The latest updates to Entrepreneurs Relief (ER) include an extension to the qualifying holding period and an extension to the definition of a ‘personal company’. Both of these are significant changes and will likely impact your eligibility to pay capital gains tax (CGT) at a reduced rate under ER.
Philip Hammond, Chancellor of the Exchequer, announced the changes in his budget speech on the 28th of October “to ensure it is going to genuine entrepreneurs”, as he put it. The extension on the definition of a personal company came into effect immediately (on the day of the budget) while the extension on the qualifying holding period will only come into effect on the 6th of April 2019.
ER qualifying criteria can get very technical so below we’ll:
- Briefly look at what ER is and how it works.
- Discuss the changes to ER and their impact.
- Consider the impact of these changes on alphabet shares specifically.
- Look at what steps you can take if you are unsure of how your ER eligibility is affected.
1. How does Entrepreneurs Relief work before the changes?
ER allows you to pay a reduced CGT rate of 10% (instead of 20%) on all qualifying assets.
What are qualifying assets? This can be broken down into 3 broad categories:
You’re selling all or part of your business
In order to qualify you must be a sole trader or business partner and you must have owned the business for at least one year (increases to two years from April) before you sell it.
You’re selling assets you lent to the business
In order to qualify you must sell a minimum of 5% of your part of the business partnership or shares in a personal company (see definition below) and you owned the assets but let your business partnership or personal company use them for at least one year up to the date you sold your business or shares.
You are selling shares or securities
This is the more common scenario and in order to qualify you must be an employee or office holder of the company for at least one year before the shares are sold and the main activities of the company must be in trading (as opposed to non-trading activities like investment).
There may be greater flexibility if the shares were acquired as a result of an Enterprise Management Incentive (EMI). If this applies to you then please seek advice on your specific scenario.
If, however, the shares are not from an EMI, the business must have been a personal company for at least one year before the shares are sold. To qualify as a personal company, you must own at least 5% of the share capital and 5% of the voting rights (but also note the extra condition now added in as outlined below).
2. The changes to Entrepreneurs Relief and their impact
To tackle the misuse of ER, the first update with immediate effect is the widening of the definition of a personal company and will likely only have an impact on individuals selling shares in a personal company. Before the budget, a personal company was considered to be one where you held at least 5% of the share capital and a minimum of 5% of the voting rights. This definition has now been extended to also include an entitlement to at least 5% of the profits that are available for distribution and an entitlement to at least 5% of the assets on winding up of the company.
The second update is an extension to the minimum qualifying period and will impact all 3 scenarios discussed above. From the 6th of April, the minimum qualifying period will be 24 months instead of 12 months. According to the budget speech, the goal with this change is “to support longer-term business investments.”
3. The impact of these changes on alphabet shares specifically
Many companies issue multiple classes of shares, also known as alphabet shares. In most cases, it is at the directors’ discretion to declare dividends on each class of share independently.
The result is that there is not necessarily an entitlement to available distributable profits (as it’s up to the discretion of directors) and it might not necessarily be at 5%. Furthermore, shareholders who previously qualified for ER are not eligible anymore if the two extended requirements are not also met.
Unless the Articles of Association specifically include an entitlement to dividends of 5% or more on a specific share class, ER is not applicable, even if dividends of more than 5% are declared by directors in a certain period.
The Articles of Association can be amended to include a specific entitlement of 5% or more on certain share classes to restore ER but HMRC’s likely stance will be that the shares must then be held for 2 years from the date of the amendment (so 2 additional years in practice).
4. What steps can you take if you are unsure of the impact on your ER eligibility?
It is important to remember that the legislation is in the draft stage so it can still change. HMRC have released two policy papers on the changes (Capital Gains Tax: Entrepreneurs’ Relief: minimum qualifying period extension and Capital Gains Tax: Entrepreneurs’ relief: definition of a ‘personal company’) for further guidance.
Individuals impacted by these changes need to be considered on a case by case basis as each person’s situation is likely to be different so a blanket approach to addressing this cannot be adopted.
Therefore, if you are unsure about the possible impact these updates have on your eligibility for ER and you would like greater clarity on your specific situation, please get in touch with us. Liam Henry and our other professional tax experts will be happy to help.
Please read an update to this article here following the government announcements in December.