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Entrepreneurs’ relief on cessation of personal company status

One provision in the draft Finance Bill that is of specific relevance to SMEs is the legislation (to be introduced as TCGA 1992 Part V Chapter 3A) permitting  entrepreneurs’ relief (ER) to be retained following a dilution in the taxpayer’s shareholding below 5% in certain circumstances.

Under current law, one of the conditions for ER to be available in respect of a disposal of shares or securities is that the company must be the taxpayer’s ‘personal company’ throughout the one year period ending with the disposal. This requires the holding of at least 5% of the voting rights by virtue of holding at least 5% of the company’s ordinary share capital.

Where dilution occurs on the day of sale and is caused by the exercise of options, HMRC does not consider that eligibility to ER is affected (see the agreed note of 13 February 2012).

However, it has long been objected that, in other circumstances, dilution can act as a disincentive to seeking outside funding.

Consider the situation where Matthew, Mark, Luke and John each hold 25% of the ordinary share capital of NewLife Ltd, a medical startup company. To develop the project further requires substantial further investment, so an investment fund has offered to subscribe the necessary capital for 85% of the enlarged share capital. The effect will be that the company will cease to be the personal company of any of the founders, who will not be entitled to ER on any subsequent

Chapter 3A addresses the difficulty by permitting two elections to be made. The first, under s 169SC, deems a disposal and re-acquisition to take place immediately before the time at which the shareholding (or voting power) is diluted below 5%, with the result that the gain on the notional disposal potentially qualifies for ER. The second, under s 169SD, avoids a ‘dry tax charge’ by deferring recognition of the notional disposal until an actual disposal takes place.

Note that the elections are separate, with separate time limits. It is possible to elect only under s 169SC but not s 169SD and thus to accept a dry tax charge, though it is difficult to see in what circumstances that might be desirable. One such case might be where a taxpayer is not resident in the UK at the time at which the dilution occurs but expects to become UK resident by the time of a subsequent actual disposal. In such a case, it would appear that the effect of an election under s 169SC would be to create a tax-free re-basing.

For shares, the notional disposal is for an amount that is equal to the consideration that would be apportioned to them if, immediately before the diluting share issue, the whole of the issued share capital of the company had been sold for a consideration equal to its market value at that time. This will usually be higher – perhaps very much higher – than the market value of the shares valued in isolation as a minority holding.

For securities, the notional disposal is for an amount equal to the market value.

The trigger for the s 169C election is a ‘relevant share issue’ – that is, an issue of shares for cash where the transaction is commercial and untainted by tax avoidance motives – that dilutes the taxpayer’s shareholding, voting rights or both below 5%. It does not, therefore, assist where the dilution occurs as a
result of an acquisition paid for in shares.

Where an election has been made under s 169SC, the gain on the notional disposal may be deferred by a further election under s 169SD. In each case, the election is irrevocable. Under s 169SE(2), any s 169SC election must be made on or before 31 January next-but-one after the end of the tax year in which the relevant share issue occurs; and under s 169SE(3), any s 169SD election may be made up to four years after the end of the relevant tax year.

Neither refers to the making of a tax return, so s 169SE(4) is puzzling. This provides that where elections are made under both s 169SC and s 169SD and no tax return would otherwise be required for the relevant tax year, the elections may be made ‘by giving notice on or before the first anniversary of the 31 January following the relevant tax year’. Whether this is intended to shorten the time limit for the s 169D election (and if so, why) is obscure to the writer.

Where, as may be expected to be the normal case, elections are made under both sections, the gain on the notional disposal is attributed to the shares or securities of the company that are the subject of the notional disposal. If there are multiple classes of share or security, the gain is attributed between them in proportion to the gains accruing in respect of each class on the notional disposal (not, it should be noted, in proportion to the value of each class, which may be different). When disposals are subsequently made of any share or securities, the notional gain attributable to those shares or securities becomes chargeable (in addition, of course, to any actual gain made on them). Where part only of the holding (or of a class) is disposed of, a proportion of the notional gain becomes chargeable. Provision is made for appropriate adjustments where there have been bonus issues or other reorganisations.

Finally, note that when the notional gain becomes chargeable, ER is not automatic: it must be claimed. Further, ER is available only if all the other requirements for it are fulfilled at the date that the notional gain becomes chargeable. The s 169SC and s 169SD elections merely impose the statutory fiction that, at the date the notional disposal becomes chargeable, the company is the taxpayer’s personal company. They do not, for example, deem it to be a trading company or deem the taxpayer to be an employee or officer of the company: these conditions are tested by reference to the position actually obtaining when the notional disposal
becomes chargeable. It is thus possible that a notional gain that would have qualified for ER had it not been deferred under s 169SD will not qualify for ER when it subsequently becomes chargeable.

This article was first published in Tax Journal (Issue 1407) and is also available on the Tax Journal website.

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David Whiscombe


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