UK 2018 Spring Statement – allowing Entrepreneur’s Relief on gains made prior to a dilution

The Government is consulting on its proposal to introduce legislation in the Finance Bill 2018/2019 to allow individuals to claim Entrepreneur’s Relief (ER) where they no longer hold the necessary 5 per cent shareholding in a company, where their stake has reduced below 5 per cent as a result of that company issuing shares to raise capital for trading purposes. The changes are proposed to apply to shares held immediately prior to equity fundraisings taking place on or after 6 April 2019. The consultation document focuses on the mechanism by which the Government intends to achieve its aim of amending the ER qualifying conditions, following the announcement of the changes by the Chancellor at the Autumn Budget 2017.

ER operates to apply a 10 per cent rate of capital gains tax to qualifying gains made by individuals, up to a lifetime limit of £10,000,000. Where ER is not available or claimed, qualifying gains are taxed at 10 per cent up to an individual’s basic rate band upper limit, and at 20 per cent on the balance. A qualifying gain is a shareholding of 5 per cent or more. It has become a key relief for owner/managers when they are starting up or investing in a business.

The proposed changes seek to change the requirement that a person wishing to claim ER must hold at least 5 per cent of a company’s ordinary share capital for at least twelve months, up to and including the time of disposal of those shares. Consequently, individuals who have started, or founded their own companies and directed the initial growth in their business may fail to obtain ER when, later in the development of the business, it is decided to issue new shares to investors who have been brought in to develop that growth.  The consultation also highlights other unintended non-tax consequences of the existing 5 per cent rule, such as the danger of individuals exiting their company early in order to retain ER in respect of their shareholding, where they would otherwise remain shareholders in the business after the fundraising, or even shareholders resisting external fundraisings entirely.

The Government’s stated aim is to ensure that entrepreneurs are not discouraged from seeking external investment in circumstances where their own shareholding would become diluted. It has therefore been proposed that entitlement to ER is preserved on the increase in value of an individual’s investment up to immediately before their eligibility is lost as a result of the dilution. Individuals will have the option to elect to crystallise gains on their shares in their tax return for the year in which the dilution occurs. The normal self-assessment time limit applies to making the election, by which point the taxpayer must be comfortable that he/she can meet any charge to tax by either offsetting available losses or have sufficient cash to meet the tax liability. The election operates to treat the individual as having sold and immediately reacquired their shares at market value. Alternatively, it is possible to then elect to defer the accrual of the gain so that ER applies to the deferred gain only when the shares are eventually disposed of. At this time the acquisition cost is calculated as equal to the value of the shares as at the time of the deemed acquisition. Should the individual suffer a loss on disposal, this can be set off against the deemed gain prior to dilution where accrual of the gain has been deferred.

The dilution of an individual’s shareholding must be as a result of an issue of shares made by a company for genuine commercial reasons. Further explanation or guidance on what constitutes “genuine commercial reasons” is not provided in the consultation document. It would be assumed that a third party fund raise to finance the business, or an issue of shares to attract managers to join the business is accepted as being for commercial reasons.

For these changes to be effective, it will be important that no taxpayer is prejudiced by making an election and having a “dry” tax liability – where a tax charge is calculated by reference to a higher figure than the ultimate cash proceeds. If this is done, it seems unlikely that the option to pay tax on the deemed disposal at the time of dilution will be exercised in practice, unless for instance there were reliefs available to offset the gain.

Once an election has been made claiming ER for a deemed gain prior to dilution, ER will not be available on any gains that follow that loss of eligibility. The consultation document is not clear on whether this is the case even where the individual later meets the ER eligibility requirements. Individuals will therefore have to consider carefully whether there is any possibility they may, in the future, meet the 5 per cent shareholding, and therefore be able to claim ER on the gain made on final disposal of the shares.

Shareholders’ agreements commonly include provisions which have the effect of putting restrictions on managers’ shareholdings being diluted below the 5 per cent threshold, in order to ensure that ER eligibility is maintained. The introduction of these changes may result in these sort of provisions appearing much less frequently in shareholders’ agreements for new and growing companies.

The consultation runs to 15 May 2018, following which we expect to see draft legislation and further guidance on the application of these proposed changes.