Entrepreneurs relief lost as a result of dismissal

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Entrepreneurs relief lost as a result of dismissal

Our client was a former director and shareholder. He was dismissed following an argument with the CEO. Entrepreneurs’ relief was lost. We sued the company.

How we resolved the tax dispute

We were instructed, and:

  • Challenged the dismissal and the company’s classification of our client as a “bad leaver”.
  • Entered into mediation with a view to ensuring fair value for our client’s shares.
  • Brokered a commercial settlement agreement, outside of court.
  • Obtained damages for our client equal to the loss of tax as a result of the wrongful dismissal.

Background to our client’s dismissal

Our client joined the technology company as a director. After a while, he received 10% of ordinary shares in the company in appreciation of his good work. After a year, our client and the CEO fell out over organisational matters. After a particularly bad row, the CEO dismissed our client on the spot. The dismissal was in breach of our client’s service agreement as the requisite six months notice was not given.

The company’s documents – fair value

The company’s articles of association provided that when a shareholder leaves the business, his shares will be compulsorily repurchased. The price of the shares depends of whether the leaver is a “good” or “bad” leaver. Under the articles a good leaver:

  • Was defined as a person who leaves the business as a result of death, incapacity or any other reason which the board, in its absolute discretion, considers to be a good reason.
  • Would receive the market value for the shares and make a profit at the time of repurchase.

and a bad leaver:

  • Was defined as a person who was not a good leaver.
  • Would receive the subscription price for his shares, and make no profit on the shares.

Following the dismissal, the company initially characterised our client as a good leaver. The board then discovered that the company lacked sufficient distributable profits to buy our client’s shares at market value. The company then re-characterised our client as a bad leaver so the shares could be repurchased at the subscription price.

Our client sued the company for the loss representing the difference between the market value of his shares at the time of dismissal ~ around £1.5m and the subscription price ~ around £2k.

Loss of entrepreneurs’ relief

The dismissal also meant that the client was not a director or employee of the company when the shares were repurchased. Consequently he lost his entitlement to claim entrepreneurs’ relief. Had he not been wrongly dismissed, he would have qualified for entrepreneurs’ relief. Entrepreneurs’ relief would have reduced his capital gains tax liability from 28% (which was the top rate at that time) to 10%. The dismissal caused an 18% hike in his tax liability. The damages claim therefore included an amount representing the 18% difference in tax resulting from the dismissal.

Gannons share valuation & taxation advice

We valued the business to estimate the market value of our client’s shareholding at the time of his dismissal. The business was profitable and the dividend yield was stable. We prepared two valuations based on:

  1. Price earnings multiple (P/E ratio) method;
  2. Dividend discount method.

We calculated a range of values, which we discounted to reflect our client’s minority shareholder status.

Scheduling the loss of entrepreneurs’ relief

Further, we prepared a schedule of tax loss comparing our client’s tax position had he not been wrongly dismissed and after he had been dismissed. Our schedule of loss together with the schedule of loss of share value was used in mediation to increase the settlement.

We advised on the taxation of damages. Our client wanted to know whether settlement reached out of court is taxed differently to damages awarded by the court. Our advice informed our client’s decision whether to continue with the court proceedings or settle out of court.

The client settled the case out of court. Our advice was successfully used during negotiations with HMRC. HMRC agreed the settlement amount would be taxed as a capital, not as an income payment. This was because the settlement was a payment in connection with a capital asset loss.

Risks for shareholders that are also employees

Shareholder-employees should consider the impact of dismissal on their shareholding and include tax loss in the damages claim. A well-put together schedule of loss can increase the damages and secure a more advantageous capital treatment of your payment.

Catherine Gannon heads the tax team at Gannons. The expertise encompasses employment aspects, commercialism, and tax issues. We blend our experience to provide you with full picture advice.