By Mike Hayes, Tax Partner, Kingston Smith LLP
It is well known that an individual selling a business or shares in their company will often qualify for Entrepreneurs’ Relief (ER) — which applies on any gains made to reduce the tax rate on the sale to 10%. As this is considerably more favourable than the ‘standard’ capital gains rates of 18% and 28%, it is no wonder this is often at the forefront of people’s minds when they come to sell their business.
However, while the regime is reasonably generous towards business owners looking for the exit door, the fact that there are strict conditions which have to be satisfied first is often overlooked, and the relief taken for granted. Here, we explore some of the potential traps that any prospective seller should be aware of. This article looks at the key issues relating to a disposal of shares.
By way of an overview, for ER to apply to a sale, the following conditions must be satisfied:
Firstly, there needs to be a material disposal of business assets by an individual. This may include a disposal of shares or an interest in shares.
In addition, the seller must meet the following conditions:
- The company must be trading or be the holding company of a trading group;
- The individual selling must hold at least 5% of the ordinary share capital, giving them at least 5% of the votes; and
- The individual must be an employee or officer (i.e. director or secretary)
of the company.
These conditions have to be satisfied for at least 12 months prior to the share disposal. The rules apply differently if the company ceases to trade before the shares are disposed of.
Although these rules are very prescriptive, there are many reasons why business owners can fail to meet the criteria — and doing so can lead to a large unexpected tax bill! For example:
Scenario 1 - Different share classes with different rights
It is not unusual for limited companies to have several classes of shares. Each class may, for example, allow its owner differing voting rights; a set amount of assets on a winding up; or differing rights to dividends declared. A shareholder owning more than 5% of the total shares in a company will fail to qualify for ER on a disposal if these shares don’t equate to 5% of the voting rights.
For example, votes attributable to preference shares may not count towards the 5% test; it is the ordinary shares that must give the votes for this purpose.
Scenario 2 — Shareholder, but not director
For owner-managed businesses, a majority shareholder will commonly also be a director. However, this is not always the case and it is not unusual for the spouse of a company owner to be given shares without being made an officer or employee of the company.
In this situation, the spouse could own 50% of the company and still not qualify for relief. Timing is crucial here, as the conditions will need to have been satisfied for a year prior to a sale, as noted above. Therefore, if you are planning to make your partner a director or an employee, you will need to think about this well in advance of a sale completion for them to qualify for ER.
It is advisable that anyone appointed as a director should be carrying out duties consistent with this role, such as attending board meetings and being involved in decision making.
The same principle applies for employees; it is not sufficient for an individual to simply be on the payroll; they must undertake some work. The substance of the relationship should point towards an employer / employee relationship and there should be a commercial salary paid for the services performed.
Scenario 3 - The company whose shares are being sold is not deemed to be ‘trading’
According to HMRC, a company is trading if its activities are not substantially ‘non-trading’. In this case, substantially generally means more than 20%, as applied to the following criteria:
- Its income from non-trading activities;
- Expenses incurred or time spent by employees or officers in undertaking the activities of the company;
- The asset base of the company and whether the company’s non-trading assets are substantial in comparison to its trading assets;
- The company’s history and whether past activities would be considered trading.
Therefore, a substantial amount of income coming from a rental property could, for example, risk the trading status of the company.
In reality, these factors are to be taken on balance and their relevance will be assessed by HMRC in the context of the company’s activities as a whole. For instance, excess cash held in the business arising from its trading activity is not generally an issue for ER purposes, providing it is not actively managed as an investment.
How to avoid the traps
Many of the situations listed above are avoidable if proper and timely planning is undertaken prior to the sale process taking place.
It is important to talk to your accountant or tax adviser well before considering a disposal.
Next time: What about entrepreneurs’ relief for trustees? Mike Hayes reviews the qualifying factors that should be considered.