Entrepreneurs Relief - How to maximise your relief - Part II
Obstacles to Obtaining Maximum Relief
Not all individuals selling shares in unquoted companies will qualify for Entrepreneurs Relief.
There are a few pitfalls that can prevent the relief being given. The two key cases where relief is not available are as follows:
• Where the company is not a trading company.
• Where you have not owned the shares for at least one year.
We'll look at each of these rules in a little more detail, as they can often hold some nasty surprises for business owners about to sell up.
Trading Companies
As most readers selling their businesses will be holding shares in unquoted companies, they will only qualify for Entrepreneurs Relief if the company is either a trading company or the holding company of a trading group.
It is therefore very important to determine whether a company is a trading company, as this can make the difference between receiving or being denied Entrepreneurs Relief.
How Does the Taxman Define a Trading Company?
As you'd expect, there is no simple answer to this question, as each case is approached differently. Tax legislation doesn't include much of a definition of a trading company, so it's simply down to Revenue and Customs and the courts to establish some guidelines. Thankfully, because of the significant impact that this distinction can have, Revenue has given us some general rules that can be used as a guide.
The legislation on the new Entrepreneurs Relief states that it will follow the old taper relief definition of a trading company. This states that a company is classed as a trading company provided its activities "... do not include to a substantial extent activities other than trading activities".
Pretty straightforward, and provided a company doesn't have "substantial" non-trading activities there should be no problem qualifying for the relief.
However, the taxman's view of 'substantial' is probably not the same as yours and they would take this to mean more than 20% of the income or assets.
The guidance they've published on this states that they will look at a number of factors including:
So when looking at whether your company is a trading company, it's probably advisable to review the statutory accounts for the previous six years or so, looking at these measures for any indications of non- trading activities.
The kind of things Revenue and Customs could regard as non-trading include:
The surplus cash issue is a particularly nasty one, and although it's aimed at so-called 'money box' companies where cash is rolled up in a company, it can apply to genuine trading companies that happen to build up large cash reserves.
How to Get Classed as a Trading Company
When looking at the accounts for the period in question, if you do find there are substantial non-trading activities, you'll then need to consider whether these can be satisfactorily explained to the tax inspector so that they don't 'taint' the status of the company. The two main exemptions from the non-trading rules are:
• Time period. When looking at the status of the company you would usually examine the position over the course of a number of financial years. It may well be the case that in some years the 20% threshold was exceeded, and in others it wasn't. In this case it could be in your interests to take an average position over the entire period. In such cases HMRC have been known to accept that, although in one or two isolated years non-trading income had been substantial, when compared with total receipts over the entire period in question the 20% threshold was not breached.
• Reasonably required for business purposes. The other main option is to argue that although the 20% threshold has been breached, this does not amount to a non-trading activity. This would mainly apply to cash held on the balance sheet, particularly where the cash is invested.
For the cash to amount to a non-trading activity it would need to be shown that it was not reasonably required for business purposes. Therefore retaining the cash to avoid incurring a personal tax charge on extraction would not be a good enough reason to avoid being classed as a non-trading purpose.
If you did manage to establish that the cash was used for a business purpose, then it's unlikely that HMRC would restrict trading status. To do this you'll need to look at the specific business environment and requirements of your particular trade. It may be, for example, that you were required to retain a fixed level of cash on deposit (as in the case of bookmakers, insurance agencies and travel agencies), which would clearly be a persuasive argument that you held the cash for a business purpose. Any legal duty or recommendation from a trade association, for example, for a certain level of liquid assets would be likely to satisfy the taxman.
Similarly if your company had sold a part of its operations and was holding the proceeds on deposit while seeking out potential acquisitions, this would also be likely to be accepted as a trading purpose.
Ownership Requirements
It sounds pretty obvious but to qualify for Entrepreneurs Relief you need to have held the shares for one year immediately preceding the disposal and during that period the shares would need to be qualifying shares. In other words, the company needs to be a trading company and you need to own more than 5% of the shares and be an officer or employee.
Of course for most disposals of family companies these requirements will not present a problem.
One pitfall to watch out for is when you've been running your business as a sole trader or partnership for a long period and then decide to incorporate (transfer the business into a company). There are a number of tax reliefs available to ensure that the incorporation can be made at minimal tax cost.
But what if someone then came along and offered to buy your shares shortly after incorporation?
Although you may have been running the business for a lengthy period, you may have owned the shares for only a few months. If that was the case, and based on the provisions as they currently stand, you wouldn't be entitled to any Entrepreneurs Relief. To make matters worse, if you'd kept running the business as a sole trader or partnership you probably would have qualified for Entrepreneurs Relief.
So if it's been less than one year since you incorporated your business, you should think carefully before disposing of the shares.
Although the 5% test does not present a problem for many company owners, in certain circumstances it could be an issue. This may be the case where you have a venture capital backed company with the investor holding more than 95% of the voting rights. The other shareholders would not then qualify for Entrepreneurs Relief.
However, in these cases as the 5% test does not relate to the economic rights attaching to the shares it is possible to create special classes of shares with economic rights of less than 5% which are structured so as to satisfy the tests.
You could therefore create two classes of "growth shares" with voting rights of 5% per class. These "growth shares" would be entitled to a specified percentage of consideration achieved above a threshold.
This would then allow the other individual investors to also qualify for Entrepreneurs Relief (assuming the other conditions were met).
Associated Disposals
As well as shares in your personal company you can also qualify for Entrepreneurs Relief on other 'associated disposals'.
An associated disposal is a disposal of an asset owned by a shareholder and used for the purposes of a business carried on by the shareholder's personal company.
In order to qualify as an associated disposal a number of conditions need to be met. These include:
• You are selling shares in your personal trading company.
• The disposal of the 'associated asset' is part of your withdrawal from your dealings with the company.
• The assets sold have been used for the purpose of the trade carried on by the company for a period of one year ending with the date of the disposal of the shares (or if earlier, the cessation of the company).
Where these conditions are satisfied the gain on the 'associated assets' will then qualify for Entrepreneurs Relief.
The main case where this will apply is when a property that you own personally is used by your company.
Example
Johnny owns all the shares in Johnny Ltd. He acquired the shares for £10,000 and is about to sell them in July 2011 for £500,000. He's therefore looking at a gain of £490,000. Assuming he qualifies for Entrepreneurs Relief on the disposal, and assuming his annual exemption is otherwise utilised, he would pay CGT of £49,000.
If he also personally owned a property that was used by the company he could sell the property and benefit from Entrepreneurs Relief. If the property gain was, say, £300,000 this would qualify for Entrepreneurs Relief and the CGT bill would be £30,000.
Remember, however, that if the total gain on the shares and property exceeds the £10 million limit, the excess would not qualify for any Entrepreneurs Relief and would therefore suffer a tax rate of 28%.
Points to Watch Out For
Qualifying Company
Unlike the old taper relief rules, the definition of a qualifying company is stricter for Entrepreneurs Relief. As we've seen you need to own more than 5% of the shares and also be an officer or employee.
If a property (or other asset) is used by a company that is not your personal company it won't qualify for Entrepreneurs Relief.
Note though that assets can also qualify for the 'associated disposal' rule if they're used by a partnership in which you are a partner.
Payment of Rent
Again, unlike taper relief, the assets would need to be used by the company without the payment of rent to qualify for full relief.
This will be a blow for many business owners. Under the taper relief rules you could rent out property to any unquoted trading company and qualify for business asset status. The fact that rent was or wasn't charged was irrelevant.
When calculating Entrepreneurs Relief on any 'associated disposals' such as property used by your personal company, if you have charged rent, part or even none of the gain may qualify for relief.
The legislation provides for a reduction in the gain that qualifies for the relief. This is to be calculated on a 'just and reasonable' basis taking account of the extent to which the rent paid is less than the full market rent.
So if a full market rental was paid there would be no Entrepreneurs Relief, whereas a rent at 50% of market value would equate to 50% Entrepreneurs Relief.
The Revenue's thinking here is that if the property was available only if rent was paid, it is effectively held as an investment and not for the purposes of the business.
Example
Patrick owned a property that was rented to his personal trading company for the use in its trade. He's about to sell his company and has been offered £300,000 for the property. He originally acquired the property in May 2009 and is looking at a disposal in December 2011. If he originally acquired the property for £50,000, he would be looking at a capital gain of £250,000.
He would then need to assess how much Entrepreneurs Relief he is entitled to. Assuming the £10 million limit will not be breached, he would need to compare the market rental with the rent actually charged to his company.
If, for example, he charged the company 50% of the market rent in the period May 2009 to December 2011, the gain that would qualify for Entrepreneurs Relief would be £125,000. His CGT charge at 10% would be £12,500.
His remaining gain of £125,000 could be reduced by the annual exemption of £10,600, and his CGT charge at 28% would be £32,032. His total tax would be £44,532.
If he had charged the company a full market rent no Entrepreneurs Relief would be due on the property disposal and his CGT charge would be £67,032, assuming all the gain is above his higher rate tax band.
It's important to note that the adjustment for any rent charged will only apply where rent is paid after 5th April 2008 and is less than the full market rent.
So if there was rent paid both before and after April 2008 you would need to apportion the gain that qualifies for Entrepreneurs Relief into (1) the pre-April 2008 gain and (2) the post-April 2008 gain.
The pre-2008 gain would qualify for Entrepreneurs Relief irrespective of any rent paid, but the Entrepreneurs Relief on the post-2008 gain would be based on the amount of rent charged.
Example
On 5th April 2011 Jack sells the shares in his wholly owned trading company. He realises a capital gain on the shares of £500,000 which qualifies for Entrepreneurs Relief. His CGT charge is £50,000.
He also personally owned the premises out of which the company traded. He agrees to sell these to the purchaser and realises a capital gain of £400,000.
He originally purchased the property on 5th April 2000 and since that date he's always charged the company a full market rent for the use of the property.
To calculate the amount of gain qualifying for Entrepreneurs Relief on the property Jack should split the gain into the pre and post April 2008 gain.
In this case the pre-2008 gain would equate to 8/11ths (ie the period April 2000 to April 2008) and the post-2008 gain would be the remaining 3/11ths.
Entrepreneurs Relief would be due in full on the pre-2008 gain but the payment of a full market rent on the post-2008 gain would eliminate Entrepreneurs Relief on this element of the gain.
The gain that qualifies for Entrepreneurs Relief would therefore be calculated as follows:
Pre-2008 Gain:
£400,000 x 8/11 = £290,909
Post-2008 Gain:
£400,000 x 3/11 x 0% = £0
The total gain qualifying for Entrepreneurs Relief in this case would therefore be £290,909.
Non or Partial Business Use
There are provisions in the legislation that restrict the amount of Entrepreneurs Relief on an associated disposal where:
• The asset was used by the company for the purposes of its business for only part of your period of ownership.
• Only part of the asset was used by the company for the purposes of its business (for example, if you owned a property and the company only used half of it for its trade with the other half unused or used by you for another purpose).
You were involved in the business as an officer or employee for only part of the period that the asset was used for the purposes of the company's business.
• If any of these applied, you would need to restrict the gain on the associated asset that qualified for Entrepreneurs Relief. As above the amount of the restriction is based on a 'just and reasonable' apportionment. However, the legislation does provide some guidance on how the apportionment should be reached.
It's pretty much common sense really but the apportionments would look to be (respectively):
• Period of business use/Period of ownership
• Proportion of asset used for business/Total asset
• Period involved in the business/Period assets were used by the business
In each case the aim is to try and restrict the Entrepreneurs Relief according to the amount of non business use.
Summary
When planning any disposal, Entrepreneurs Relief should be one of the key considerations. In particular, you should assess whether you can qualify, and if not, why not?
Associated disposals, such as property owned personally should also be considered, bearing in mind the potential for apportionments if the property was let or if there was any non business use.
Finally, remember that Entrepreneurs Relief is a new relief and as such you should make sure that you take detailed advice when planning any disposal, to take account of any new tax planning opportunities.
About the Author
The Author of this article is our site Editor, Lee Hadnum. Lee is a rarity among tax advisers having both legal and chartered accountant qualifications. After qualifying a prize winner in the Institute of Chartered Accountants exams, he also went on to become a chartered tax adviser (CTA).
He worked in Ernst & Youngs Entrepreneurial Services department for a number of years before setting up his own tax planning practice. He is now a full time tax author.
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