Entrepreneurs relief: does the trade qualify?

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Entrepreneurs relief: does the trade qualify?

To claim Entrepreneurs Relief the company must be a “trading” company. The definition is, alas, complex. We outline the main requirements. If the position is “grey”, which is not unusual, we obtain clearance from HMRC on the trading status.

We work with shareholders and partners to help them determine if the share or asset sale will qualify for Entrepreneurs Relief.  We apply our specialist tax law expertise to a range of sectors to solve issues.

What does trading mean for Entrepreneurs Relief purposes?

The Entrepreneurs Relief regime which if applicable reduces the rate of capital gains tax on profits to 10% is attractive. However, there are qualifying conditions the taxpayer must satisfy. One such condition is that the business in which the shares or assets were held is “trading”.

There are cases where the question of trading causes a risk the Entrepreneurs Relief is not available. We set out below risk areas where we can provide guidance and may be able to put things right before it is too late.

Meaning of trade

There is no statutory definition of “trade” apart from that “trade” includes any venture in the nature of trade. The courts have decided that “trade” refers to: “Operations of a commercial kind by which the trader provides to customers for reward some kind of good or services”.

Implications of the trading definition for Entrepreneurs Relief

The definition of trading company for Entrepreneurs Relief purposes has implications:

  • The extension of the “trade” definition to ventures means that one-off or speculative transactions which yield unexpected profits can amount to a trade;
  • The company does not have to make profits to be “trading”.

Cessation of trade

The trading requirement will be available if the company has ceased trading provided the company:

  • Satisfied the trading conditions for one year ending on the day the company ceased trading; and
  • Ceased trading within three years ending on the date of disposal of its assets.

Holding company for a trading group

Entrepreneurs Relief is available on the disposal of shares in a holding company of a trading group. The trading status of the holding company will be implied from the trading activities of the subsidiary or subsidiaries provided the holding company owns over 51% shareholding in each subsidiary.

We have seen issues arise where groups trading internationally are precluded under the laws of he home jurisdiction of a subsidiary from controlling as much as 51% of the local business.  This is an area we can review for you.

Trading company status and joint ventures

If a company or a member of its group participates in a joint venture the trading status of each company should be considered separately. The trading status of the joint venture company can be “borrowed” by the holding company if the joint venture is considered trading. An individual shareholder holding shares in the holding company will need to establish at least a 5% interest in the trading company.

There are tests set out in the legislation we can run to calculate whether the direct and indirect shareholdings are sufficient to satisfy the conditions necessary to claim Entrepreneurs Relief.

Example of Entrepreneurs Relief and joint ventures

For example, Mil Ionaire has 10% shares in A Ltd and 80% shares in B Ltd. A Ltd owns 40% of a joint venture whilst B Ltd owns 10% of the joint venture. Mil Ionaire has an indirect holding of 12% in the joint venture. If he also owns 5% or more of voting rights in the joint venture, for the purposes whether A Ltd or B Ltd are trading companies his share in the join venture will be taken into account and he may qualify for Entrepreneurs Relief.

Partnerships

Partners in professional partnerships can qualify for Entrepreneurs Relief when they leave the partnership and sell their entitlement to capital.  HMRC will deny capital treatment on payments they consider are income payments.  In practice the partner will need to establish that he has the right to sell capital on leaving and the consideration received relates to capital.

Establishing a capital account

Establishing a claim will depend upon the documentation and maintenance of income and capital accounts whilst a partner.

Partners leaving hedge funds can be successful in claiming Entrepreneurs Relief on the growth in value of investments which are sold off providing the partner was given a right to capital growth in a particular investment. It is important to consider whether carried interest is not an employment related security and therefore, subject to income tax.

Based on past experience, we advise partners to record the terms of leaving a partnership in a settlement agreement setting out the nature of the payments received.

Pitfalls – non-trading activities

Most companies have activities that are not trading activities. The legislation states that such companies and groups are trading if their activities: “… do not include to a substantial extent activities other than trading activities.

Examples of non-trading activities can include:

  • Property development;
  • Investment activities;
  • Licencing arrangements.

If a company has foreign operations HMRC will consider all company activities, including activities overseas.

Reinvestment relief

Capital gains from the sale of shares in a trading company can be further reinvested into early companies under the SEIS scheme without charge to capital gains on the sale of SEIS shares. It is also possible to defer capital gains when funds are reinvested in EIS scheme provided the company satisfies the trading activities test. However, the SEIS and EIS company’s activities must not comprise excluded activities.

If you reinvest funds into an SEIS or EIS company and the trading activities cease or are excluded activities you may lose your entitlement to any or all tax reliefs.

Meaning of substantial in practice

Whilst not legislated, here HMRC interpret “substantial” as over 20%. The next question is how non-trading activities are assessed as substantial. The answer is, HMRC considers:

  • Income from non-trading activities: rental income is usually non-trading.  This means that property companies can qualify as trading companies for entrepreneurs’ relief purposes providing other activities such as rental income are less than 20% of the overall trade;
  • The asset base of the company. Goodwill can be taken into account in most cases;
  • Time spent by staff on trading activities;
  • History of the trade;
  • Balance of indicators: HMRC considers matters in the round.

Cash rich companies and Entrepreneurs Relief

Many cash rich trading companies with investment properties or accumulated cash may struggle to meet the trading company requirements. We investigate the history of the business and the reasons for accumulated cash to ascertain whether the trading status can be supported.   The general view taken by HMRC is that cash built up should be extracted as a dividend – with the higher rates of tax applicable to dividends applying.

Care is needed to prepare so that a strong argument can be advanced.

HMRC clearance on trading status

Companies can seek HMRC’s opinion as to its trading status. HMRC can confirm whether, having regard to company’s accounts, the company is considered as trading for tax law purposes. Obtaining a clearance from HMRC improves the chances of successfully claiming Entrepreneurs Relief. HMRC does not correspond directly with individual shareholders.

Trading company status: Case Study 1

We acted on behalf of a company producing padlocks. The company had £1.2m cash representing profit accumulated over seven years. The cash was kept in the business with a view of investing it in a new warehousing facility, so far the biggest cost of the business. The 100% shareholder was offered to sell 50% of shares in exchange for a warehouse which he wanted to take up but feared that his shares will not qualify as shares in a trading company.

We analysed the trading history of the company and ascertained its’ non-trading activities. We prepared a clearance application to HMRC and successfully argued that the company’s trading history indicated incidental investment activities which do not qualify as substantial. The clearance was successfully given and the sale of shares went ahead.

Trading company status: Case Study 2

We acted for a mattress manufacturer. The client owned two companies, a trading company producing mattresses and a property company, holding a number of flats for rental. The owner was looking to retire in a couple of years and came to us for Entrepreneurs Relief advice.

We advised the client that his shares in a property holding company will not qualify for entrepreneurs’ relief. We suggested an alternative structure whereby the non-trading activities of the group would be spread over a number of companies. That made the trading companies’ investment activities insubstantial. Based on our restructuring, we helped the client incorporate the new companies and allocate the assets accordingly. The client is now looking to sell on the shares at entrepreneurs’ relief rate and retire in Portugal.

Track record in reviewing trading requirements and Entrepreneurs Relief

Sometimes trading status arises because a shareholder wants to retire and wants to liquidate a company. Or sell a part of business which contains some incidental property. We are skilled in clarifying the trading status so the transaction can go ahead. We act for companies to facilitate transactions.

We have recently acted in the following cases:

  • Advised on the trading status of a financial services consultancy company pre-winding up;
  • Successfully obtained HMRC clearance on the sale of 50% of shares in a padlock manufacturing business;
  • Restructured a group of companies including a property holding company to satisfy the trading activities test on the sale of the group;
  • Analysing the company’s accounts and advising on the investment activities.