Writing for Tax Journal, BKL consultant David Whiscombe explains how HMRC has rethought some of the Budget 2018 changes to entrepreneurs’ relief.
Changes in the Budget restricting entrepreneurs’ relief to individuals holding shares entitling them to at least 5% of distributions were widely criticised as inappropriately denying relief in a number of common situations. HMRC announced just before Christmas an alternative test based on the expected share of proceeds on a notional sale at market value of the entire ordinary share capital of the company. The new test operates alongside the ‘distributions’ test and as an alternative to it and in most cases remedies the defects of the original proposals.
In his Budget speech, the chancellor proposed important changes to the definition of ‘personal company’ for the purposes of entrepreneurs’ relief, supposedly the better to target the relief on ‘genuine entrepreneurs’ by limiting the relief to individuals whose economic interest in the company passed a de minimis threshold. This was to be done by adding to the existing requirement of a holding of at least 5% of the ordinary shares carrying at least 5% of the voting rights the further condition that the holding should also entitle the holder to at least 5% of the profits available for distribution to ‘equity holders’ (a term imported from CTA 2010 and encompassing much more than simply holders of ordinary share capital), including in a winding-up. In the Budget Day announcement, HMRC offered the view that the change would affect fewer than 1,000 individuals and would generate only modest amounts of additional tax. The reaction of the tax profession to the proposal suggests that HMRC badly miscalculated the potential scope and effects of the change, some of which have been highlighted in ‘Entrepreneurs’ relief: Hammond’s disappearing trick’, Tax Journal, 23 November 2018. That HMRC could get it so wrong is perhaps a cause for some concern: but to its credit it was quick to take on board the objections to the original proposals and on 20 December an amendment to the Finance Bill was published. The amendment does not remove the test that caused such controversy, but introduces a new test that operates as an alternative to it.
Under the new test (introduced as s 169S(3)(c)(ii)), a company will be an individual’s personal company if (in addition to holding at least 5% of the share capital carrying at least 5% of the voting rights) the individual would ‘in the event of a disposal of the whole of the ordinary share capital of the company be beneficially entitled to at least 5% of the proceeds’. For this purpose, the amount to which the individual would be entitled at any time is taken to be the amount to which ‘having regard to all the circumstances as they existed at that time, it would be reasonable to expect the person to be beneficially entitled’; and the effect on that amount of any ‘avoidance arrangements’ (defined as one would expect) is to be disregarded. As now, where shares are held jointly, each holder is treated as the sole holder of a proportionate number of them and as having appropriate voting rights and entitlement to proceeds.
Entrepreneurs’ relief on the disposal of shares in or securities of a company requires the qualifying conditions (of which ‘personal company’ status is of course only one) to be met throughout a qualifying period (currently one year but increasing to two years for disposals after 5 April 2019). That period most commonly ends on the date on which the disposal takes place, but may end on the date, up to three years before the disposal date, on which the company ceases to be either a trading company or a member of a trading group. However, in respect of the new ‘proceeds of sale’ condition, the legislation tests the position by reference only to the market value at the end of the qualifying period (or, in the case of a claim to ‘associated disposal’ relief, by reference to the date of the material disposal) – see new s 169S(3A) (a) and s 169K(1B)(a). This is a sensible piece of drafting, the effect of which is to ensure that the relief is available (as it should be) to shareholders whose entitlement, although established at the outset, passes the 5% threshold only as the value of the company increases. The example below illustrates how this works in a simple case.
Newco has A shares (held by management) and B shares (held by investors). Shares rank pari passu save that B shareholders are entitled to the first £2m on sale or liquidation. Austin Galahad holds A shares representing 7.5% of the ordinary share capital carrying 7.5% of the votes. The company is sold for £10m on 30 April 2019. On 1 May 2017 the company had a market value of £5m. Newco is Austin’s personal company, because his £600,000 exceeds 5% of £10m. This is despite the fact that a sale at market value at the start of the qualifying period would have given him only £225,000, which is less than 5% of the total market value at that time of £5m.
Note that, in contradistinction to the ‘distribution’ test, the ‘sale proceeds’ test has reference only to the rights of holders of ordinary share capital: the extent to which ‘equity holders’ other than holders of ordinary share capital (as defined at ITA 2007 s 989) receive proceeds on a sale is not relevant.
It does seem odd that two tests, both purportedly aimed at determining whether an individual has at least a 5% economic interest in a company, should differ in what is counted as an economic interest. Further, taking a concept (‘equity holder’) from its corporation tax home and shoehorning it into the CGT code seems undesirable; the simpler and better course would seem to be to define economic interest for the purposes of both tests solely by reference to ownership of ordinary share capital. But, subject only to that niggle, the HMRC rethinking evidenced by the introduction of the ‘sale proceeds’ test is to be welcomed.
The article was originally published in Tax Journal issue 1427 and is also available on the Tax Journal website.
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