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At the end of last year on 29 October 2018, Philip Hammond delivered his autumn budget. Following widespread speculation, the budget confirmed changes to the conditions which must be satisfied for shareholders to take advantage of Entrepreneur’s Relief (ER) on a disposal of their shares.
Entrepreneurs Tax Relief is a government scheme which means you may be able to pay less Capital Gains Tax when you sell a business or shares of a business. Those who qualify for this scheme will benefit from a generous capital gains rate of 10% up to £10m of lifetime gains.
Under current legislation (2018), Entrepreneurs Relief is generally available to any shareholder who:
Provided that the above conditions are met for a period of 12 months before the disposal, the shareholder should qualify for Entrepreneurs Relief.
Crucially, under the existing conditions, whilst there are requirements concerning voting rights and nominal value, there are no requirements for a shareholder to have any specific entitlement to dividends or return of capital.
As a result, many companies have issued shareholders with special classes of shares that carry the requisite voting rights, but do not carry fixed or minimum capital or, crucially, dividend rights. Under the existing regime, these shares should qualify for ER.
However, the proposals in the autumn budget stipulated new conditions, which were that:
In addition, the qualifying period during which the conditions must be met has been extended from 12 months to 24 months.
Whilst the logic behind the changes are apparent (that the relevant shares truly represent 5% of the underlying economic interest in the company), it may be that there are some unintended adverse consequences for shareholders who hold alphabet shares, growth shares or other classes of shares which have special rights.
Many companies have an alphabet share structure which allows the company to pay different dividends on different classes of shares. Alphabet shares provide more freedom and flexibility in paying shareholder dividends, so payments can be made to certain classes without having to pay the same amount in dividends to each company shareholder.
It is, however, not common to see any guaranteed minimum percentage return of dividend rights. Accordingly, there is arguably no certainty that those shareholders are guaranteed to receive the requisite 5% of distributable profits required to qualify for Entrepreneurs Relief. Based on the initial draft of the legislation, this has been noted as a significant problem which puts the availability of ER at risk for many shareholders.
On 21 December 2018, HMRC released a revised draft of the legislation, considering the numerous concerns which had been raised.
HMRC has listened to the concerns raised and has produced a revised draft of the legislation which seeks to rectify the issue. The revised legislation retains the initial test for 5% profit and asset entitlement; however, it also proposes a new “alternative” test.
The alternative test requires the shareholder to be entitled to at least 5% of the proceeds in the event of a disposal of the whole of the company’s ordinary share capital.
The shareholder must also still satisfy the 5% voting rights and ordinary share capital conditions. However, provided that this “alternative” test is satisfied, and the shareholder can demonstrate that the conditions have been met for the 24-month period prior to the sale, the shareholder will not have to demonstrate that it also had an entitlement to 5% of the distributable profits and net assets.
The new alternative test is a welcome revision to the draft legislation and does go some way to address the concerns around special classes of shares and the availability of ER on their disposal. On the face of it, special rights concerning dividends will not preclude the availability of ER to shareholders, provided the “alternative” test can be satisfied.
However, the new alternative test does also give rise to several additional queries, and HMRC guidance will be needed to properly apply to the test. This is particularly the case with more unusual share structures, for example on ratchet/growth shares which may be entitled to 5% of the proceeds at the date of a disposal, but which may not be able to demonstrate an entitlement to 5% of the proceeds during the whole 24 month qualifying period.
It should also be stressed that the legislation remains in draft format, and it is possible that HMRC may make further amendments. Once the legislation is in final form, we would recommend that you take appropriate legal and financial advice to ensure your share structure does not preclude you from obtaining ER.
If you wish to discuss any of the issues concerning the availability of ER, please contact our expert Corporate Commercial team.