Entrepreneurs' relief planning points

Maximising entrepreneurs' relief

This guidance considers some practical and planning points relating to entrepreneurs' relief.

Application ofEntrepreneurs’ Relief
Entrepreneurs' relief is a key relief in many business scenarios. To read about it in context of some common types of transactions, see the following guidance notes:

·  Rollover reliefs

·  Tax implications of share sale

·  Tax implications of trade and asset sale

·  Share for share exchanges

·  Loan notes and Qualifying Corporate Bonds (QCBs) and non-QCBs

·  Tax treatment of earn-outs and deferred consideration

·  EIS deferral relief

·  Informal winding up

Spouses' shares
Under independent taxation, both spouses and civil partners (hereafter 'spouse') are entitled to claim the relief separately and this offers an opportunity to double the lifetime limit.

Thought should be given to bringing a spouse into the business. For example, a sole trader might bring in his spouse to form a partnership by transferring to the spouse a proportion of the business in return for the spouse performing a limited function in the business. Gains on the eventual disposal of the partnership business would then be spread between the spouses, thereby maximising entrepreneurs’ relief.

In the case of a company, one spouse could transfer 5% or more shares to the other spouse who would then work part-time for the business. Again this would have the effect of enabling both spouses to claim the relief on the disposal of the shares.

However, you should be aware that HMRC may argue that the settlements legislation applies to such a transfer (of company shares or a share in the partnership). See The settlement provisions and The ‘Arctic Systems’ case.

There is no 'spousal aggregation' for the purposes of the 5% holding of shares in a trading company. For example, if a husband holds 4% of a company and his wife owns 2%, neither of them will be entitled to entrepreneurs’ relief on a disposal of their shares.

In this instance, the wife can transfer her 2% holding to her husband on a no gain no loss basis. However, the husband would then need to wait 12 months before disposing of his new 6% holding. Otherwise he would not have had shares in a 'personal company' for 1 year.

Jointly owned assets
Assume a husband and wife jointly own an asset (eg, a building) which is used in their partnership. The partnership is dissolved and the building is sold. The gains made by husband and wife on the disposal of the building will qualify for entrepreneurs’ relief.

However, assume instead that a husband and wife jointly own an asset (eg, a building) which is used in the husband’s sole trade. The trade ceases and the building is sold. In this case, only the husband’s proportion of the gain will qualify for entrepreneurs’ relief as he is the only one carrying on a business which uses the asset. The wife’s gain will not qualify.

In this case the couple should either consider a transfer of the wife’s half of the asset to the husband to obtain relief, or the wife could be made a partner of the business (as long as this is more than 12 months before the business ceases and the asset is sold).

To affect the transfer, the property would have to be transferred in writing by deed and registered with the Land Registry. This will incur legal costs and potentially costs in amending the names on the mortgage.

Also, even if no money changes hands between the spouses, there may be a stamp duty land tax (SDLT) charge if the amount of any mortgage exceeds the nil rate band (£150,000 for commercial property). Also, if the consideration (including deemed consideration by way of a mortgage) exceeds £40,000, a SDLT Tax Return must be filed with HMRC within 30 days of the transaction. FA 2003, Sch 4 para 8; FA 2003, s 55; FA 2003, ss 76-77A

Family members
Where the business is an owner-managed company, another method of maximising entrepreneurs' relief is to bring family members into the business. To meet the conditions for relief, the family member needs to work for the company and own at least 5% of the shares for at least 12 months before any sale.

Inter-family share transfers may be needed to ensure each family member owns at least 5% of the shares. Transfers between connected persons who are not spouses or civil partners take place at market value. Therefore, even if the shares are given to the transferee family member for no consideration, they are deemed to be sold for full market value proceeds meaning the transferor has capital gains tax to pay without having received any money to fund it.

However, the transferor and transferee can elect to defer the gain under TCGA 1992, s 165(1)(b). Effectively, the gain will crystallise on the transferee at a later event (usually sale of the shares). This is discussed in the Gift relief guidance note. You will need to check that the conditions are met and whether the relief needs to be restricted (see the Gift relief - restrictions guidance note).

There are several points to consider when making a share transfer between family members:

·      that the transferor understands that this will mean dividends on these shares will be due to the transferee and the transferee will receive proceeds on sale of the company. This might seem obvious but where a client considers the company to be his business and his money, this clarification may be necessary.

·      the impact on the control of the company (it is unlikely that the controlling shareholder will want to relinquish control in order to bring in other members of the family)

·      whether a professional valuation of the company is required, which may be costly (see the Gift relief guidance note to see whether the valuation can be deferred)

·      the need for 'drag-along' and 'tag-along' rights to be added to the shareholders agreement

·      whether the transfer will be caught by the settlements legislation, meaning the transferor will still be taxable on any income and gains arising from the shares

'Drag-along' rights is the term for the requirement that minority shareholders must sell their shares if other shareholders sell their shares to a third party. It ensures that a family split does not effect the ability to sell the company. ERSM30520

'Tag-along' rights is the term for the minority shareholder's right to sell his shares if other shareholders decide to sell their shares. It ensures that the minority shareholder is not left holding shares in the company which is now controlled by a third party. HMRC has agreed that these rights do not effect the value of the shares for the purposes of the employment-related securities anti-avoidance. These shares are therefore not restricted shares.

For more on the anti-avoidance provisions, see the Employment-related securities guidance note (subscription sensitive).

Assets disposed of within 3 years of cessation
Entrepreneurs’ relief is available if a business ceases and within 3 years of cessation, an individual disposes of an asset which was used in the business at the time of cessation.

For example, assume a trader, Jack, sells his business to Jill in December 2014, but Jack retains the building from which the trade was run (Jill has her own business premises and did not want to buy Jack’s). Jack can claim entrepreneurs’ relief on the gain on the sale of the business and on the gain on the sale of the old building (as long as this is before December 2017).

In this case it does not matter what Jack does with the building in the 3 year period. He could let it out to another unconnected business and still receive full entrepreneurs’ relief. Jack just needed to have been using the building in his business at the date of cessation.

Also in this scenario, Jack could let out the building and charge at a full commercial rent for the use of the building, and this will not prejudice his entrepreneurs’ relief. This is because the 'rent restriction' rule only applies to 'associated disposals' and the sale of assets in the three years post cessation is not an 'associated disposal'.

Associated disposals - rent for use of assets
=== – link 12 === If an individual owns a building which is being used in the trade of his personal company, the gain on the disposal of the building can qualify for entrepreneurs’ relief as an 'associated disposal' (providing that the building is sold as part of the taxpayer’s withdrawal from the business as a whole).

For the sale of the business premises to qualify as an associated disposal, it must be associated with a ‘material disposal’ of shares and the sale of the building must be made as part of his withdrawal from the business. A stand alone sale is not eligible for relief (unlike the old taper relief rules). See the Entrepreneurs' relief guidance note and Flowchart - summary of conditions for entrepreneurs' relief for more details. TCGA 1992, s 169K

The receipt of rent from the company will restrict entrepreneurs’ relief. Commercially many taxpayers will have taken the decision to charge rents for the use of the asset as:

·      such income is received gross without withholding (thereby giving a cash flow advantage)

·      no national insurance is payable on the rental income

·      the taxpayer requires rent in order to claim relief for any mortgage interest paid

·      the payment of rent is tax deductible for the company

Where rents have only been charged for a proportion of the period of ownership, gains will need to be split into 'eligible' and 'non eligible' elements on a 'just and reasonable' basis. Gains are only apportioned based on rents charged after 5 April 2008. Therefore a waiver of rent from 6 April 2008 will have the effect of maximising entitlement to entrepreneurs’ relief.

TCGA 1992, s 169P

Shares acquired from share option schemes
Many employees hold shares in their employer company, often acquired as a result of participating in a share option or share incentive scheme.

Remember one of the requirements for the individual to claim entrepreneurs’ relief on a disposal of shares is that he must have at least 5% of the ordinary shares and voting rights. In most instances this will not be the case and so they will not be eligible for entrepreneurs’ relief when they sell their shares.

However, consideration should be given as to whether or not the shares disposed are relevant EMI shares which can attract entrepreneurs’ relief without the 5% holding requirement.

Planning for the sale of a company
If the sale of a company is in contemplation then the availability of entrepreneurs' relief should be considered more than 12 months prior to the likely date of sale so that remedial action can be taken if necessary to maximise the gains qualifying for relief.

Trustees may be asked to co-operate in this exercise.

The likely steps to be taken may include:

·      transferring shares out of trust to individual beneficiaries who have less than a 5% holding of ordinary shares in the company

·      co-operating with arrangements for the issue of additional shares to shareholders who do not have a 5% holding of ordinary shares

·      co-operating with arrangements to allow non-working shareholders to take up an appointment as a director or employee of the company (or of a group company)

When the date of the impending sale is drawing near, further steps may include:

·      terminating an interest in possession of a beneficiary who does not meet the criteria necessary to qualify for relief (or who has previously used up his entrepreneurs' relief allowance)

·      appointing an interest in possession in favour of a beneficiary who meets the other criteria necessary to qualify for relief

·      equalising holdings of shares (including trust shareholdings attributed to a qualifying beneficiary) in order to make best use of the relief if the gains arising to each individual shareholder are likely to exceed his or her unused allowance

Each of these steps may have wider tax consequences that will also need to be considered.

Earn outs


When a company is sold, it is common for the purchaser to defer payment of some of the purchase price until the results of the current, and sometimes subsequent, trading periods are known. The amount finally payable may vary according to the results of the business and this is known as an “earn-out”.

Such earn-outs have invariably been structured for tax purposes, so that once the targets are achieved, rather than paying cash, the purchaser would issue loan notes (or occasionally shares) to the sellers. The loan notes would typically be held for at least six months and would then be cashed in. This is in order to fall within TCGA 1992 s 138A (see D6.208), whereby any capital gains tax that would have arisen on the value of the earn-out consideration is deferred until it is encashed. When the loan notes or shares are sold, part of what is received is the earn-out right, which is deemed to be a security, and when the earn-out is determined, this deemed security is exchanged for shares and loan notes in the purchaser. Capital gains tax would be payable at either 18 per cent or 28 per cent when the loan notes are encashed.

A solution could be to revert to a cash based earn-out and trigger a gain (see below). Traditionally, cash earn-outs have not been favoured for reasons which were highlighted in the case of Marren v Ingles1 in which it was held that the right to receive future earn-out consideration must be valued at the date the shares are sold and that the sellers are taxable, at that time, on the value of that right to receive contingent monies in the future. A right to receive earn-out monies is a “chose in action” and as such is a legal right that is received at the time.

The entrepreneurs' relief legislation does not contain any special rules in connection with earn-outs. However, entrepreneurs' relief can apply to securities as TCGA 1992 s 169I(2)(c) provides that the gain on shares or securities is a qualifying disposal. Therefore, an earn-out satisfied in the form of securities under TCGA 1992 s 138A (as opposed to a cash earn-out) could potentially qualify. However, entrepreneurs' relief can only be obtained if throughout the period of one year before the disposal, the company qualifies as the individuals' personal company (see C3.1302) and he is an officer or employee of that company or of a fellow group company. It is unlikely that an individual will hold over five per cent of the shares in a company during an earn-out such that he can qualify for entrepreneurs' relief in respect of this deemed security under TCGA 1992 s 138A. Indeed, if the individual does continue to hold the necessary shareholding to qualify for entrepreneurs' relief, then there may well be an issue in obtaining clearance under the Transactions in Securities legislation in the first place. The likelihood will therefore be that in general, entrepreneurs' relief will not be available on the earn-out element of consideration.

Instead, it may be preferable to disapply TCGA 1992 s 138A if the earn-out is satisfied in the form of securities such that the Marren v Ingles principles can apply, or to structure the earn-out as a cash based transaction. The difficulty is that in order to make use of entrepreneurs' relief, it will be necessary to crystallise the liability and this will be payable even if funds have not yet been received under the earn-out element. Clearly, any planning here will depend upon the nature of the transaction and the sums involved, but in general, the optimum structure is likely to be an earn-out arrangement satisfied in the form of securities under TCGA 1992 s 138A but with sufficient cash proceeds being received up front to make use of the available lifetime limit.

It remains necessary to consider whether the earn-out right could be taxed as employment income. This is discussed Earn-out rights- employment income risk

Example

Alan subscribed for the whole share capital in Design Ltd in 1975 with £50,000 for £1 ordinary shares at par value. On 20 October 2011, he sells his entire holding to a rival company for an initial cash consideration of £1.5 million (after disposal costs) which is paid on completion and deferred earn-out consideration on defined earn-out profits for the two years ended 30 October 2013 which will be paid in cash but with a maximum amount of £2.5 and £3.5 million for each year respectively. The value of the earn-out rights are agreed with HMRC at £2 million for the two years ended 30 October 2013. The residual earn-out right is £1 million. Alan's liability will be calculated over a three year period as follows:

2011–12 – Share sale October 2011 £

Cash for £50,000 ordinary shares 1,500,000

Value of the earn-out 2,000,000

Total value 3,500,000

Less: cost (50,000)

Chargeable gain 3,450,000

Less: annual exemption (10,600)

Entrepreneurs' relief rate at 10% on gain 3,439,400

343,940

2012–13 – Earn-out payment 30 October 2012

Earn-out proceeds 1,800,000

Less: apportioned base value

(1,285,714)

514,286

Less: annual exemption (10,600)

Chargeable gain @ 18% / 28% 503,686

2013–14 – Earn-out payment 30 October 2014

Earn-out proceeds 2,000,000

Less: residual value (£2m – £1,285,714) above (714,286)

1,285,714

Less: annual exemption (10,900)

Chargeable gain @ 18% / 28% 1,274,814

Business structures and position of employees and investors
Entrepreneurs' relief is in some ways more favourable to shareholders in limited companies and partners in partnerships than to sole traders. This is because sole traders will have to dispose of the whole or part of a business (see C3.1303) to qualify for relief, and they do not qualify for relief on associated disposals at all. Consideration therefore needs to be given to any assets held outside the business. In addition there are no spouse or civil partner provisions in entrepreneurs' relief and this could cause problems where assets are held jointly by a husband and wife or civil partners, but only used in a sole trade.

However, the requirement that shareholders must hold at least five per cent of the shares limits a company to a maximum of 20 individuals who could possibly qualify for entrepreneurs' relief, whilst there is no limit to the number of partners in a partnership who could qualify. Therefore, where there is an intention to develop a business for sale Limited Liability Partnerships may be preferable to limited companies. This is particularly the case for service sector businesses where a significant external investment by third party shareholders is not required.

The requirement that in the case of companies individuals must own five per cent of the shares and be either an officer or employee will disadvantage significant external investors and some employees and this will be a particular problem for Enterprise Investment Scheme (EIS) relief1 (see Divisions C3.10, E3.1). It is, however, no longer a problem for Enterprise Management Incentives (EMI) relief2 (see C2.817, E4.543–E4.551) following the introduction of entrepreneurs' relief for EMI shares broadly for disposals on or after 6 April 2012, but see C3.1302 for full details.

Broadly, under EIS, an investor who is not otherwise employed or involved in the company could qualify for a capital gains tax exemption on a holding of up to 30 per cent of the shares. If for some reason EIS status is not available because not all the qualifying conditions are met, entrepreneurs' relief will not be due either and the gain will be subject to the full capital gains tax rates of 18 per cent and 28 per cent. In such circumstances it may be worth considering making external investors directors.

When EMI was introduced it was specifically provided that business assets taper relief would run from the date of grant rather than the date of exercise of the option. For entrepreneurs' relief to apply the disposal of the relevant EMI shares must take place at least a year after the grant of the option, and the other qualifying conditions must be met (see C3.1302). Nonetheless, for a company which meets the EMI requirements such options will still be preferable to a Company Share Option Plan (CSOP)3 (see C2.816, E4.581–E4.590) because—

•  (i)     there is complete freedom to impose restrictions on options (see E4.544, E4.586);

•  (ii)     the limit on the market value of shares which can be held is £250,000 compared with £30,000 under a CSOP (see E4.544, E4.585);

•  (iii)     options can be granted at a discount to market value (although there is a tax cost) (see E4.548, E4.588); and

•  (iv)     no holding period is required to obtain income tax and NIC relief (see E4.548, E4.588).

Care must be taken when advising family companies on entrepreneurs' relief, as many shareholders who believe that they will qualify for the 10 per cent tax rate may not in fact qualify, as illustrated in the following example—

Example

Bold Ventures Limited has 1,000 issued shares which are owned as follows:

Number of shares

Charles – Managing Director 501

Ann (Charles' mother) 100

Brian – Chairman (Ann's husband) 1

Diana – Director 24

Edward – Director 24

Hannah (Diana and Edward's mother) 100

Gary (family shareholder) 250

1,000

Bold Ventures Limited was established some time ago and the shares are held by a number of different family members. Gary, Hannah and Ann have no involvement in the business and are not directors or otherwise employed. The Board do not want these people employed or to be directors. Charles has driven the company forward and has brought in his mother's second husband, Brian, as Chairman because he has considerable experience of managing growing companies. Ann does not want to transfer any shares to Brian because Brian has children from a previous marriage and they are concerned to keep the wealth of the respective families separate. Bold Ventures Limited has just won a large contract and hopes to sell for at least £10m in one to two years time.

Only Charles will qualify for entrepreneurs' relief. This is because he is the only shareholder to hold at least 5% of the shares and be an officer or employee of the company. This is unlikely to be appreciated by the respective shareholders.

Even with a 25% shareholding Gary will not qualify for any relief unless he is an officer or employee of the company. Diana and Edward are officers of the company but have less than 5% of the shares. Their mother, Hannah, could transfer shares to the two of them, but this depends on whether she is prepared to give up the proceeds that would otherwise be due to her. Also, Ann could gift shares across to Brian, but does not wish to because of the family difficulties referred to above. It would seem that even a trust arrangement would not be sufficient as TCGA 1992 s 169S(3) requires the individual to hold at least 5% of the shares.

In the case of spouses or civil partners, there is no provision under entrepreneurs' relief for the aggregation of qualifying periods. Care must therefore be taken in respect of pre-sale spouse or civil partner transfers where the transferor will not otherwise fully utilise the available lifetime limit.

