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Entrepreneurs’ Relief: don’t get caught

Entrepreneurs’ Relief should be a tax gain for business owners when they sell all or part of their company. But many traps lie in wait for owners who aren’t fully aware of the regulations

After years of painstakingly growing your businesses, you may be able to look forward to a lucrative sale. And one of the key factors that affects the amount you will realise from this final deal is Entrepreneurs’ Relief (ER) – the tax allowance where a company owner is able to pay less Capital Gains Tax on the sale of shares or assets in a business.

But there are many traps that you can fall into just when you are about to reap the rewards of years of hard work. The introduction of the sinister sounding Targeted Anti-Avoidance Rule or TAAR in April 2016, for example, means that your entitlement to ER may be wiped out if you set up a so-called “phoenix company” in a similar trade or activity within two years of sale.

Another occasion when your hopes of benefitting from ER can go up in flames is when you resign as an employee or director way too early.

Andrew Evans, Tax Partner and Chartered Tax Adviser at Geldards, recalls the case of one individual who held 30% worth of shares in a company for 13 years. “In early 2009, following a disagreement with the other shareholders, it was agreed he would sell his shares back to the company and resign as a director and an employee,” he says. “He was treated as resigning as a director and employee on 28 February 2009. However, the purchase of the shares by the company did not take place until 29 May 2009, some three months later, when a special resolution authorising the purchase under the Companies Act 2006 was passed.”

HMRC successfully challenged the claim for ER on the basis that the individual was not a director or employee up to the date of the sale. He should have continued as a director or an employee until 29 May 2009 to gain his ER.

Another trap is getting your wife or husband involved through some seriously ill-advised transfers of shares before you sell your business. “If you have owned all the shares in a company but then decide to transfer half of them to your wife just before a sale, then she won’t qualify if she is not an employee or director of the company,” explains Evans. “She will not have owned the shares for the required length of time.”

Some owners also do not fully understand the need to have at least 5% of ordinary shares and 5% voting rights in the company they are selling. “Only ordinary shares qualify for ER,” says Evans. “Any shares with a right to a fixed dividend will not qualify for ER. Also, be cautious about the early exercise of share options diluting existing shareholders below the 5% test at the time of sale.”

In addition, shareholders and directors who, on or after 29 October 2018, realise gains on disposals of shares in their personal company will need to be entitled to at least 5% of the distributable profits and net assets of a company to claim the relief.

Ready for another trap to avoid? This one sounds pretty straightforward but also catches unsuspecting owners out.

You have to be sure that your company qualifies for the tax allowance. To do so it must be a trading company, which is defined as a “company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities”.

In short that means that if you have over 20% of assets from non-trading activities, such as investing profits in commercial or residential property or renting out property, then you may not qualify for Entrepreneurs’ Relief. Similarly, if you have built up a large cash surplus in the business – piggy banking cash – you may not qualify unless you can prove that the cash is being set aside for future trading activity.

All of the above may sound rather daunting but the traps are becoming increasingly more relevant. “HMRC is taking a closer interest in issues of tax avoidance and qualifications for tax relief,” Evans warns. “It’s a very good tax relief but business owners need to be careful. You must ensure you meet the qualifying conditions and the correct timing to avoid any future fights with the Revenue!”

What is ER?

Through Entrepreneurs’ Relief a company owner may be able to pay less Capital Gains Tax when they sell all or part of their business.

So, instead of being taxed at 20%, the proceeds from the sale of shares or assets in the business will only be taxed at 10%. However, you have to meet the qualifying conditions.

You must claim it as an individual, such as owning shares in your limited company, being a sole trader or in a partnership. You must have owned the business for a year either up to the date of disposal or the date the business ceased.

The minimum period throughout which the qualifying conditions for relief must be met will be extended from 12 months to 24 months for disposals made on or after 6 April 2019. Where the claimant’s business ceased, or their personal company ceased to be a trading company (or the holding company of a trading group), before 29 October 2018, the existing one-year qualifying period will continue to apply.

The seller must also be an officer or employee of the company or a company within the same group.

From April 2019, the government will remove disincentives for companies to take on external investment by ensuring that, even if an individual’s shareholding is diluted to below 5% as a result, they will be able to claim the relief on gains made up to that point.

You are entitled to relief on your first £10 million of lifetime gains.

The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.

Where the opinions of third parties are offered, these may not necessarily reflect those of St James’s Place.