Entrepreneurs’ relief lost as a result of dismissal

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Gannons sued a company for unfairly dismissing our client, a former director and shareholder in the business. As a result of his unfair dismissal, he was no longer entitled to Entrepreneurs’ relief on his shares, and incurred a significant tax penalty.

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

How we resolved the tax dispute

Firstly, we challenged the dismissal and the company’s classification of our client as a “bad leaver”. Then we entered into mediation with a view to ensuring fair value for our client’s shares, before we were able to broker a commercial settlement agreement, outside of court. Finally we obtained damages for our client equal to the loss of tax as a result of the wrongful dismissal.

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.

Good leaver

The company’s articles defined a good leaver 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. This entitled them to receive the market value for their shares and make a profit at the time of repurchase.

Bad leaver

The articles simply defined a bad leaver as any person who was not a good leaver. Bad leavers would only receive the subscription price for their shares, and make no profit on them.

Our client’s categorisation

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 they would only have to repurchase his shares at the subscription price.

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

Loss of entrepreneurs’ relief

Our client lost his right to claim entrepreneurs’ relief. This was because the company had dismissed him before repurchasing the shares. 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 and tax 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 possible valuations. The first based on the price earnings multiple (P/E ratio) method. The second based on the dividend discount method.

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

Scheduling the loss of entrepreneurs’ relief

In addition, we prepared a schedule of tax loss for our client. This compared our client’s current tax position with what his position would have been had he not been wrongfully dismissed. We used both our schedule of tax loss along with the schedule of loss of share value in mediation to increase the settlement.

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

The client settled the case out of court. We then successfully negotiated with HMRC, who agreed to tax the settlement amount as a capital, rather than 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.

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