouraging to note that the Enterprise Management Incentive (EMI) rules are unaffected by the economic benefit test outlined above. The only change affecting EMI option holders is the extension of the holding period to two years, rather than the current twelve months, from the date of grant. This makes EMIs an even more attractive option and they should be considered as a means of getting shares to employees where possible. They could also be considered as a possible “fix” to any problems identified in ER entitlements.
We would recommend that, especially where a sale is being considered, advice should be taken on the company’s articles of association and any shareholders’ agreements to ensure compliance with the new provisions. The review would be aimed at working out which shareholders continue to qualify for ER in light of the amendments under the Bill and, where possible and appropriate, taking steps to maintain ER if it is in jeopardy. It will likely only be possible to maintain ER by increasing the economic benefits of the shareholder and this will not be appropriate, or even desirable, in all cases and could have tax implications in itself. However, if it can be done, it is best to make the changes sooner rather than later (particularly as the holding period is increasing to 2 years).
The Finance Bill is still going through the Parliamentary process so could be subject to further change, although the main debate stages in the House of Commons are now concluded.
Nothing in this article constitutes legal or tax advice or gives rise to a solicitor/client relationship. Specialist legal and/or tax advice should be taken in relation to specific circumstances.
Keith Dinsmore is Head of Transaction Services at Vialex