Budget changes to the entrepreneurs’ relief conditions are proving difficult to translate into watertight law, so the government has announced a further test to provide a shortcut to what it intended to achieve.
What’s the goal?
In the 2018 Budget, the Chancellor announced that two additional conditions would apply with immediate effect to change the definition of a “personal company” for shareholders who claim entrepreneurs’ relief. The aim is to restrict the relief to shareholders who have a genuine material stake (at least 5%) in the company.
For a shareholder to claim the entrepreneurs’ relief on gains arising from shares, or assets used by the company, the company has to be their “personal company” and they must be an employee or officer of that company, or of another company in the same trading group.
Personal company definition
For a company to be their personal company the shareholder must meet four conditions with regard to their shares:
hold at least 5% of the ordinary share capital;
control at least 5% of the voting rights which are exercisable by virtue of that shareholding;
have a right to at least 5% interest in the distributable profits; and
have a right to at least 5% of the net assets due to the equity holders on a winding-up of the company.
Tests 3) and 4) are the new additions but these concepts are proving difficult to codify into law. Instead of thinking the problem through from first principles, the civil servants have cut and pasted provisions relating to companies, intended to prevent abuse of corporation tax group relief, into the entrepreneurs’ relief rules.
The result is a complex mess. To understand the new tests the shareholder (or their adviser) would have to refer back to definitions written for a company receiving a distribution from another company.
There are also questions about how a shareholder determines whether they are entitled to dividends, as such entitlement does not come into being until a dividend resolution is passed by all the eligible shareholders. The law does say that a dividend doesn’t have to be actually paid to prove entitlement to a dividend, but that doesn’t get around the basic entitlement question.
The CIOT and other professional bodies have been in discussions with HMRC over the wording of the draft legislation, and late on 21 December 2018 the government tabled an amendment to the Finance (no. 3) Bill 2019, Sch 15, para 2.
This amendment adds an alternative test for a “personal company” based on the shareholder’s entitlement to proceeds in the event of a hypothetical sale of the whole company.
This new test essentially says: “will the shareholder be entitled to at least 5% of the proceeds in the event of the disposal of the whole company?”
It assumes that the entire company is sold for its market value on the last day of the qualifying period (ie the date of disposal of the shares/ assets which are the subject of the ER claim), and ignores anti-avoidance rules for the purpose of this hypothetical sale. This new test doesn’t rely on the definitions in the Corporation Tax Act 2010 and it can be used instead of the tests 3) and 4) above.
However, the new tests 3) and 4) have been left in the draft Finance Bill, apparently to “provide certainty to those with straightforward company structures”.
Also, any disposals made between 29 October 2018 and 20 December 2018 must apply tests c) and d) rather than the new hypothetical sale test which only comes into being from 21 December 2018.
A complicated fudge
What we have is a fudge to make the new conditions operate in the way the Chancellor intended. This is welcome, as in most cases it will be easier to estimate the value of the whole company on a single day, rather than having to worry about changing shareholder’s rights and dividend entitlements over the entire qualifying period (12 months to date of sale, rising to 24 months on 6 April 2019).
However, where there is a valuation there is always room for argument, particularly as the companies concerned are unlikely to be listed on a stock market. Even with the fudge, entrepreneurs’ relief just got a whole load more complicated.