Following the Budget on 29 October, it has become fairly well known that the ‘qualifying period’ for entrepreneurs’ relief (ER) is increasing from 12 months to 24 months for disposals on or after 6 April 2019. Apparently, the Government now feels that ownership for 24 months demonstrates entrepreneurial activity whereas 12 months is more characteristic of investment or speculation.
As a transitional measure, where a business ceased prior to 29 October the qualifying period remains 12 months, regardless of whether the disposal occurs after 5 April 2019, so as to avoid any element of retrospective taxation.
The qualifying period is the period throughout which certain conditions must be met to obtain the relief.
What is less well known is that two new conditions were introduced for the sale of shares in a company, effective for disposals on or after 29 October.
As a reminder, prior to the Budget a shareholder could qualify for ER where the company is a trading company and the shareholder is an employee or officer of the company and holds at least 5% of the company’s ordinary share capital, giving them at least 5% of the voting rights.
The two additional tests are that the shareholder now needs to be beneficially entitled to at least:
- 5% of the profits available for distribution; and
- 5% of the assets available on a winding up of the company.
On the face of it, these new tests may seem innocuous – surely, 5% of the shares gives you an equivalent entitlement to votes, dividends and assets? For many companies with straightforward share capital the answer will be ‘Yes’ and ER will be available. But what about companies with different share classes?
There are a number of reasons why a company may have more than one class of shares; one common reason being to provide flexibility over the declaration of dividends. Where this is the case, the entitlement to dividends of each share class will likely be decided by the directors as and when they see fit. After all, prescribing the entitlement in the company’s Articles of Association or a shareholders’ agreement might undermine the desired flexibility.
It is this situation where the first of the new tests may cause a problem. If the entitlement to a dividend is left to the discretion of the directors, does the shareholder have an entitlement to at least 5% of the distributable profits at any given time? Arguably, not.
When announcing the change, the Government stated it believes ER should be targeted to individuals who show ‘the characteristic of true entrepreneurial activity, as distinct from simple investment or employment’ and believes the change would affect a very limited number of cases. In our experience, multiple share classes are a common feature of many entrepreneurial companies and the impact of the change could be far reaching.
The second of the new tests provides for some interesting calculations where the company has non-commercial debts and, in theory at least, it needs to be assessed every day of the 24-month period. For most companies it will be easy to assess but, once again, it may have unintended consequences.
The draft legislation setting out the new tests has been published. We have raised our concerns with members of Government, our professional bodies and Tax Counsel and we await the Government’s next move. If there is no change to the legislation before it is enacted, affected companies will need to consider amending their Articles to give shareholders the required entitlements. Where an individual has ceased to qualify for ER from 29 October, it may be a further the 24 months before the relief becomes available again.
In the meantime, we hope the consequences of the change are indeed unintended and the Government will address it.