Entrepreneurs’ relief changes lead to retrospective taxation
The last few Budgets have not been kind to owner managed businesses, with a series of measures being enacted to curtail perceived abuses of the rules for entrepreneurs’ relief.
So it was a welcome change this year to see the Government announcing a relaxation of some of the restrictions that they introduced in 2015.
Unfortunately, in their haste to put matters right, they’ve actually made matters very wrong.
It all comes about as a result of proposals to backdate the amendments to 18 March 2015 when the rules were first changed. If the legislation is passed in its current format, some people who lawfully claimed the 10% rate under the associated disposals rules will find that they didn’t qualify after all. As a consequence, the higher 18%/28% rates should have applied, which means that there is some tax still owing. Will these people be asked to make good the shortfall?
New rules for entrepreneurs’ relief and associated disposals
The purpose of entrepreneurs' relief is to encourage individuals to set up and grow their own business. If the relevant conditions are satisfied, capital gains arising on the sale of the business are taxed at a rate of 10%.
The relief applies to a disposal of business assets consisting of either:
- Shares or securities in a trading company, including the holding company of a trading group. The company must be the individual’s personal company in which he holds at least 5% of the ordinary share capital, together with the associated voting rights.
- Assets of a trade, where the individual operates either as a sole trader or member of a partnership. The assets disposed of must constitute all or part of a business.
There is a one year holding period for which the assets must have been owned up till the date of disposal. There are further provisions that permit relief if the assets are disposed of within three years of the business ceasing to trade.
Relief is also possible for an associated disposal where a business owner personally provides an asset for use in the trade (TCGA 1992 s 169K). The 10% rate will apply to a disposal of the asset provided that:
- The asset has been used in the trade for at least one year, ending on the date of the disposal, or (if relevant) when the business ceases.
- The asset disposal is linked to the individual withdrawing from the business by disposing of all or part of his shares or partnership interest as the case may be. This disposal must also satisfy the conditions for entrepreneurs’ relief.
In short, there must be two disposals: The asset used in the trade, together with the individual’s personal share of the business.
For example, consider the case of a partnership that trades from premises owned by one of the partners in his personal capacity. He decides to retire, selling his share of the business to his fellow partners. The partners also buy the business premises so that they can continue trading from the property. The latter transaction constitutes an associated disposal.
What are the new rules?
It isn’t actually necessary to sell your entire interest in the business to qualify for associated disposals relief. However, last year, a new condition was introduced, requiring that the interest disposed of must constitute a minimum 5% stake in the business.
Industry insightsView more
This led to some objections, particularly from the CIOT who claimed that the new rules would adversely impact succession planning in family businesses. For example, older members planning their retirement will transfer holdings to other family members gradually, over a period of time. However, any personal assets loaned out to the business will fail to qualify for the relief once the holding dips below the 5% level. This can be a harsh outcome if the asset had been employed in the trade for many years.
So the Government has decided to change the rules again (Finance Bill 2016 Clause 73):
- For partnerships, when selling out completely, it is no longer necessary that the holding constitutes a 5% stake at the point of sale. However, the relevant partner must have held a 5% stake for a continuous three year period during the 8 years leading up to the date of the disposal.
- A partner can still sell a partial stake, but this must constitute a 5% interest.
- For both partnerships and companies, a person providing an asset to the business must have owned it for at least three years before he can qualify for relief under the associated disposal rules.
The effect of the first two rules is to permit the sale of a partnership holding in tranches, with each tranche consisting of a 5%-plus stake until the final sale. Once the holding dips below 5%, the partner has a further five years to make a final disposal.
What is the mischief?
The mischief lies in the fact that these changes have been backdated to 18 March 2015 when the original 5% rule was introduced (Finance Bill 2016 Clause 73(15)).
|After 18 March 2015 (Finance Act 2015) (“old” rules)||After 18 March 2015 (Finance Bill 2016) (“new” rules)|
|Ownership period of asset used in business||Asset must be used in the business for 1 year.||3 years|
|Ownership period of partnership interest (partial sale)||1 year||1 year|
|Ownership period of partnership interest (complete sale)||1 year||3 years|
Consider the example of the partner selling the business premises to the partnership as part of his retirement plans on 19 March 2015:
- If he had owned the property for one year, the 10% rate would have applied under the old rules. But as a result of the backdated new rules, he shouldn’t have qualified and may now have an additional tax liability.
- If he had been a partner for just one year, he would have qualified for the relief, assuming that he also satisfied the 5% rule. Under the backdated new rules, he’s safe if he sold a partial stake, but he’s in trouble if he sold out completely.
The last result is bizarre. The associated disposal rules are designed to apply when a person is withdrawing from the business. So why is the person who sold out completely to be worse off than the person who still retains an interest in the business?
Clawback of relief?
So what’s going to happen to all these people who sold early and thought they’d ticked all the boxes? Are they going to have to pay the extra tax?
There is nothing to suggest that this is the intention, though at the same time, there is nothing to suggest that the Government has spotted the slip of the pen – if indeed it is a slip. What is important is that this needs to be corrected sooner rather than later, and certainly before the Finance Bill receives royal assent.
Satwaki Chanda is a tax lawyer, who has worked for both a Big Four practice and City law firms. He now writes extensively on business and property taxes - you can find more articles from him on his Tax Notes blog.
A tax lawyer with more than 15 years of tax experience, having worked for City law firms and a Big Four accountancy practice.