Last updated on November 24th, 2019 at 03:47 pm
Entrepreneurs’ Relief (ER) is a relief that reduces the amount of Capital Gains Tax (CGT) that is paid when some or all of a business is sold. ER reduces the rate of CGT down to 10% on the first £10 million of qualifying gains for individuals and trustees.
ER reduces to 10% the rate of CGT payable on qualifying disposals of business assets; such as:
- disposals of the whole or part of a trading business;
- disposals of assets (or interests in such assets) following a cessation of a trading business; and
- disposals of shares or securities of a company (or an interest in such shares or securities) where the company is a personal trading company.
ER does not apply to disposals of investments or non-business assets.
There are no specific territoriality requirements for ER (other than the obvious point that there needs to be a liability to UK CGT), so UK resident individuals may also claim ER for disposals of overseas businesses which satisfy the ER conditions.
ER is available to most individuals, qualifying beneficiaries and some trustees of settlements, but is not available to companies, personal representatives of deceased individuals or to trustees of a discretionary settlement. Spouses or civil partners are entitled to make a separate claim provided that they each satisfy the relevant conditions for ER.
There is no limit on the number of claims you can make as long as you stay within the lifetime limit of gains which qualify for ER (currently £10 million). Gains in excess of the lifetime limit allowance will be charged at the prevailing CGT rate for that period (at present 20%, unless it is a disposal of residential property or carried interest which is 28%).
a) Disposals of the whole or part of a business
Whether you intend to sell the whole business or part of it, in order to claim ER you must have owned the business directly (or you must have been a member of the partnership that owned the business) for at least 2 years before the date you make the sale.
The same conditions apply in the event that you are closing your business. Additionally, you must also dispose of the business assets within 3 years from the cessation to qualify for ER (this is a statutory limit and HMRC have no discretion to extend the period).
b) Disposals of shares or securities
To claim ER on a disposal of shares or securities, you have to fulfil the following conditions:
- you have to be an employee or officeholder;
- the company must be your personal company; and
- the company must be either trading or part of a trading group.
c) Trading company
HMRC considers a trading company to be a company where no more than 20% of turnover is from investments, no more than 20% of assets on the balance sheet are non-trading assets and no more than 20% of management time is spent on non-trading activities. HMRC applies the test ‘in the round’; so it is possible for the test to be satisfied even if the cash in the business exceeds 20% of the assets in the balance sheet, if that cash is necessary for working capital.
A ‘trading group’ means a group of companies in which one or more members carry on trading activities and the members’ activities when taken together, do not include (to a substantial extent) non-trading activities.
Top tip: whilst you can apply to HMRC in advance of a disposal to confirm whether the business is a trading business, it is not a requirement to do so. In practice, those businesses that are confident of meeting the trading criteria see no need to apply for confirmation; and those businesses that are concerned that they fall into an uncertain or “grey” area tend not to want to seek confirmation because they do not want to flag to HMRC the possibility that they may not be trading.
d) Personal company
A company is your personal company if you satisfy the following:
- (test 1) you hold at least 5% of the ordinary share capital and votes of the company; AND EITHER:
- (test 2, option 1) you are entitled to at least 5% of the sale proceeds on disposal of all the ordinary share capital (there is no need for the shares to be paid up so nil paid or partly paid shares can qualify); or
- (test 2, option 2) you are entitled to at least 5% of profits (dividends), and assets available for distribution to all equity holders on a winding-up of the company.
e) Ordinary share capital (OSC)
To qualify for ER the shares must be OSC. If there is only one class of share in issue, then the question of whether shares are OSC is unlikely to be relevant. However, when there are shares of different classes, and in particular where there are “preference shares”, establishing whether a given shareholding is made up of OSC can be crucial.
OSC has a statutory definition, being “’all the company’s issued share capital (however described) other than capital the holders of which have a right to dividend at a fixed rate but have no other right to share in the company’s profits”; hence the complication where preference shares are involved. There have been some recent cases on whether different types of preference share are OSC or not, and HMRC have published guidance on the topic – in September 2018 the Chartered Institute of Taxation published a table setting out HMRC’s views on a number of different types of share capital that could be considered ordinary share capital, each with differing dividend rights. Unfortunately though, the combined effect of the case law and the guidance is such that it has left some uncertainty about certain types of preference share.
One case (McQuillan) concerned zero-coupon preference shares. HMRC successfully argued that shares with no dividend rights do not have a right to a fixed rate of zero, they have nothing and so are not fixed rate preference shares. As such, they form part of the OSC. In this case it meant that the selling shareholder would have to have 5% of the total amounts payable in respect of the “ordinary” shares and the preference shares.
In another recent case (Warshaw) the courts took an even wider view as to what counts as OSC (and contradicted historic HMRC guidance). The shares in that case were cumulative fixed rate preference shares, with a rate of 10% applying on both the subscription amount and any amount of preference dividend that was unpaid and had compounded. It was held, on the facts, that the shares were OSC because of the variable (second) element of the coupon i.e. they were entitled to something other than a fixed rate.
HMRC had previously stated in its guidance that cumulative preference shares would not be OSC, whereas non-cumulative preference shares would be OSC on the basis that in the latter case the dividends are effectively not fixed as they depend on the company having the profits to pay them. HMRC have maintained that position in their latest guidance but have added that shares with compounding dividends are “borderline” cases, adding that the second case described above is not a binding precedent and saying that the outcome will depend on the specific facts of the case.
The key point here is that whenever preference shares are in issue, real care needs to be taken to understand whether those shares are OSC or not, as the impact on ordinary shareholders could be very significant. Preference shares with a zero coupon or which are not cumulative are likely to be OSC. Where preference shares are cumulative the position is less clear and will depend on the exact terms.
Companies with preference shares where the ordinary shareholders are expecting to qualify for ER on a future sale should review their position now. If existing preference shares would be OSC it might be possible to do something to rectify this so that (after a further two year holding period) ER would apply.
f) Special Rules for shares acquired on exercising Enterprise Management Incentive (EMI) options
EMI option holders do not need to hold 5% of shares by nominal value, voting rights or economic value in order to qualify for ER. This special relaxation of the ER rules for shares acquired as a result of exercising EMI options makes the use of EMI options to incentivise employees even more attractive. This means it is still possible to grant EMI options over non-dividend bearing, and non-voting shares and still qualify for ER.
Top tip: the period during which an EMI option is held as an unexercised option also counts towards the 2 year ER qualifying holding period; so you do not need to exercise an EMI option and hold the resulting share for a further 2 years in order to qualify for ER.
g) Disposal of trust business assets
The qualifying conditions for getting ER on trust gains are complex; but very briefly ER is available for trust gains when:
- there is a disposal of ‘settlement business assets’ (being assets which are part of the settled property of the settlement and which have been used for the purposes of a business); and
- there is an individual with an interest in possession of the settlement business assets (the ‘qualifying beneficiary’), who meets all the ER qualifying conditions throughout a period of two years ending not earlier than three years prior to the date disposal of the trust business assets.
In the case of gains made by trustees, the ER limits are determined by reference to the status of the qualifying beneficiary. If disposals are made on the same day by the qualifying beneficiary and the trustees, ER is available in priority to the beneficiary. All earlier claims by both the beneficiary and by the trustees (in relation to that particular beneficiary) are taken into account in determining whether the lifetime allowance limit for ER (currently £10m) has been met.
ER must be claimed as it does not apply automatically. It can be done either:
- through the self-assessment tax return in the supplementary Capital Gains Summary section; or
- by filling in Section A of the Entrepreneurs’ Relief help sheet.
Trustees of a settlement
For disposals made by trustees, the trustee and the qualifying beneficiary must jointly claim ER. Joint claims may be made to HMRC in writing or by filling in Claim Form HS275 (Section A is completed by the qualifying beneficiary and Section B is completed by the trustee).
Claims for ER must be made by the first anniversary of the 31 January following the tax year in which the qualifying disposal is made. For example, if the disposal was made on 1 October 2018 (that is the 2018/2019 tax year), relief must be claimed on or before 31 January 2021.
Top tip: Claims can be amended or revoked within the time limit.
Income Tax or Capital Gain?
The first thing to establish is whether the company’s purchase of own shares needs to be treated as an income distribution (and so subject to dividend income tax rates) or whether it is a distribution of capital. The default position is that when a company buys back its own shares, any payment in excess of the capital originally subscribed for the share will be taxed as an income distribution.
However, the share buyback can be treated as a capital distribution so that any payment in excess of the capital originally subscribed will be taxed under CGT if the following conditions are fulfilled:
- the company is an unquoted trading company or holding company of a trading group;
- the shareholder is UK tax resident;
- the shareholder has held their shares for at least 5 years;
- the shareholder does not have a material (more than 30%) connection with the company after the buyback;
- the shareholder reduces their interest in the company by at least 25% as a result of the buyback; and
- the buyback is to the benefit of the company’s trade (subjective test).
Top tip: you can apply to HMRC to confirm that capital treatment will apply to the disposal.
Watch out: if the shareholder from whom the company is buying back the shares resigns as an officer and employee before the date of disposal of the shares, ER will not be available.
What is the date of the disposal?
The general rule is that the date of disposal of an asset is when the contract is made, unless the contract is conditional (for example, it is subject to approval by special resolution), in which case the date of the disposal is when the condition was satisfied. In other words, the date of disposal for CGT purposes is the date that a contract becomes (or already is) unconditional.
If the purchase of shares is made through ‘multiple completion contracts’, rumours are circulating that HMRC may be challenging whether the later completions will qualify for ER as it is believed that the shareholder will already have ceased to be an officer or employee of the company at the time when these disposals will take place.
It is important, therefore to ensure that the conditions for ER are satisfied at the date when a company buys back its own shares.
Enterprise Investment Scheme (EIS)
It is possible for investors to benefit from both ER and EIS deferral reliefs. Gains which qualify for ER may subsequently be reinvested in EIS (or Social Investment Tax Relief), take advantage of the EIS ability to defer capital gains already realised, and still remain eligible for ER when the deferred gain that has been reinvested into EIS shares is eventually realised.
ER can only be claimed if the original gain which has been deferred would have qualified for relief at the time of the earlier disposal, following the rules which applied at that time.
Top tip: it is important to claim ER the first time that any part of the deferred gain comes back into charge, even if there is no tax to pay due to losses or the annual exemption. If ER is not claimed on the first part of the gain to be realised, then it cannot be claimed later in respect of any of the remaining gain.
You can read more information about EIS here.
Seed Enterprise Investment Scheme (SEIS)
CGT deferral relief is not available for SEIS investments. However, reinvesting the gain using SEIS provides a CGT exemption for 50% of the gain (not a deferral of the gain as long as the disposal of the asset and the reinvestment took place in the same tax year).
You can read more information about SEIS here.
Investors’ Relief (IR)
It is possible for someone who is an unpaid director or shareholder in a company to satisfy both the ER and IR qualifying criteria. If you are likely to exhaust the £10m ER (or IR) limits, it’s worth structuring your investments to qualify for both reliefs – this gives you the opportunity to pay 10% CGT on £20m of lifetime capital gains (or £40m if you include your spouse/civil partner).
You can read more information about IR here.
The rules surrounding ER are complicated and there may be other conditions to check or pitfalls to avoid in order to make sure you qualify.
Jonathan Lea Network can help you claim ER, as well as assisting with other areas of selling a business.
For all new clients, we offer a no cost no obligation call of up to 20 minutes to first discuss your matter and requirements before confirming a scope of work and quote. This can be arranged by sending your details together with an overview of your matter through our contact form.