In the Budget Statement the Chancellor announced significant changes to Entrepreneurs’ Relief (‘ER’), some of which were welcome reforms to ensure that people did not lose out on a valuable relief when their shareholdings were diluted by funding rounds or the exercise of employee share options or when groups of companies were restructured, other changes may be less welcome to entrepreneurs and shareholders in private companies.
The changes pose particular problems for companies with multiple share classes (or ‘alphabet shares’), which are often set up so that family members can benefit from dividends.
The old rules
In order to qualify for relief, shareholders must have held shares in a company that was their ‘personal company’ for at least twelve months before they sell them (different rules apply to shareholders who derive their holdings from EMI options).
The Finance Bill increases the holding period to two years and also changes the definition of ‘personal company’. Before the budget statement, a company was a shareholders’ ‘personal company’ if:
- The shareholder must have at least 5% of the ordinary share capital of the company; and
- The shareholder must be able to exercise 5% of the voting rights by virtue of their shareholding.
‘Ordinary share capital’ basically means all of the company’s shares except fixed rate preference shares.
The changes proposed in the draft Finance Bill clauses released after the Budget speech add two new tests to the definition of ‘personal company’:
- The shareholder must be ‘beneficially entitled’ to 5% of the profits available for distribution to the equity holders; and
- The shareholder must be beneficially entitled on a winding up to 5% of the assets available for distribution to the equity holders.
The term ‘equity holders’ can include loan-note holders and fixed-rate preference shareholders.
This will clearly affect shares structured as ‘growth shares’ and many private equity-backed companies, but could have a knock-on effect for other private companies too.
Many private companies’ articles of association allow the board of directors to pay differing rates of dividends on different share classes or to pay dividends on one share class to the exclusion of the other classes. There are often no fixed rights to a distribution.
The test set out in the draft legislation is to ask what each shareholder would be entitled to by virtue of his or her shareholding on a hypothetical distribution of the whole of the company’s profits.
The test excludes rights to dividends that arise from other sources (for example, under a shareholders’ agreement). In the Revenue’s manual, they state their view that rights which change for different accounting periods will also be disregarded (CTM81045).
The impact of these provisions is that it is questionable that where there is more than one class of shares and where there is no clear statement on proportional rights to dividends set out in the articles, that any one shareholder has a beneficial entitlement to any given proportion of the company’s profits.
This means that there is a risk that none of the shareholders will be entitled to claim ER if the company is sold.
We are planning to make representations to the Treasury about the new rule on dividends, but there is a risk that this measure will make it to the statute-book unchanged.
Where clients have more than one share class in issue and are thinking about selling in the future, we strongly advise that their professional advisors should review their articles of association to see if they are impacted.
Where the position is ambiguous, it should be possible to make changes to articles of association, so that shareholders in companies with multiple classes can ensure that ER can be claimed. However, it should be borne in mind that the new two-year clock for ER will only begin once the changes have been made.
For many business owners this unwelcome budget change could have the consequence, at the minimum, of resetting their ER clock, so that their holding period for ER purposes only runs from the date that remedial action is taken; for other business owners, if the point is missed, they may lose ER entirely.
Abbey tax are offering practitioners a review of entitlement to ER for shareholders which would include opinion on company trading status and the impact of the new rules. We will prepare a written paper confirming whether or not ER is eligible based on information provided and the current rules and proposals with suggestions on what action should be considered to improve the position where applicable. The cost of this review would be fixed at £950 plus VAT.
For further information and help with entrepreneurs’ relief please contact us on 0345 223 2727 and ask for Martin Mann.