Company founders may not qualify for entrepreneurs’ relief when they sell their shares because subsequent rounds of fund-raising have diluted their own shareholdings.
To claim entrepreneurs’ relief (ER) the individual shareholder must hold at least 5% of the ordinary share capital of his company, and be either an employee or director of the company or of a company in the same trading group. The 5% rule is strictly applied. If the individual holds 4.99999% of the shares they won’t qualify for ER, even if all the other conditions are met, as was the case in Castledine v HMRC (TC04930).
When the founders of a company need to raise further funds, they may issue new shares, perhaps using the Enterprise Investment Scheme (EIS) or the Seed Enterprise Investment Scheme (SEIS). Those new shares will dilute the founders’ shareholdings, perhaps to the point that each original shareholder holds less than 5% of the ordinary share capital.
The dilemma for the company founders is whether to sell some shares at an early stage when external investors are introduced and pay the ER rate of 10% CGT on those gains or wait until they can dispose of all of their shares and pay the full rate of CGT on their smaller percentage of the company in the future.
It may not be possible to dispose of existing shares at the point when new EIS or SEIS shares are issued to external investors, as there is unlikely to be a market for the company’s shares at that stage. Also, the rate of CGT may well increase over time, so the founders are balancing 10% CGT on a smallish gain compared to CGT at 20% (or possibly higher) at a future date.
The government is consulting on a possible solution for shareholders to allow ER to apply on the gains made before the shareholding is diluted. Just before the external investors are issued with new shares, the existing shareholders would be able to elect to crystallise their gains, by deeming that their current shares are sold and reacquired. This election could only be made if the individual’s shareholding would be diluted below the crucial 5% threshold by the issuing of new shares.
However, the gain arising on this deemed disposal need not be immediately chargeable to CGT, the shareholder will be able to make a second election to defer the deemed gain until he actually disposes of those shares. Thus the proposal involves two new tax elections:
- Election A: to make a deemed disposal and reacquisition of the existing shares at a date falling just before the issue of new shares. Election A would have to be made within the tax return covering the year in which the deemed gain arises, or as an amendment to that tax return.
- Election B: to defer the gain realised from deemed disposal created by election A, until the shares are actually disposed of at a later date. Election B would have to be made within four years of the end of the tax year in which the deemed gain created by election A arises.
If the shareholder makes election A but not election B, they will claim ER on the deemed gain made and pay CGT, but they won’t have any proceeds with which to pay the tax due.
If the shareholder makes both election A and election B, they bank the deferred gain and the ER due on that gain until he sells the shares. If their shares have dropped in value by the time they sell them, the loss can be set against the deemed gain which becomes taxable at the disposal date. If the shares have increased in value by the time of disposal, the shareholder will have a further taxable gain over and above the banked deemed gain, but they are unlikely to qualify for ER on that further gain due to the dilution of their shareholding.
- The taxpayer may not dispose of all the shares at the same time, in which case the banked gain will have to be brought into charge proportionately to the number of shares sold.
- Where the shares are pooled, because further shares of the same company and class are acquired, the CGT calculations will get particularly hairy.
The consultation document says this preservation of ER will not apply to shares held by a trust, and it will not be extended to dilutions of interests in a trading partnership. The disposal of assets in an associated disposal will not be affected.
The new law would form part of the Finance Bill 2019, and if that is passed, the new rules would take effect for shareholdings diluted on and after 6 April 2019.
This consultation is open until 15 May 2018, you can respond directly to [email protected] or post your comments below and we will make a collective response on behalf of all AccountingWEB members.
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.