Tax Tuesday has mixed feelings about correctly predicting the reduction in the lifetime gain eligible for Entrepreneurs’ Relief (ER), announced in last week’s Budget.
Thankfully, the attractive relief has survived, albeit at a reduced level, so now is an ideal time to consider its application………
According to reports, it was all too likely that ER, the 10% rate of Capital Gains Tax, would cease to exist. In fact, Mr Sunak kept it alive but took its scope back to where it began its life, in 2008.
ER is a 10% rate of Capital Gains Tax. It applies to gains on qualifying disposals of trading businesses and shares in trading companies, wherever they are situated or operating in the world.
The critical conditions which apply to a disposal of shares are as follows:
- The disponor (seller) of the shares must have held a qualifying stake (a “5%” stake – see (iii) below) for at least a two year continuous period through to the date of disposal;
- The disponor of the shares must have been an officer or employee of the company (or of a group company) in which the shares are held, for at least a two year continuous period through to the date of disposal;
- The “qualifying stake”, referred to in (i) above, is a holding of ordinary shares which represents at least 5% of the nominal value of the company’s total ordinary share capital and commands at least 5% of the total voting rights in the company;
Care is always required when assessing whether a taxpayer meets essential conditions, of course, and, by way of example, this “5%” test can throw up unexpected pitfalls in relation to what does, or does not, constitute “ordinary share capital”.
- The company (or group) in which the shares are held must have been a trading company throughout a continuous period of at least two years through to the date of disposal, and must not have been engaged in non-trading activities to a “substantial” extent.
“Substantial non-trading activities” is a very vague and subjective concept which probably warrants a blog-post of its own. Suffice to say, here, that;
- wherever there are non-trading assets or activities within an otherwise trading company (or group), careful attention is required to assess whether they can safely remain there, without undue risk of disqualifying ER on the shares; but
- as a generality, the retention of substantial undistributed profits in cash should not cause the company to lose ER qualifying status, as long as that cash has not become the subject of active management (which might then imply real non-trading activity).
If the conditions for ER are fulfilled, both by the company (or unincorporated business) and by the individual owner (or trustees of a settlement holding shares in specific circumstances), then a capital gain arising on a disposal will qualify for the 10% rate unless the disponor has already utilised his or her “lifetime gain” capacity.
Prior to last Wednesday, an individual’s lifetime gain limit was £10m. At this level (combining with another £10m contributed by a spouse, perhaps), the relief enabled serial entrepreneurs to build and sell more than one business in their lifetime and enjoy the 10% tax rate on some or all of their successive gains. But the limit has now been brought back down to £1m per individual, arguably making it much more likely that it will provide some reward for a singleton business which is grown and sold. Nevertheless, with £2m between husband and wife to work with, ER still provides up to £200,000 of tax saving compared to the CGT position which would have applied on disposals of shares otherwise subject entirely to the 20% nominal rate of CGT.
To the portfolio of privately-owned trading clients looked after by this practice, scope to realise up to £2m of gain within a preserved 10% tax rate is undoubtedly welcome.
It should be noted that the newly-reduced lifetime gain capacity is not a “fresh” allowance beginning on 11 March 2020 – it takes into account any and all prior ER qualifying gains, so those who might previously have realised over £1m gains at the 10% rate will have no further capacity.
It is not uncommon for trading assets to be held outside the company in some instances (sometimes for protection purposes, alternative ownership structures, taxation management etc.). This is most likely to involve trading premises or intellectual property, in our experience.
Where there is a disposal of the underlying business, including a sale of shares in the company (or group), it is possible for a disposal of the separately-held trading asset (at, around or after that time) also to qualify for ER.
ER applies to disposal by individuals but it can also apply to disposals of qualifying assets by the trustees of a settlement where specific conditions apply. Those conditions include the situation where an individual who holds a qualifying shareholding directly in the trading company, is also the beneficiary of a “life interest” in a settlement for him or her. This facility can enable us to combine the wider benefits of a trust with preservation of good CGT efficiency through ER.
Enterprise Management Incentives (EMI) share option scheme
The preservation of ER is particularly good news in relation to the ongoing use of the highly advantageous Revenue-approved share option scheme known as EMI.
EMI is the subject of a blog-post here dated 24 September. Within that outline of the features and benefits, we explained how some of the conditions for ER are significantly relaxed for shareholders who have acquired their shares through EMI. By the very nature of share option schemes for employees, these will typically involve small stakes and stakeholding values which are rarely in the same ballpark as that of the majority owners. As a result, the retention of the relief at the £1m lifetime limit should ensure that this scheme will continue to offer a powerful solution for the recruitment and motivation of key personnel.
A considerable part of our work as tax advisers and planners involves achieving extraction of value from the privately-owned company at lowest tax cost.
Avoiding Income Tax rates altogether and substituting CGT rates (including 10% ER, in particular) can make a huge difference to net monies retained. Family Succession arrangements are major potential events which can be capable of this highly advantageous outcome. Even when Mum and Dad don’t actually need or want a “payday”, succession can play an important role in tax management for the whole family.
Incorporations of trading business can also be a source of low-taxed capital, instead of “income”, out of future profit streams. Although we aren’t able to access ER from disposals of goodwill or other customer-related intangible assets, on incorporation, businesses which involve other chargeable assets, like trading premises, provide a source of ER-qualifying disposal worth considering.
It is a major relief to us and to our clients that ER remains on the statute book. We should make sure that we do not miss the opportunities which it continues to present, even at the lower limit which now applies.
If you would like to discuss how this relief might assist you in your taxation management or to check that you are, indeed, safely compliant with its conditions, please contact your relationship principal here, or email Tax Partner, Chris Barrington.