Entrepreneurs’ relief, the 10% capital gains tax rate on sale of trading business interests, is an emotive subject. It is either the ‘worst relief’ and costs the Government £2bn a year (The Resolution Foundation) or it’s one of the reasons why people are encouraged to set up businesses and pay tax in the UK. Business owners certainly don’t seem to emigrate to avoid UK capital gains tax like they did in the 1990s.
Most taxpayers are willing to accept a 10% tax rate and are keen to manage their affairs in a way that does not prejudice their entitlement to pay at the lower rate. Prior to changes announced in the Budget, this meant that shareholders in eligible companies had to make sure that they owned at least 5% of the votes and owned 5% of the ordinary share capital for one year prior to the sale. For disposals on or after 29 October 2018, the shareholder will need to meet these tests and have a 5% interest in the company’s distributable profits and net assets on a winding up (“the economic tests”) for two years.
Previously, HMRC published clear guidance on how the “Five per cent of what?” test should apply and people generally abided by it. Where this has run into trouble is that the tests applied to specific measurable features of the shares (their voting rights and face value) and not to their economic rights. What HMRC objects to is shares that have these features but do not necessarily entitle the holder to 5% of the proceeds of a sale or winding up of the company. It’s decided that such shares are being used to abuse the system. Maybe so, but not in all cases.
To understand why the innocent may be being swept up with the guilty, it is first necessary to consider why share classes with different economic rights exist in the first place. The shares created at the foundation of a business will typically be ‘ordinary’ shares with equal legal and economic rights to share in the profits of the company. So far, so good. But what happens when you grow and want to introduce new management and, possibly, attract new investment? This is typically where new share classes allow different shareholders to achieve different things.
Speculative investors may require a return on their investment in priority to the other shareholders (it’s their money and their risk that you can’t deliver the results you say you can). Incoming management may not have the same levels of cash available as the investors. They may therefore agree to take a class of share that entitles them to share in the growth of the company beyond a certain value (“growth shares”). They back their ability.
Everyone’s interests are broadly the same and they set out to achieve their objectives over a given timescale – typically 5 years. This is all a bona fide commercial practice that has evolved here in the UK and elsewhere in the world where entrepreneurs’ relief is not a consideration.
However, the owners of growth shares may now not be eligible to claim entrepreneurs’ relief unless they can demonstrate that they meet the 5% economic tests for the two years prior to the sale. This could be a highly subjective question that may come down to the estimated value of the company throughout the period. It’s bound to lead to protracted arguments with HMRC with the risk of suffering additional tax and penalties if HMRC won’t accept your claim.
It seems unfair to set the arbitrary importance of the number 5 above the risk and initiative taken by the ‘entrepreneur’. Why is 5 better than 4.99 anyway? The 5% test is already set aside for people who acquire their shares through the Enterprise Management Incentive scheme. Why do we need it at all? There must be better things to do than argue about the meaning of 5 at some dusty Tax Tribunal.
