New law: Directors and employees planning to benefit from Entrepreneurs’ Relief should check their eligibility following budget changes

Directors and employees of limited companies hoping to claim Entrepreneurs’ Relief (ER) against capital gains tax (CGT) when selling their shares, should check whether changes to the qualifying conditions for claiming ER made by the recent budget have affected their eligibility.

ER significantly reduces the rate of CGT payable by individual directors and employees to 10 per cent on a ‘material disposal’ (or a disposal ‘associated’ with a material disposal) of their ‘qualifying’ ordinary company shares, provided certain conditions are met. The relief also applies if they meet these conditions in relation to a holding company of a trading group.

Previously, it was a condition of claiming ER that the director or employee had to hold at least five per cent (in nominal value) of the ordinary shares, and five per cent of the voting rights in their company for at least 12 months before they disposed of their shares.

The recent budget stated that for disposals from 6 April 2019, the director or employee must satisfy a further five per cent ‘economic test’. This means they must also hold an interest of at least five per cent in both the distributable profits of their company and in its assets on a winding up. The five per cent is calculated by reference to the amounts available for distribution to ‘equity holders’. Furthermore, both the existing and new five per cent rights must be held for two years rather than 12 months.

This creates a number of pitfalls for existing shareholders. For example, if a venture capitalist has bought shares in a company and is entitled to a fixed rate dividend calculated by reference to the nominal value of those shares, the shares do not count when calculating whether a shareholder is entitled to five per cent of a distribution. However, if the dividend is calculated by reference to the original subscription price paid for the shares, the shares carrying the fixed rate dividend do count, and must be taken into account when calculating which shareholders have a five per cent interest in distributable profits.

Shareholders of companies with fixed dividend share rights should therefore consider whether the new rules mean their entitlement to dividend has dropped below five per cent – if it has, they no longer qualify for ER.

Similarly, if the venture capitalist is entitled to (or could be entitled to) an enhanced return on assets per share on a winding up compared to other shareholders, this could mean those other shareholders fail to satisfy the new requirement that they hold an interest in at least five per cent of the assets on a winding up, and no longer qualify for ER.

Similar checks may also be required if the company has, for example, convertible, founder or growth shares: can directors and employees who previously qualified for ER still satisfy the conditions, given the changes made by the budget?

Shareholders of a company which finds that its existing capital structure is a problem could consider changing that structure so they can satisfy the necessary conditions – though they may have to wait a further two years from the date of change before they can apply for ER. Also, reorganising the company’s share capital may itself have tax consequences, and there is no sign of any concession which would disapply those consequences in these circumstances.

Note, however, that the budget contains special rules for Enterprise Management Incentive share schemes, which could make holding shares through such a scheme an alternative option for directors and employees for whom ER is no longer available.

Operative date

  • Now

Recommendation

  • Directors and employees of limited companies hoping to claim Entrepreneurs’ Relief (ER) against capital gains tax (CGT) when they sell their shares in their companies should check whether changes to the conditions they must satisfy before they can claim ER in the recent budget have affected their eligibility

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