Budget 2018: Entrepreneurs’ relief curtailed

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Investors who hold shares with restricted rights have lost access to entrepreneurs’ relief, as the definition of a “personal company” for that relief was revised from Budget Day.

For entrepreneurs’ relief to apply to gains arising from the disposal of shares or securities, the company that issued those shares must be the taxpayer’s personal company. The government has added two new conditions of the definition of a “personal company” with effect for disposals made from 29 October 2018.

Three becomes five

The taxpayer must now meet the following five conditions for a 12-month period ending with the date of disposal, or the date the company ceased trading or ceased being a member of a trading group, where the shares are sold within three years of that cessation:

  1. Be an employee or officer of the company
  2. Hold at least 5% of the “ordinary share capital”
  3. Hold at least 5% of the voting rights associated with that ordinary share capital
  4. Be entitled to at least 5% of the company’s distributable profits
  5. Have a right to at least 5% of the net assets of the company available to equity holders on a winding-up

Why?

The government says that these additional conditions (numbered 4 and 5 above) have been added to ensure that individuals who benefit from entrepreneurs’ relief have a true material stake in the company. The Budget briefing goes on to say: “Having such an interest is characteristic of true entrepreneurial activity (as distinct from simple investment or employment), so the measure ensures that allowable claims are limited to those which are within the spirit of the relief.”

What is ordinary share capital?

Until 29 October 2018, an individual holding shares with restricted rights to dividends or to assets on a winding-up could qualify for entrepreneurs’ relief. This is because the definition of “ordinary share capital” covers all the shares of a company except fixed dividend shares. In other words, just about any class of shares, however they are described, are included. As long as the shareholder also has enough voting rights, the other rights they hold to dividends can be negligible.

HMRC has recently updated its guidance on ordinary share capital to include situations where the position is marginal between the shares being ordinary share capital or not, and has included a number of examples.        

Who will be affected

Individuals who have built up their own company and hold ordinary shares with full voting rights and rights to the company’s assets on a winding-up should not be affected.

Employees who have acquired shares through employee share schemes, particularly EMI shares, may find they have suddenly lost their right to entrepreneurs’ relief, as employee shares tend to be issued with restricted rights.

Directors and managers who have taken part in a management buyout who hold shares acquired through the buyout may also have few rights to the company’s assets on a winding up, as those asset-related rights will be held by the financers of the deal who have a different class of shares.

Where an individual sells a business asset in association with a disposal of shares, (an “associated disposal”), the company in which the shares are held must also be the taxpayer’s personal company. So those taxpayers could also be caught be this change in the personal company conditions.

Period of qualification

Another change to entrepreneurs’ relief will be introduced for disposals made from 6 April 2019, but it starts having an effect immediately.

Currently, all the conditions for entrepreneurs’ relief must be met for at least one year ending with the date of sale, or if the business has ceased, to the last day of trading. From 6 April 2019 all of the qualifying conditions, including the new conditions for a personal company described above, will have to be met for at least two years ending with the date of disposal, or the cessation of trading.

If the business ceased trading before 29 October 2018, the one-year qualifying period will still apply to the gains arising from the shares or assets disposed of after cessation.

About Rebecca Cave

Consulting tax editor for Accountingweb.co.uk. I also co-author several annual tax books for Bloomsbury Professional and write newsletters for other publishers.

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05th Nov 2018 10:30

Do theses changes apply to EMI shares? The personal company definition doesn't apply and they have to be relevant EMI shares. Might this not make EMI more attractive?

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By Ruddles
to pridgway
05th Nov 2018 10:45

That's a point that I made earlier - the 5% tests and the EMI condition are mutually exclusive. My concern is that the underlying requirement of EMI status is that the options are granted to retain and/or recruit key employees. HMRC might have something to say about this if EMI options start to be used simply as a means of circumventing the 5% tests, especially if the vesting period is short. (I have seen instances of options being granted, and excercised the following day, as a means of giving employees less than 5% in the company yet qualifying for ER.)

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By djn24
05th Nov 2018 10:40

What if we have a company structured like this with three directors:

Director 1 owns 65 ordinary A shares
Director 2 owns 45 ordinary B shares
Director 3 owns 40 ordinary C shares

Shares carry full rights with regards voting and dividends. I suppose all of these shares would still qualify for ER?

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05th Nov 2018 10:47

I can't see alphabet shares are an issue because presumably there is still ENTITLEMENT, but what about dividend waivers?

I know dividend waivers are not a great idea but, setting aside other potential problems with them, if a shareholder, otherwise qualifying, signs a dividend waiver will that mean he no longer qualifies for entrepreneurs' relief? He has forgone his entitlement.

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to graydjames
05th Nov 2018 11:07

I think waivers are perhaps less of an issue than alphabet shares. With a waiver the shareholders have an entitlement under the articles that is constant but the shareholder makes a personal decision not to have it. With alphabet shares, although they rank equally, it is the directors who decide. Also, because of the need to have satisfied the conditions for a year (soon to be two) it might be the historic position that we have to look at. I would tend to agree with you that alphabet shares should be OK; however, the tests applied were never meant to apply to situations like this (they were meant to ascertain whether there was a group relationship during an accounting period AFTER the period had ended) and this is just lazy cut and paste drafting.

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By Ruddles
to pridgway
05th Nov 2018 11:22

Agreed - with a waiver one is generally giving up their entitlement to participate in a specific dividend. They will otherwise continue to be entitled to share in the profits of the company (which could include other dividends declared on the same day). Waiving entitlement to all dividends for a specified period (especially if open-ended) is likely to be more problematic.

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to Ruddles
05th Nov 2018 12:11

Even with a waiver of all dividends I am not sure there is a problem. The rights attaching to the shares is for a dividend and this is in the articles. The waiver does not alter the articles, it just says "I don't want it". If the shares were sold they would be sold with an entitlement to the same dividends as all the other shares of that class. I think the problem is the historic aspect. Would it be "you weren't entitled to a dividend because you waived it" or "you were entitled to a dividend but you waived it". It may yet be a case of legislate in haste, repeal at leisure; it happened with goodwill; it happened with associated disposals and may yet happen with this.

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By Ruddles
to pridgway
05th Nov 2018 15:54

Perhaps the problem is in the wording of the waiver. Most that I have seen are along the lines of "I hereby waive my entitlement to ..." So, regardless of what the Articles may say, if I have surrendered my entitlement I am, by definition, no longer entitled ...

The fact that a subsequent owner may be entitled to dividends (and thus ER) has no bearing on my own status. ER availability is dependent on the status of the person holding the shares and not intrinsically on the shares themselves, though the two may of course be connected. If I hold 4% (non-EMI) shares and B also has 4% neither of us are entitled to ER. If one of us sells our shares to the other then the buyer becomes entitled to ER.

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05th Nov 2018 11:07

Open ended dividend waiver I would think does sacrifice entitlement, and therefore new personal company status, but not necessarily a one-off in respect of a particular dividend.

I think this _could_ affect alphabet shares too - if A, B & C classes can all receive a dividend independent of the others then is any shareholder actually _entitled_ to a dividend? Any class could be totally excluded, with all profits distributed to one or both of the other classes.

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05th Nov 2018 11:50

I think there is a major problem with alphabet shares.

The draft legislation says "beneficially entitle P to at least 5% of the profits available for distribution to the equity holders of the company".

If shareholder A may not get any dividend at all on his A shares if the directors so decide then it seems to me that there is no way that you can say that A is 'beneficially entitled'.

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to jon_griffey
05th Nov 2018 12:03

Again, I think the historic position may be the issue.

However, what if the directors say "This year we will declare no dividends"? Does that mean that it can't be the personal company of any of the shareholders? Shareholders funds is the residual amount payable to the ordinary shareholders after any preferential rights; so if no one else is entitled to them, the ordinary shareholders are and they are entitled to them pari passu. Who is entitled to them otherwise? How those funds are then distributed is a matter for the directors. I think if you look at in the abstract at any point in time you would say that all the shareholders are equally entitled absent a decision of the directors.

I throw these questions out as much to try to clarify my own thoughts (and question them) as to challenge in order to find some sort of answer.

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to pridgway
05th Nov 2018 12:29

If you have just one class of shares then an individual shareholder is beneficially entitled to ANY dividend pari passu that happens to be paid. If there is no dividend paid in a particular year it does not detract from this right.

With alphabet shares, the whole of the divided could be paid to the B class, leaving the A class with nothing. There is no way that any class can be said to be 'entitled' - as clearly they are not.

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to jon_griffey
05th Nov 2018 12:56

So if you have a company with 5 classes of shares A, B, C, D and E which rank pari passu save that dividends are to voted by the directors and in one year, notwithstanding healthy reserves, the directors decide not to declare a dividend, what is their entitlement?

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to pridgway
05th Nov 2018 13:00

Is it necessary to work on the premise that a dividend IS to be declared? Then on that basis ask what is the beneficial entitlement.
If there is one class of ordinary shares then there is an entitlement to the relevant proportion, but if there are alphabet shares then no shareholder has an entitlement because any (but not all) could be completely excluded from a share of that dividend.

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to Brian Gooch
05th Nov 2018 13:30

I think the draft legislation can be better worded. The control test under Section 450(3)(c) CTA 2010 states:

"so much of the issued share capital of C as would, on the assumption that the whole of the income of C were distributed among the participators, entitle P to receive the greater part of the amount so distributed"

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to Brian Gooch
05th Nov 2018 13:33

Therein lies the problem. Someone must be entitled to the company's reserves, they are, after all, shareholders' funds. Where there is one class of share then I think you are right. Where there is more than one class of share I don't think no one can have an entitlement because the reserves belong to the shareholders. One could say they are equally entitled. Even then, if someone is voted £1, the others are still entitled to the balance until it is voted elsewhere.

Similarly, where you have two classes of share, an "A" share which is vanilla ordinary and a "B" share which is entitled to the first £100 and then ranks pari passu with the "A" share. With £100 of reserves "A" has no entitlement. With £200 of reserves "A" has a 25% entitlement.

The legislation says you look at the accounts for the accounting period and it is the entitlement during that accounting period. If you vote dividends after the accounting period then your entitlement during the period is unaffected by what happens afterwards. And your entitlement during the period is only relevant to the previous period as the reserves may be materially different. On that basis I would say that the entitlement to alphabet shares is the same if they rank pari passu during the accounting period and cannot be affected by voting of dividends afterwards, nor during for the previous period.

Really what I am saying is that the legislation was intended for something entirely different and as far as ER is concerned is not fit for purpose.

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to pridgway
05th Nov 2018 13:56

I agree it makes no sense for no-one to have an entitlement, but maybe it's Schrodinger's reserves - until you prod the directors to decide how to pay out the reserves, you don't know who will get that entitlement.

You are right, it is a nonsense and the legislation has been pulled out of context to try to fit somewhere that it doesn't work.

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By Ruddles
to jon_griffey
05th Nov 2018 13:13

I disagree - you are working on the premise that the B shareholders are not entitled to a dividend because no dividend has been declared on that class of share. Which means that no-one is entitled to a dividend until it is declared. Which means that a person holding 100 out of 100 it’s will fail to qualify if no dividends are declared.

The test is whether a shareholder has, by virtue of his shareholding, an entitlement to share in the distributable profits - whatever the amount of those profits may be.

Taking your argument to its illogical conclusion, if the company is loss-making, no shareholder of any description will have an entitlement to profits, so no ER.

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to Ruddles
05th Nov 2018 13:35

The legislation says if there are no reserves you take a notional £100; the conclusion you come to is the same. Someone must be entitled to the £100 otherwise there is no reason to have it.

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to jon_griffey
05th Nov 2018 14:06

I'm with Jon on this point. If you have two classes of shares and they don't rank pari passu, then neither is entitled to 5%, and nobody gets ER. The point about there being no declaration of a dividend is a red herring, IMO. You have to assume that there is a dividend; to say that no dividends mean no ER would be nonsense. It would be easy to put an assumed £100 dividend rule into the law. They could lazily copy and paste from S165 CTA10 group relief rules.

Edit: Oops! Cross-post with pridgway and Ruddles.

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05th Nov 2018 12:13

If I have understood the interpretation of the draft legislation correctly, there will be a problem if an equity holder has preference shares and the net assets are low. If A has £100k of prefs and 75% of ords and B has 25% of ords but the net assets (before deducting pref shares) are only £120k, B is only entitled to £5k on a winding up which is under 5% of net assets. As A is an equity holder, I believe one has to count the total amount due to him in respect of all shares and loan capital and not just the amount due to him in respect of his equity holding, leaving the balance of net assets for B. B's entitlement could therefore change each year depending on the level of retained profits or losses.

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to tonyaustin
05th Nov 2018 12:25

Yes, that is right. The test was originally meant to test whether there was a group for group relief purposes.

I think (I have to look at this in more detail and wrap a cold towel round my head) if you take the test to its logical conclusion a holder of 100% of 100 ordinary £1 shares who loans the company £50,000 interest free might not be entitled to more than 5% of the assets in a winding up and hence not get ER on the disposal even though there are no other shareholders or creditors.

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By Ruddles
to pridgway
05th Nov 2018 15:27

But surely in that case the loan would be repaid prior to commencement of winding up, and the shareholder would be entitled to 100% of what is left, even if what is left is £0.

Or, the loan is repaid in the course of the winding up in which case the cash repayment would be included in the assets to which the shareholder is entitled.

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to Ruddles
05th Nov 2018 17:50

It doesn't have to be wound up, the test is only whether the shareholder would be entitled to 5% of the assets in a winding up.

And it has to have been your personal company throughout the period of a year (or 2) prior to the disposal so any non-commercial loans during that time could dilute the shareholder.

Or you could take a hypothetical example of a person who sets up a company with £100 share capital and injects £100,000 to develop an app or some such thing. After 15 months the money is spent but they now have the app and someone comes along and offers £10m for the company with the loan repaid at completion. The company has no reserves and a notional £100 would go to the creditor on a notional winding up with nothing for the shareholder. I don't think ER would be available.

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By Ruddles
to pridgway
05th Nov 2018 18:34

Point taken. Although if we are testing the actual financial position of the company against the requirements at any given point in time we end up with the potential nonsensical position where the owner has no entitlement to dividends because the company has no reserves.

I don’t believe that the intention is to do any more than look at the rights attached to the shares in a hypothetical scenario assuming that there are sufficient reserves, assets etc rather than to consider the financial position of the company each and every day during the 2-year period.

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By Ruddles
to pridgway
05th Nov 2018 18:34

Point taken. Although if we are testing the actual financial position of the company against the requirements at any given point in time we end up with the potential nonsensical position where the owner has no entitlement to dividends because the company has no reserves.

I don’t believe that the intention is to do any more than look at the rights attached to the shares in a hypothetical scenario assuming that there are sufficient reserves, assets etc rather than to consider the financial position of the company each and every day during the 2-year period.

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By Briar
05th Nov 2018 12:28

Should we rewrite the Articles so that Alphabet (ordinary) shares now become entitled to at least 5% of distributable profits?

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By Ruddles
to Briar
05th Nov 2018 15:57

What happens if you've used every consonant in the alphabet?

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to Ruddles
05th Nov 2018 16:12

I think you would just insert a "ZA" class randomly like they do in legislation.

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By Ruddles
to pridgway
05th Nov 2018 18:25

My point was that if there are 21 (or more) share classes you can’t stipulate that they are each entitled to 5% of profits.

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to Ruddles
06th Nov 2018 02:03

You could technically get "scrwd" somewhere in the middle - which is a Welsh technical term for something I can't quite remember :)

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to Briar
05th Nov 2018 16:04

I suspect that what we should do is wait and see. We could all spend hours (and clients' money) changing Articles for what we think HMRC might mean by badly/lazily drafted legislation, which (on the face of it) hits a lot more targets than it was aimed at - only for them to say 'as you were', while they think about how to sort out the mess. (I say 'on the face of it' because we do not actually know if this is the law of unintended consequences at play here, or if it is HMRC being cleverer than we give them credit for!) All very unsatisfactory!

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05th Nov 2018 17:46

In terms of EMI options, I'm not convinced that using restricted shares will negate ER, even under the new rules. It's perfectly possible to use non-voting and/or non-dividend shares for EMI, and quite common for time-based vesting structures. Is there a source for Rebecca's contention re restricted rights and EMI? Everything I have seen so far says that only the increase in the eligibility period from 12 months to 24 months applies.

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to jerryd46
05th Nov 2018 17:53

EMI does not use the definition of personal company for ER purposes. Provided they qualify under Condition C or Condition D then for the moment they qualify as before.

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06th Nov 2018 02:08

The changes will not affect EMI shares, but could easily affect founder shares in companies that have received venture capital investment if the rights to profits/assets on winding up are written up by reference to the share price paid rather than nominal value.

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07th Nov 2018 04:27

Usually, I never comment on blogs but your article is so convincing that I never stop myself to say something about it. You’re doing a great job Man. Best article I have ever read

Keep it up! Thanksgiving

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