Entrepreneurs’ Relief – The Pitfalls
The introduction of the new Investors’ Relief on 6 April 2016 may have made Entrepreneurs’ Relief (“ER”) appear slightly less important, however it is still a very valuable capital gains tax (“CGT”) relief worth up to £1.8m in the right circumstances. In addition there are important differences between the two reliefs, as we have covered previously – for example, an investor cannot be an officer or employee of the company and many investors in small and medium sized businesses will prefer to work in the business.
Both reliefs apply a 10% CGT rate in the right circumstances. If a disposal does not qualify for either relief then the CGT rate doubles to 20% for higher and additional rate income tax payers for a sale of shares. If a disposal fails to qualify for ER, it is highly unlikely to qualify for the Investors’ Relief; therefore it is important to be clear from the outset which relief you aim for otherwise the CGT liability will potentially be doubled.
Most owner managed businesses will seek to apply ER on a disposal, for this reason we have set out below 5 common pitfalls which would preclude the availability of ER on the sale of company shares.
Significant non-trading activity
The shares in question must be shares in a trading company. If the company carries out non-trading activities to a ‘substantial’ extent, it may prejudice a claim to ER. HM Revenue & Customs has gone on record to say that they consider ‘substantial’ to mean more than 20%. The 20% test is applied to various things such as turnover, total assets and the proportion of time spent on non-trading activities. The company must be looked at ‘in the round’ rather than focusing on one particular item.
Less than 5% in shares
In order to qualify for ER a shareholder must have held at least 5% of the ordinary share capital of the company throughout the 12 months prior to sale. There is however no aggregation of shares held by spouses so where relevant it is important to ensure both husband and wife each hold the minimum shareholding in their own right.
Skewed voting rights/share capital
The requirement to have at least a 5% interest in the company applies also to voting rights. It is not uncommon for a company to have additional classes of shares which all need to be taken into account when considering whether the requisite 5% of voting rights and 5% of share capital has been satisfied.
Shareholder is not an employee
The shareholder must also be an officer or employee of the company up to the point of sale. If shares are passed to a non working spouse pre-sale or are being disposed of by an employee after retirement for example they will not qualify for ER. It is important to note however that there is no requirement for employment to be on a full time basis.
12 month qualifying period
For normal share sales all of the above conditions must be satisfied throughout the 12 months up to the date of disposal. Again shares passed to a spouse or other family members pre sale with a view to taking advantage of their annual exemptions or lower tax bands will not qualify unless the 12 month test has been met.
When contemplating any business or share disposal the availability of ER is likely to be one of the key issues. As indicated there can be many pitfalls and early consideration of the key factors is crucial so that planning opportunities may be identified in good time.
It is also important to point out that there is a time limit for claiming ER and failure to meet this deadline could be a costly mistake.
If you would like any further information about Entrepreneurs’ Relief or Investors’ Relief please contact our Tax Director, Jenny Marks.
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