In an attempt to continue the seasonal spirit, we have some good news in relation to Entrepreneurs’ Relief (“ER”).
There has been major concern that a lot of management and employee shareholders might lose their entitlement to ER since it was announced in the Budget on 29 October that the requirements to be met in order to qualify for ER were becoming more stringent. See our earlier article here. As hoped, we are pleased to report that the Government has made a partial climb-down on those changes, which had been expected to result in many management teams losing their entitlement to benefit from ER, where their holding had previously been qualifying.
Broadly, the new proposals (announced on 21 December) mean that relief may now be available where an individual is or would be entitled to 5% or more of proceeds of sale of all of the company’s ordinary share capital.
To recap on our previous article, in order to qualify for ER on disposals on or after the Budget, a new economic benefit test was required to be satisfied. The original formulation of this economic test (as per the Budget announcement) required individuals to have been entitled to at least 5% of profits and of the assets on a winding up, at all times during the two years before sale (the Budget also extended the ER one year qualifying period to two years for disposals on or after 6 April 2019). This 5% test was likely to be problematic in the case of ratchet/waterfall structures. This economic test was required to be satisfied in addition to the pre-existing conditions that the individual has held not less than 5% of the ordinary share capital and 5% of the voting rights throughout the two year period.
Amendments have now been made at Report Stage which introduce an alternative 5% economic test. This alternative test will be satisfied if the individual is beneficially entitled to at least 5% of the proceeds of sale of the company’s ordinary share capital (or would be if 100% were being sold). This will apply to share disposals on or after 29 October 2018. The qualifying period will remain one year for disposals before 6 April 2019 but increase to two years for later disposals.
In relation to this alternative economic test, it is again necessary to satisfy it during the qualifying period preceding the individual’s disposal (one or two years depending on the disposal date); however the market value of the company’s ordinary share capital at the date of disposal is deemed to apply throughout the qualifying period, so it does not matter that valuations of the company earlier in the qualifying period would have resulted in entitlement to less than 5% of proceeds at the previous valuations. Assuming that the individual actually receives at least 5% of the equity proceeds and no changes have been made to the shareholding during the qualifying period, we would expect that this test should be satisfied.
It is not necessary for there to be an actual sale of the entire company (although in most cases there will be); the test can be satisfied on an earlier disposal by an individual if he/she would have been entitled to 5% or more of proceeds if all of the company’s ordinary share capital had been sold on that date.For this purpose, it is assumed that the whole of the ordinary share capital is sold for consideration equal to its market value at the date on which the individual disposes of his/her shares (for the purpose of valuations (i.e. minority discounts) and matters such as vesting).
Again, the existing conditions requiring the individual to hold not less than 5% of the ordinary share capital and 5% of the voting rights throughout the qualifying period still apply.
Vesting, ratchet and other private equity-type share capital structures arrangements will still need careful consideration as these changes do not solve all of the difficulties caused by the Budget changes. In addition, it is worth noting, on the basis of the new test, to the extent that an individual’s percentage share of the equity proceeds depends on the overall exit price (i.e. there is a preferred return or a ratchet) and could drop below 5%, it now may not be possible to determine prior to a disposal, whether the individual is going to qualify for ER in relation to their holding.
The legislation will also contain an anti-avoidance provision which disregards, for the purpose of this new 5% of sale proceeds test, the effect of any arrangements the main purpose of which is to secure the benefit of ER. The intended scope of this may not become clear until guidance is published. It may, for instance, be intended to cover any contrived provisions setting a minimum 5% share of proceeds for employee shareholders seeking ER, but, hopefully, as such provisions have real economic consequences - and may be commercially motivated as well – this will not be the case.