Entrepreneurs’ relief: the brave new world
13 March 2019
This is an update on the changes to the qualifying criteria for entrepreneurs’ relief introduced in the October 2018 Budget, amended in December and now embodied in statute.
Last October we reported on the Budget 2018 changes to entrepreneurs’ relief as part of our general Budget update which can be found here.
The changes are so significant – with the potential to create a negative impact on some perfectly innocent structures - that we always intended to do a more substantial article on the topic. Then, just to make all our Christmas dreams come true, the government responded to some of the feedback it had received and amended the draft legislation in December. This update factors in those changes, which have now all passed through Parliament.
Changes to the left of me, changes to the right…
This update focuses on the changes to the qualifying criteria for taxpayers to benefit from entrepreneurs’ relief on a sale of shares. These changes were announced to come in with effect from 29 October 2018.
There is also a change to the qualifying holding period for sales of shares. This will take effect from 6 April 2019. The minimum holding period to qualify for all sales after that date increases to two years, from one year.
That has a funny cliff-edge effect. To take the most extreme example, someone who acquired shares on 5 April 2018 might qualify for entrepreneurs’ relief if they sell shares on 5 April 2019 (satisfying the current holding period of one year) but won’t be able to qualify for entrepreneurs’ relief after that unless they wait until 5 April 2020. Cliff-edge changes like this are really easy to avoid. Just “grandfather” in shares acquired on or before 5 April 2018.
But who said tax wasn’t meant to be taxing? (Answer: The government. Repeatedly.)
So what isn’t changing?
The good news is that shares which derive from EMI options will continue to benefit from their current advantageous treatment. There’s no 5% test of any kind for shares derived from EMI options; and that won’t change.
EMI options will be affected by the new two-year qualifying holding period though. What this means is that there needs to be a two year gap between an EMI option holder getting their option, and the eventual sale of shares derived from that option, in order to be able to claim entrepreneurs’ relief.
For all other selling shareholders – those who have actual shares rather than EMI options - the basic tests for entrepreneurs’ relief are also the same. The new tests introduced by the government are additional to the old tests. So you still need to meet the following conditions:
The four basic conditions
- You must hold at least 5% of the ordinary share capital of the company (measured by reference to the total nominal share value);
- your shares must give you at least 5% of the voting rights in the company;
- you must be an employee or officer of the company in which you have shares, or of another company in the same group; and
- the company or group must be a trading company or group (that is, without substantial investment activities).
And these conditions must be met throughout the one year (soon to be two years) leading up to sale.
What is changing then?
Finance Act 2019 introduces two new alternative gateways to getting entrepreneurs’ relief. They are not described as gateways, and they are not given names in the legislation. I think of them as the Strict Gateway and the Fuzzy Gateway. You need to pass through one of these gateways – in addition to meeting the four basic conditions outlined above –to claim entrepreneurs’ relief.
How does the Strict Gateway work?
The Strict Gateway is an extension of the existing 5% tests. To pass through this gateway you must hold shares which:
- entitle you to at least 5% of the profits available for distribution (if they were all distributed) to equity holders (the profit test); and
- on a hypothetical winding up, entitle you to at least 5% of assets so available (the asset test).
And further you must meet these conditions for the one year (soon to be two years) leading up to sale.
This extension is clearly designed to capture shares that don’t just carry 5% of voting rights, but also 5% of the true economic rights.
Is the Strict Gateway too strict?
The devil here is in the detail, and shareholders in companies with more complicated share capital structures might find this test difficult to satisfy.
For example, it is quite common for companies with multiple classes of share to include in the share rights the flexibility of paying different dividends on different classes of shares from time to time, at the directors’ discretion. Historically, shareholders have been comfortable with that structure. Now, such discretion causes all the company’s shares to fail the profit test, because no single shareholder can claim an entitlement to such distributable profits; at best there might be a presumption, subject to the directors determining otherwise, that dividends would be declared proportionately on all shares. But that’s not an entitlement.
Similarly, companies with any kind of economic waterfall in their share rights become much more difficult to analyse when applying the asset test.
For example, say a 100% shareholder / founder seeks investment in her tech start-up business, and a third party puts in £2 million for new equity on condition that they are paid £2 million first in the event of a sale or winding up (that is, they get a preference). It is then extremely unlikely that the founder would be entitled to 5% of the assets on a hypothetical winding up.
Other difficulties and complications with the asset test include the following:
- the hypothetical winding up exercise requires the drawing up of a simplified balance sheet which likely won’t include any value for goodwill. This dramatically undervalues many businesses; and
- the balance sheet that you are meant to use is actually the one for the accounting period during which you have to apply the asset test. That might mean that at the point of sale you don’t know if you satisfy the test, because you cannot draw up the balance sheet to assess the test!
Hmmm. Not sure I like this Strict Gateway. How about the Fuzzy Gateway?
Lots of people didn’t like the Strict Gateway and it has widely been characterised as only useful for the simplest of share capital structures. So the government (to give it its due) listened and, in December, came up with the alternative Fuzzy Gateway to assist everyone else.
The Fuzzy Gateway requires you to hold shares which entitle you, based on a reasonable assessment, to at least 5% of sale proceeds on a sale of all the ordinary share capital of the company. In applying this test, you assume a sale for market value.
There is a particularly helpful provision enabling you to treat the percentage which you would hypothetically receive at the end of the one year (soon to be two years) qualifying period as being the percentage you would have received throughout that period.
So how does the Fuzzy Gateway work?
The best way to think about this is to go back to our hypothetical start-up company which takes investment from a third party who is given a preferential return. Building on this example, the investor puts in £2 million on the basis that they will be paid the first £2 million and then share any excess proceeds 50:50 with the founder, on a sale or winding up. A year later the start-up hits a rocky patch, and on any assessment of market value it’s worth no more than £1 million on a sale. Taking a snapshot at that point, the founder is entitled to 0% of proceeds (because on the hypothetical sale, the whole £1 million would go to the investor). But the start-up recovers and another year later is sold for £3 million. The founder gets £1 million of that on sale (33% of the proceeds, comfortably in excess of 5%). The fact that she would not have met the 5% test throughout the qualifying period does not matter because – assuming the sale was an arm’s-length transaction, and so the £3 million sale price can reasonably be taken to be market value – she’s deemed to have been entitled to 33% throughout.
The Fuzzy Gateway is subject to an anti-avoidance condition which basically says that any planning done mainly to try to obtain entrepreneurs’ relief can be disregarded. It’s very difficult to see when HMRC would actually apply this. Presumably they do not consider that someone who negotiates to acquire 5% of a company after being offered only 4% - partly with the aim of claiming entrepreneurs’ relief – would be caught by this condition. Our working assumption is therefore that this condition will be reserved for wholly uncommercial structures which aim to boost someone’s entitlement on sale in a narrow way without genuinely expecting to deliver such an economic entitlement.
The Fuzzy Gateway is therefore much easier to apply than the Strict Gateway for many companies. Some tricky areas remain. For example, how do you assess someone’s percentage entitlement to proceeds if the actual deal on the table includes an earn-out? That earn-out might not be resolved for many years but it’s implicit in the legislation that you have to be able to form a view at the point of sale. The answer must be that the selling shareholder has to assess the likely total sale proceeds (including earn-out) and work out what their percentage would be on that basis. It won’t always be straightforward, but there’s at least a logic at work.
A narrowing of the conditions for entrepreneurs’ relief has been on the cards for a while. It’s a shame that the government’s first attempt did not accommodate real-life share structures adopted for sound commercial reasons. But following amendment the legislation we now have seems like a reasonable place to land.
The simpler change is the one that might have more impact. Changing the qualifying holding period to two years will mean that it’s more important than ever for companies to sort out their incentives and employee share plans as quickly as possible if the participants are to have any chance of benefiting from entrepreneurs’ relief.
If you have any concerns about your own capital structure, do get in touch.