Tribunal sets out guidance on public benefit test for use of rooftops as telecoms sites
Out-Law Legal Update | 15 Jul 2019 | 1:40 pm | 6 min. read
The rules regarding when an individual can claim entrepreneurs' tax relief on a sale of shares have changed significantly over the past 12 months. Individuals hoping to benefit from the relief should carefully review their position before selling their shares.
Entrepreneurs' relief from UK capital gains tax (CGT) reduces the CGT payable on gains realised on disposals of shares to 10% subject to a number of conditions. However, multiple changes to these conditions have been introduced over the past 12 months, which may leave some individuals unsure about their tax position and whether they can claim the relief on a share sale. This legal update considers the current status of entrepreneurs' relief and provides some recommendations for individuals considering selling shares in the coming months.
UK CGT is payable at 20% for higher rate taxpayers on any gains realised on a sale of shares in a UK company. Entrepreneurs' relief reduces the CGT payable by an individual to 10%. For entrepreneurs' relief to apply, the individual selling the shares must be employed, or hold an office in the company or group in which the shares are being sold.
In order to qualify for the relief various tests relating to the ownership of shares need to be met. Until recently these tests were limited to holding 5% of the voting rights and 5% of the ordinary share capital by nominal value of the company whose shares were being sold. The main change made in the 2018 Budget is that an economic ownership test now applies.
Since 6 April 2019, the conditions need to have been met for two years to qualify. Previously the holding period was just 12 months.
In the 2018 Budget, the chancellor announced two changes:
First, the minimum holding period for the relief to apply was extended from 12 months to two years for disposals on or after 6 April 2019.
Secondly, entrepreneurs' relief would be restricted from 29 October 2018 so that it would only be available to individuals on disposals of shares where they have held at least a 5% interest in both the distributable profits and the net assets of the company available on a winding up.
The revised test was viewed as overly restrictive and was subject to widespread criticism. The changes were introduced to tackle perceived avoidance in the system and were intended to target share structures which enable individuals with less than a full 5% economic ownership to benefit from entrepreneurs' relief. However, the changes ignored the fact that companies may have complicated share structures for entirely commercial reasons. Overnight, the availability of entrepreneurs' relief for individuals with shareholdings in companies with more than one share class became uncertain. Companies were being advised to review their terms to ensure that the consideration waterfall they had agreed for commercial reasons would not now prohibit key shareholders, often the founders of the business, from qualifying for the relief.
Given that the definition of equity holders used to determine the 5% tests could also capture some debt, it also became important for companies to review the terms of loan notes and other financing before providing any assurances regarding the availability of entrepreneurs' relief.
In December 2018, the 5% economic ownership test was amended. An alternative test was proposed to ensure that entrepreneurs' relief would be available to individuals who are entitled to at least 5% of the sale proceeds of the company in the event of a disposal of the whole of the ordinary share capital of the company, even if the 5% test in relation to distributable profits and assets on a winding up was not satisfied.
The new provision, which is included in Finance Act 2019, applies to share disposals from 21 December 2018 and is subject to an anti-avoidance provision so that in applying the test of entitlement to sale proceeds, arrangements will be ignored if their main purpose or one of their main purposes was to obtain the relief.
The amendments were welcomed since working out the percentage entitlement to sale proceeds would be much easier than working out the entitlement to profits available on a hypothetical distribution. However, calculating profit entitlements remains difficult where there are a number of different classes of share capital and a number of debt funders, as is common for genuine commercial reasons in private equity transactions.
Consequently, although the sale proceeds test may give a better result for some individuals, often it may still be difficult to confirm whether an individual will qualify for relief until a transaction actually takes place.
The Finance Act 2019 also contains a provision to ensure that individuals whose shareholding is "diluted" below the 5% qualifying threshold as a result of a new share issue occurring on or after 6 April 2019 will be able to obtain relief for gains up to that time. This measure is designed to ensure that entrepreneurs are not discouraged from seeking external investment to finance business growth in circumstances where their own shareholding becomes diluted.
Affected shareholders will need to make an election for shares to be treated as disposed of and immediately reacquired at market value prior to dilution, giving rise to a chargeable gain on which they can claim entrepreneurs' relief. A further election will then enable them to defer the resulting gain until they sell the shares.
This case concerned the availability of entrepreneurs' relief for the purpose of the pre-Budget 2018 conditions, whereby to claim the relief an individual had to hold 5% of the "ordinary share capital" and voting rights of the company whose shares it was selling. The decision highlighted the importance of assessing share rights carefully when considering eligibility for entrepreneurs' relief, since small difference in the terms of shares may create very different tax results.
Stephen Warshaw was trying to claim entrepreneurs' relief following the disposal of both ordinary and preference shares in a company. The First Tier Tribunal decided that preference shares, which carried the right to a fixed cumulative preferential dividend, were "ordinary share capital" for the purposes and therefore, entrepreneurs' relief was available. The preferential dividend was based on the aggregate of the subscription price and the amount of any compounded preference dividends which had not yet been paid.
Ordinary share capital is defined for the purposes of entrepreneurs' relief as "all the company's issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company's profits".
The Tribunal determined that the issue of whether shares carry a right to a dividend at a fixed rate is not dependent on what dividends actually accrue but rather on the rights accorded to the shares in the company's articles. Here, the Tribunal held that the preference shares dividend was not fixed because the articles provided that the level of dividend could be a varying amount depending on the level of the company's distributable reserves.
The decision conflicts with guidance recently published by the Chartered Institute of Taxation and agreed by HMRC, stating that cumulative preference shares would not usually be ordinary share capital. However, since Warshaw, HMRC has updated its Company Tax Manual to clarify that a further rate of interest needs to be added to cumulative preference shares for them to be ordinary share capital.
HMRC refers to the Warshaw decision as being "persuasive" rather than of "precedent authority". Under the same fact pattern, relief would now likely be denied due to the changes in Budget 2018; therefore, it is unlikely that HMRC will appeal the decision. The inclusion of preference shares as ordinary share capital will then turn on whether the additional interest is seen as a return on the original investment, suggesting fixed rate, or whether it is seen as a separate return on amounts outstanding, with a right to two differing fixed rates and therefore, non-fixed.
Given the recent multitude of changes to entrepreneurs' relief, shareholders are strongly encouraged to seek early advice in relation to their share structure to ensure they qualify for the relief and there are no nasty surprises prior to an exit. When setting up new share structures with preference shares, particular care should be taken when drafting the company's articles as the 5% nominal value test continues to apply alongside the economic ownership test.
Peter Morley is a tax expert at Pinsent Masons, the law firm behind Out-Law.
30 Oct 2018
08 Jan 2019
Tribunal sets out guidance on public benefit test for use of rooftops as telecoms sites