By Adrian Walton, Tax Director at Smith & Williamson

The Emergency Budget in June this year brought about much needed change to the tax system. In an attempt to appease people after the inevitable rate increases, one incentive measure introduced by the Coalition Government is an increase in the level of gains that can attract Entrepreneurs' Relief (ER). This relief aims to encourage entrepreneurship in the UK by subjecting the gains to a lower rate of capital gains tax. However, the conditions remain strict.

When Labour introduced the scheme in 2008, the lifetime limit was capped at £1m. This has now increased to £5m with effect from 23 June 2010 with qualifying gains taxable at 10%. However, the increase in level of relief has been coupled with a rise in the main CGT rate (from 18% to 28%), in order to maintain the 22% gap between the rate of CGT and the top rate of income tax (now at 50%).

One headache that they have disposed of is that the fractional calculation for ER has been replaced by a flat 10% tax liability of the eligible gains. Before the changes it was possible to defer a gain (otherwise chargeable at 10% under ER) through an Enterprise Investment Scheme (EIS) investment or reorganisation, which would subsequently crystallise at the same 10%. Now the rules have changed these gains would crystallise in the future at the current rate — which is 28% at the moment. This means deferring an ER gain is not so attractive.

The increase in level of gains subject to entrepreneurs' relief means the cash value of the tax benefit can be up to £900k for higher rate and additional rate tax payers.

Planning opportunities

The new regime has, however, made some planning opportunities more viable than previously thought. Current restrictions state that shareholders must be employees or directors and hold at least 5% of the ordinary shares and voting rights to qualify as having a personal trading company. This is limited to 20 individuals per company. However, the number of partners eligible for ER is unrestricted and they only need to have possessed a partnership share for at least one year prior to disposal. As a result, when starting a business with the intention to eventually sell, an LLP may be more advantageous to an individual's tax planning.

Where individuals dispose of qualifying business assets, one opportunity is to choose to claim ER and pay the tax liability. Another is to defer the CGT by investing the gain in EIS shares, forgoing any ER available on the disposal. There is therefore a choice to be made — either pay a tax liability of 10% of the eligible gains or, if they invest in EIS shares, pay tax at up to 28% on the disposal of those shares.

For basic rate taxpayers with unused basic rate band remaining, any gains arising will be charged at 18% up to the current limit of £37,400 after which the full rate of CGT (28%) will apply.

Do the changes go far enough?

Despite the increase in allowance and simplification of some of the rules, ER is still restricted to a few qualifying individuals. With the UK still in the shadow of a recession, it may be worth making ER more widely available by reducing the required shareholding for certain individuals. Furthermore, external investors are put off by virtue of the fact that claimants must also be employees or directors of the company, as well as the having a 5% shareholding. Given that the previous taper relief arrangements were unlimited, there seem to be few salient reasons why ER should be capped — surely this acts as a disincentive to entrepreneurship?

The changes to ER are a step in the right direction, but it is clear that more could have been done to help employees with small shareholdings of less than 5%, as well as external, non-employee investors.

If you would like to speak to us about Entrepreneurs Relief or EIS, please email adrian.walton@smith.williamson.co.uk or call 020 7131 4180

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