This year’s Finance Act consolidated various changes to the Entrepreneurs’ Relief (“ER”) regime. There are two key changes that may be of particular relevance to corporate acquisitions:
- new (additional) economic ownership tests that must be satisfied in order
for an individual holding shares in a company to benefit from ER; and
- a new option to elect to crystallise a gain, and claim ER in respect
of it, in the event an individual’s shareholding is diluted below the
The ER regime has undergone continual change since its inception in 2008, and particularly in recent months. As a result, some structures may no longer deliver the benefits originally intended. We have put together this “snapshot” of the ER requirements as they apply now in the hope that it might help to demystify the current position. Please let us know if you would like us to review any existing arrangements to confirm they remain fit for purpose.
Broadly, ER reduces the rate of UK capital gains tax payable on the first £10 million of qualifying lifetime chargeable gains to 10% (from the current standard rate of 20% for higher and additional rate taxpayers), and is often one of the first things to come up during the negotiation of management terms.
In the context of private equity structures, the key conditions that must be satisfied in order for a UK individual to avail him/herself of ER in respect of a disposal of shares are:
- Qualifying holding period: the individual must satisfy each of the following tests for at least two years ending on the date of disposal of the shares; this is an extension of the one year holding period that previously applied.
- The employment test: the individual must be an officer (e.g. director) or employee of the company in which the shares are held or another member of its trading group up to and including the date on which he/she disposes of the relevant shareholding.
NB – this requirement is unchanged.
- The trading test: the company in which the shares are held must be a trading company or the holding company of a trading group.
NB – this requirement is unchanged.
- The personal company test: the individual must be disposing of shares in a company in respect of which:
- he/she holds at least 5% of the ordinary share capital, by nominal value; and
- by virtue of that shareholding, he/she is able to exercise at least 5% of the company’s voting rights.
NB – these requirements are unchanged
Additionally, however, the individual must now also satisfy an economic ownership test. This requires that he/she must be beneficially entitled to either or both of the following:
- by virtue of his/her minimum 5% shareholding, at least 5% of both i) the company’s profits available for distribution to equity holders; and ii) the company’s assets available for distribution to equity holders on a winding up; and/or
- at least 5% of the proceeds of sale in the event of a disposal of the whole of the company’s ordinary share capital. Individuals may therefore still qualify for ER even if (as is often the case with shares issued in a private equity context) they are not entitled to a proportionate amount of dividends/returns in respect of their shareholding. If an individual sells his/her shares before an exit, a valuation of the company at that date will be critical to determining whether the individual would have been entitled to at least 5% of the proceeds, had there been a sale of all the company’s ordinary share capital. In other words, any minority discount that might have applied to reduce the consideration the individual actually received should be ignored, and the market value of the company as at the date of his/her disposal is then used for the purpose of ascertaining whether he/she would have qualified throughout the two-year period. Further complications may arise where the shares in question are subject to time-vesting across the two-year period.
Anti-dilution provisions: Managers are sometimes disincentivised from supporting further investment where their own shareholding would be diluted below 5%. To address this concern, new legislation provides that, where a company issues shares for cash consideration for genuine commercial purposes, causing the manager’s shareholding to fall below the 5% threshold required to meet the personal company test outlined above, he/she may elect to treat his/her shares as having been disposed of immediately prior to, and reacquired immediately after, the dilution for market value, provided such a disposal would have qualified for ER. ER can then be claimed on any chargeable gain arising as a result of the deemed disposal (subject to satisfaction of the tests outlined above). That market value then forms the base cost in the shares for future disposals. The individual can also defer this resulting gain until an actual disposal of the shares, thereby avoiding a dry tax charge.
For the avoidance of doubt, the anti-dilution provisions only apply to such portion of the gain that has arisen up to the point of dilution; further gains realised after that point will only be eligible for ER if the tests set out above (including the minimum 5% shareholding requirement) continue to be satisfied.