The Chancellor’s October budget made significant changes to Entrepreneurs’ Relief (ER) in 2018 that could affect a wide range of different shareholders. Access to ER has been tightened up significantly and this could have an impact on shares (and securities) in issue both before and after the budget. Given the potential implications for many businesses and their shareholders, the consequences of the budget changes need to be carefully considered.
Entrepreneurs’ Relief (ER)
ER essentially reduces the amount of capital gains tax payable on the disposal of qualifying holdings by half. To be eligible for ER an individual must be employed or hold an office in the company or group in which the shares are being sold. Where the relief applies, the rate of Capital Gains Tax drops from 20% to 10%, halving the amount due. As a maximum lifetime allowance of £10 million per individual applies to the relief, it is effectively worth £1 million for each individual in cash tax terms. However, as a result of the changes being made by the budget there may be both new and existing shareholders who no longer fall within the eligibility criteria and find themselves with significantly higher tax to pay as a result. There are two key changes to note as a result of the recent budget:
- Doubling of the hold-period from 12 to 24 months
- The addition of a 5% economic ownership test
A holding period of 24 months
For share disposals after 6 April 2019, the holding period during which the relevant ER conditions must be met will increase from 12 months to 24 months. This will have an impact in a number of ways:
- Shares acquired through the exercise of EMI share options will be affected. So, as of the effective date next year, it will be necessary for the underlying option to have been held for at least 24 months prior to the option being exercised and the shares consequently sold. If these conditions are not met, ER will not apply.
- ER may be less accessible for new management equity as a result of the changes but longer term shareholders should not be affected.
- Exit planning strategy will need to be adjusted to take account of the requirement for shares to be held for two years, not one. Otherwise, the tax burden on exit will double.
5% economic ownership test
The new 5% economic ownership test is effective for transactions taking place from 29th October 2018. It will apply in addition to other pre-existing criteria for ER, including the requirement to hold 5% or more of the votes and the issued ordinary share capital (which includes deferred and certain preference shares). The changes brought in by the budget mean that, in order to qualify for ER, an individual will now also need to have an entitlement to at least 5% of the distributable profits and assets (or equity value) of a company. Both of these 5% thresholds will need to be met in order for ER to apply – if one is missed then there will be no eligibility.
It’s likely that the new 5% economic ownership test is going to severely tighten up the availability of ER. In particular, many of the structures that are frequently seen in private equity and venture capital investment returns, such as ratchet share structures, could cause problems as the relief will not be easily applied to these. This is as a result of the new definition that the draft legislation proposes, which goes further than ordinary share capital when looking at entitlement to distributable profits/equity value. As a result of the broader scope, individuals who would previously have qualified as they hold more than 5% of the ‘economic’ value attributable to ordinary shareholders, may fail to be eligible for ER as a result of the existence of other instruments, such as low or non-dividend bearing shares, deferred shares, shares with different nominal values or convertible securities. Where such instruments fall within the definition of ‘equity’ they could prevent the 5% threshold for relief being reached.
Taking action now
Given the instant impact of the 5% economic ownership test – and the implications of the doubling of the holding period – there are steps that any business should take now to establish whether ER may be denied where it was previously potentially available.
- Carry out a review of the existing company share and debt structure. Identify those shareholders who may be affected by the new rules.
- Evaluate future transaction events for shares or EMI options. Where shares or EMI options will have been held for between one and two years in April next year it will be important to review the timing of a future transaction event. As the new requirements for the doubling up of the holding period come into effect in April next year, as opposed to instantly, there is the opportunity for shareholders to make a qualifying disposal before the rule change in April 2019.
- ‘Growth’ share rights for new management equity should be reviewed in the context of the changes, for example to increase the chances of the shares attracting ER and reduce the risk to other shares’ economic rights that could affect other shareholder’s eligibility for ER.
- Exchange transactions also need to be carefully examined. Where equity that would formerly have qualified for ER has been exchanged for replacement shares that don’t fall within the ER requirements, it may be possible to disapply CGT relief on that transaction and claim ER up to the point at which it occurred.
Many businesses will now need to review existing debt and share structures in the light of changes to Entrepreneurs’ Relief in the recent budget – and adjustments may need to be made to mitigate the impact of the new criteria.