At the start of the current recession in the summer of 2007, one of the immediate outcomes for business owners was significantly reduced company valuations. This meant that for a lot of business owners, following many years of hard work, it was no longer attractive to pursue a business sale in the short term. As a result, the market for mergers and acquisitions declined sharply.
Since the emergency Budget at the end of June, in spite of the fact that the economic recovery is still very fragile, we have seen enquiries into exit tax planning start to pick up again. This is partly because of slightly improved medium-term confidence, which has had a corresponding impact on valuations. However many business owners had also shied away from selling their business in the very recent past because of uncertainties surrounding their tax liabilities in the run up to the general election.
Before the Budget, George Osborne promised ‘generous reliefs’ for business assets and he has kept to his word, at least in part. Now, although we have received confirmation of a somewhat unpopular increase to a top level of capital gains tax of 28%, we have a position which is not as bad as was feared and we have certainty concerning the longer-term capital gains tax position. Entrepreneurs’ relief has been extended quite generously from the previous Government’s £2,000,000 with the first £5,000,000 of qualifying lifetime gains now being liable to capital gains tax at a rate of 10%. This extension is not however quite as generous as it might appear on the surface, since the rate of capital gains tax on qualifying gains exceeding £5,000,000, and indeed on all non-qualifying gains of higher rate taxpayers, is increased to 28%. For larger gains therefore, this is legislation which is likely to be successful in generating revenues for the Treasury.
As entrepreneurs’ relief has now become more valuable, it is worth revisiting the overall position. When entrepreneurs’ relief was first introduced in 2008 its application was restricted to qualifying gains of £1,000,000, with excess gains being chargeable at the rate of 18%. The maximum value of the relief was therefore £80,000 (£1,000,000 @ 18% -10%), and the brevity of the qualifying criteria within the legislation reflects this. Whilst the maximum value of the relief has now escalated to £900,000 (£5,000,000 @ 28% – 10%), the brevity of the legislation remains. As a result of the escalation in the value of the relief, I think we can expect to see more challenges in the future from HMRC on the basis on which it is claimed. It is therefore important to have a good knowledge of the qualifying criteria and to keep an eye on its implementation by HMRC. This latter will be an ongoing process and in the meantime, I recommend a review of clients’ business structures to ensure they meet the qualifying criteria now, if they will wish to claim the relief in the future.
Entrepreneurs’ relief is available for ‘qualifying business disposals’. Broadly a ‘material disposal of business assets’ i.e.:
• A disposal of the whole or part of a business which has been owned for at least 12 months;
• A disposal of assets in use in the business when the business ceased, providing the business was owned for at least 12 months up to the date of cessation, and the disposal takes place within 3 years of that date; or
• A disposal of shares or securities of a company:
There are additional criteria applying to the disposal of shares or securities in a company, which are that for a period of 12 months leading up to the date of disposal the company must be:
• The individual’s personal company (i.e. he must own at least 5% of the voting share capital); and
• Either a trading company or the holding company of a trading group;
In addition, the individual must be:
• An officer or employee of the company or of another group company.
Alternatively, relief is available if these conditions are met for at least 12 months up to the date when the company ceases to be a trading company or a member of a trading group and the individual disposes of the shares within 3 years of that date.
Important areas to review on behalf of clients will be:
1. Are there shareholders owning less than 5% of the issued share capital, and voting rights? If so, can their shareholding be increased to 5% at least 12 months prior to a proposed sale? Ensure share capital includes voting rights.
2. In companies with share option schemes in place, there will commonly be a practice where employees exercise their share options and immediately sell the shares acquired. These disposals will not qualify for entrepreneurs’ relief unless the employee has an underlying shareholding of at least 5%. There have been calls for this to be addressed since relief was available in this situation under the previous taper relief rules, but it appears that entrepreneurs’ relief is intended to reward entrepreneurs for risk rather than employees. To address this, consider whether it is feasible for an underlying shareholding of at least 5% to be owned by the individual. If so, relief will apply to all disposals;
3. It is now more important to ensure shareholders are either officers or employees of the company for the qualifying 12 month period. Whilst it is arguable that someone acting as a shadow director is an ‘officer’ of the company, HMRC have no published guidance on this, therefore a formal appointment should be put in place.
Prior to the Budget, the mechanism by which ER worked was to reduce the qualifying capital gain by 4/9ths and to charge the remaining gain to tax at the then full rate of CGT of 18%.
As the full rate of capital gains tax has been increased to 28%, use of this mechanism will no longer of course result in an effective rate of 10%. Although we will need to await the Finance Bill for full details of how the relief will operate, it initially appears that the first £5,000,000 of qualifying gains will simply be charged to capital gains tax at the rate of 10%, with the fraction calculation no longer applying.
Whilst the extended relief is of course good news for clients who are selling their business and who have capital gains within the £5m limit, those having gains exceeding this amount will suffer from the 28% rate on gains exceeding £5m. The ‘tipping point’ is gains of approximately £7,500,000, i.e. at that point the capital gains tax liability under the new regime becomes more expensive than it was under the previous regime, where the first £2,000,000 of gains were effectively charged at 10% and the excess at 18%.
If the percentage calculation of entrepreneurs’ relief is to be abolished, as has been indicated, there will be a knock-on implication for deferred consideration which is received in the form of Qualifying Corporate Bonds (QCBs), and which should not be overlooked
Typically when shares in a company are sold, the vendor shareholder will receive a certain amount of the sale proceeds as immediate cash consideration, with the balance of the proceeds being paid by way of deferred consideration. The tax implications for the deferred element of the consideration will depend upon the way in which it is ultimately to be paid. In the case of QCBs the gain is ‘frozen’ at the time of completion with the capital gains tax on that frozen gain becoming payable when the QCB is redeemed. Prior to the Budget, the gain was frozen after reducing it by the available ER fraction. The effect of this was of course that when the gain eventually became chargeable, although it would have been chargeable at the full rate of 18%, the available entrepreneurs’ relief had already been deducted. Where a gain arises after the date of the Budget, if a qualifying fraction is no longer to apply, the full gain will be frozen and on redemption will be chargeable to capital gains tax at the full rate applicable to the individual. Therefore in addition to the entrepreneurs’ relief being relief is lost, the increase in the capital gains tax rate to 28% also takes effect. Whilst planning opportunities may be available for partial redemption within the individual’s basic rate band and annual exemption to ensure a rate of 18%, in very many cases the gain will be chargeable at 28%.
As always, it remains important to consider carefully how deferred consideration is taken. Given the increase in entrepreneurs’ relief there may well now be further increased merit in crystallising the tax on deferred consideration at the time of completion in order to claim the entitlement to full entrepreneurs’ relief at that stage.
To conclude, the Coalition has extended a reasonable level of generosity to reward entrepreneurs and the wider business community for taking the risks inherent in starting and running a successful concern, although as ever, there are pitfalls to watch out for. Overall however, this was a better Budget for business than had been anticipated, and marks a good first step to ensuring the country retains its position both against the rest of Europe, and longer term, as a global commercial centre as the BRIC and other developing economies continue to expand.
Lesley Stalker is head of tax at Surrey based small business tax advisers, Robert James Partnership and a specialist in exit strategy planning.