Following consultation on measures to aid in financing growth in innovative firms, HM Treasury and HM Revenue & Customs consulted on changes to Entrepreneurs’ Relief (ER) to facilitate external investment. The result is the current draft legislation for Finance Bill 2018-19, which aims (broadly) to allow shareholders to crystallise ER on chargeable gains that arise before external investment dilutes their ownership percentage below 5%. Currently, in those circumstances the company ceases to be a “personal company” for ER purposes and the shareholder loses ER completely.
The new rules are due to come into force in relation to share issues causing dilution occurring on or after 6 April 2019. On the face of it this is a welcome relieving measure, but the new rules are complex and (as always with tax changes) the devil is in the detail. Key points to note are:
- not all events that dilute shareholdings will qualify for this relief – only share issues undertaken for genuine commercial reasons and with the shares issued wholly for cash consideration come within the new rules (and so other dilution events, such as the issue of shares on exercise of employee options, may not qualify);
- the new rules only serve to relax the 5% “personal company” threshold – all other requirements for ER continue to apply;
- the effect of the new rules is notionally to separate the ownership of shares into periods before and after the dilution event, with each treated separately for capital gains tax (CGT) purposes (strictly, there is deemed to be a sale and reacquisition of the shares on the dilution event) and with chargeable gains in the period before dilution subject to CGT at the ER rate; and
- shareholders must elect to apply these rules in right form and within the deadline; and
- helpfully, the shares are valued based on the overall value of the company’s entire shareholding immediately before the dilution event, without any requirement to discount on account of minority holding.
On its face, electing to use the new rules gives rise to a tax charge in circumstances where a shareholder may not have cash to hand (a “dry” tax charge). A further election is therefore available to defer the payment of tax until the shareholder finally disposes of their shares. Crucially though, this deferral election does not remove the requirement to meet the other conditions for ER on the final disposal, it simply allows the 5% personal company test to be regarded as met on the final disposal.
Accordingly, while in the majority of situations shareholders are likely to elect to defer the payment of tax until final disposal, in some circumstances it may be beneficial to pay the dry tax charge upfront (e.g. if a shareholder will cease to be an officer or employee of the company between the dilution and the final disposal).
In addition, more complex issues may arise in a range of situations, such as if shares are not in the money after a dilution event or if a reorganisation involving loan notes takes place.