Entrepreneurs Relief can reduce your Capital Gains Tax (“CGT”) on gains arising on the sale of e.g. shares, certain assets, leaving a partnership or LLP. If applicable, Entrepreneurs Relief reduces your capital gains tax from the 20% to just 10%.
Note, Investors Relief, announced in the 2016 budget, extends Entrepreneurs Relief for passive, business investors. The relief reduces their capital gain liability from 20% to 10%
Currently, Entrepreneurs Relief is available for up to £10 million lifetime gains, potentially a £1 million tax saving. A few simple planning steps, usually taken one to three years before the transaction, is usually sufficient to obtain Entrepreneurs Relief. We often assist accountants ensure their clients obtain Entrepreneurs Relief.
The conditions depend on the circumstances which we describe below:
Entrepreneurs Relief conditions: Trading company’s share sale
The simplest case is an individual, but not a company, partnership, LLP or other corporate body. These conditions also apply to a trading company’s securities sale. The taxpayer benefits from Entrepreneurs Relief if:
- The company, or the holding company of a trading group, is trading;
- The taxpayer has been, for at least 1 year, and:
- Officer of the company or subsidiary,
- Employee of the company or subsidiary,
- Note, the taxpayer is not required to have actually worked a minimum number of hours; AND
- The taxpayer holds, for a year, over 5% of the ordinary shares, so the taxpayer has over 5% of the voting rights.
The existence of different classes of shares or deferred shares with no capital rights can impact the availability of Entrepreneurs Relief so it is important to review the shareholding structure before disposing of shares. It might be necessary to cancel or convert shares to satisfy the conditions for Entrepreneurs Relief.
Entrepreneurs relief pitfalls
A company that separates voting shares from dividend bearing shares might cause an individual to lose Entrepreneurs Relief. Beware the following scenarios:
- A share reorganisation whereby a new holding company acquires your company’s shares, offering shares in the new holding company. You might not meet the 5% threshold;
- The company enters into a joint venture. You might not meet the 5% threshold;
- A share purchase agreement that contains earn-out provisions, which we discuss below.
We often review the sale documentation, to ensure the transaction is structured to protect your right to claim Entrepreneurs Relief.
Entrepreneurs relief: sale of whole or part of a business
Entrepreneurs’ Relief is available on the disposal of all or part of a business that the taxpayer has owned for at least one year prior to the date of disposal. The asset disposal:
- Must be assets comprising the business;
- Not assets used in the business.
Some recent cases clarified this distinction:
Gilbert v HMRC
The tribunal case of Gilbert v HMRC. Here, Entrepreneurs Relief could be claimed because selling the 1/9th part of the business constituted a mini business in its own right. i.e. this part of the business could be run as a separate and individual business.
Russel v HMRC
The high court case of Russell v HMRC. Here, the sale of 35% of farm land did not qualify for Entrepreneurs Relief. The court said the sale was not a sale of a business, but was the sale of a business asset, which doesn’t qualify.
Historically, the sale of some of the farmland is not a disposal of part of a farming business. The Russell case unsuccessfully challenged this on the basis that 35% of the business was sold.
Cessation of trade & commencement of new business
A hidden feature of Entrepreneurs Relief may enable you to realise proceeds and pay tax of only 10% and still carry on trading under a shift of emphasis. The question is: When does a change in the business constitute the cessation of one trade and the commencement of a new business? Entrepreneur’s relief applies if there is a significant change in the business with chargeable gains arising on, for example, the sale of property such as goodwill, land, assets and other business tools.
What HMRC regards as a change in the trade depends on the facts of the particular case. The recent, First-Tier Tribunal decision of Rice v HMRC provides guidance, but it lacks the authority of the Court of Appeal or Supreme Court.
Rice v HMRC
Rice, the taxpayer, sold luxury second-hand cars, trading from premises he owned. He relied on passing trade for his business. Unfortunately, vandalism became a problem so in 2005 he stopped selling cars but retained the premises. He sold the premises in 2008, making a substantial gain. Rice moved to a new area, and began selling cars via the internet. However, instead of luxury cars, he sold cheaper cars.
HMRC challenged Rice’s claim for entrepreneurs’ relief. To claim, Rice had to establish that:
- The trade ceased in 2005, three years before he sold the premises; and
- The sale of cars via the internet with no passing trade was a new business.
The Tax Tribunal found in favour of Rice. HMRC lost. The Tax Tribunal relied on an established tax authority that the relocation of a local business could give rise to a permanent discontinuance of one trade and the commencement of a different one. The Tax Tribunal also considered that there was a difference between slow and gradual growth and a dramatic change.
Many traditional bricks and mortar businesses have also built successful online business. Thus there may be potential to realise the value of no-longer needed assets, e.g. property, and invest that value in new businesses.
Although Rice v HMRC involved trading premises, the principles could apply to other assets, e.g.
- Intellectual property that is no longer required;
- Customer lists in an area that the business has withdrawn from.
However, the sale requires planning, and the business assets must be sold with three years of ceasing to trade.
Distributing cash as capital not dividends
If a business ceases, the company is liquidated, and assets which are usually cash are distributed. Done right, and the distribution is treated as capital for which Entrepreneurs Relief is available.
Done wrong, the distribution is treated as a dividend, which attracts the higher rate of dividend taxes. So to claim Entrepreneurs Relief, you should:
- Document the sale;
- Maintain records to show the trade has ceased;
- Make the claim on your tax return by the first anniversary of the 31 January, following the tax year in which you make the business disposal.
Entrepreneurs Relief: asset sale
To clarify the difference between assets comprising the business and asset used in the business, consider the business activities before and after the transaction.
If the business runs exactly the same way before and after the sale, HMRC probably won’t consider the sale as a “sale of a business”. So, the sale will not qualify for entrepreneurs’ tax relief. The standard rate of capital gains tax will be charged on the gain arising on the sale.
However, Entrepreneurs Relief applies to a disposal of qualifying assets in a business which has ceased. These assets had to be used for business purposes, when the business ceased to be carried on, if the business:
- Had been owned by the individual continuously for one year, and ended when the business ceased; AND
- Ceased to be carried on for three years, that ended at the date of the disposal.
Assets for investment purposes
Assets excluded from Entrepreneurs Relief include assets:
- Held for investment purposes;
- Not used for business purposes.
This condition can catch companies with large cash deposits. Sometimes a large dividend payment could improve the tax-payer’s position.
We regularly apply to HMRC for a non-statutory clearance on behalf of cash-rich companies.
Partners or shareholders who dispose of personal assets, used in the business, can benefit from Entrepreneurs Relief. The asset disposal must be:
- Material, and the partner or shareholder must be withdrawing from the business;
- Of an asset used by the partnership or company for business purposes for one year ending on the disposal date, and not for unconnected purposes.
Often partners, who receive a capital sum on retirement, can benefit from Entrepreneurs Relief, if the settlement deed is correctly structured.
Entrepreneurs Relief: Couples
Couples, i.e. husbands, wives and civil partners, are each eligible for Entrepreneurs relief if they each satisfy the relevant conditions at the time of sale. There may be scope for pre-sale tax planning to increase the tax relief available to a couple.
Pitfalls: Transfers between spouses
We recently heard about a pre-sale transfer between spouses. This sounds like sensible financial planning. The company owner knew there was a buyer on the horizon and quickly transferred 40% of his shares to his wife. Regrettably, the seller failed to hire his spouse as an officer or employee of the company . This oversight cost the couple £56,000 in additional tax.
Transfers between spouses are treated as giving rise to neither a gain nor a loss for Capital Gains Tax purposes. Hence the company owner transferred some shares to his wife, to maximise their tax reliefs. After all, husbands and wives each enjoy an allowance of £11,100 against capital gains tax which is £22,200 per couple.
Unfortunately, his wife was not employed as an employee or officer of the company for a period of 12 months prior to sale. So, she paid the regular CGT rate of 20%. Against this she set her £11,100 allowance. However, Entrepreneur Relief at 10% would have dwarfed this saving.
The HMRC definition of “employee or officer” for Entrepreneur Relief purposes is simple:
- There is no requirement as to hours or salary;
- Non-executive directors and company secretaries count as officers;
- The officer must take on the responsibilities and duties of the role. However, in the run up to a sale a non-executive director or new employee may be very helpful.
Entrepreneurs Relief: EMI options
Entrepreneurs Relief is more generous to employees selling shares acquired under EMI option than it is for other taxpayers. There are two differences to the rules where EMI options are involved:
- The requirement to hold 5% or more of the ordinary share capital does not apply;
- There is no requirement to be a shareholder for one year as for EMI options the rule is you have to hold the option for one year!
Entrepreneurs Relief: Employee Shareholder Shares
Sale of Employee Shareholder Shares is exempt subject to a lifetime limit of £100,000. After the limit has been exhausted any gain realised on sale of Employee Shareholder Shares is subject to capital gains tax at 20% but if entrepreneurs’ relief is available tax rate can be reduced to 10%.