The Chancellor’s budget tweaks for entrepreneurs’ relief (ER) dealt a blow to a tax structure that emerged shortly after its original introduction to deal with its most unfair effect.
That structure arose because some owner-managers who could have had the benefit of taper relief on any size of shareholding under the old regime were suddenly faced with losing the ability to benefit from the lower rate of capital gains tax (CGT) available to owners of trading businesses. This was because the new ER required a minimum shareholding of 5%.
Accountants quickly came up with the structure of the ‘ManCo’. It worked so that managers in a business could instead invest in shareholdings in excess of 5% via a management-owned company (ManCo) that would itself have a shareholding in excess of 10% in the main trading company. Bingo! Provided the other conditions for ER were met, on an exit of the trading company it should be possible to ensure the managers got their ER, paying CGT at 10% and not the higher rates.
The Chancellor said this was an abuse which was not intended.
So what was intended?
Isn’t the clue in the name? Entrepreneurs’ relief. Relief from CGT for entrepreneurs.
In my experience, your typical entrepreneur will start with very little more than an idea and his own cash and will back his own judgment. Often he might work with colleagues. They will set up a company with nominal capital. They allocate the shares between themselves and develop the idea for a while sacrificing a regular salary and benefits and often taking out personal loans and credit card debt to live on while the business takes shape. This can be a challenging and uncomfortable existence.
If the idea has legs they will raise third party funding, often in the form of equity investment from business angels initially and then to the next stage from venture capital or private equity houses.
Along the way they will see their initial 100% ownership of the company whittled down. As the business gets more value, their shares obviously become worth more but at the same time their stake in the business decreases as new investors come in. Eventually the stake of an original entrepreneur could drop below 5% and ER is lost when the company is eventually sold.
So getting back to that ManCo structure. Yes the whole thing looks artificial; naughty by today’s ‘standards’. But it was designed to deal with the artificiality and unfairness of the 5% test inherent in the ER legislation. Its availability meant that the business community didn’t make much of a noise when ER was first brought in.
They will make more noise now. ER in its pure form warps the environment for investment in growing companies and George has inadvertently stuffed quite a few of the very people whom he claims are bringing the country out of the Great Recession. The ones who started with nothing, took all the risks, did all the work and created the value.
Given that ER was supposed to encourage entrepreneurs, why take away their relief because they have created a successful business but their shareholding has dropped below 5%?
This issue needs to be looked at again. Taper relief worked fine before ER came along; why not introduce a suitably modified version? Or instead bring in a tax on second kitchens.