Dilution affects employee share schemes too

Posted by RM2 at 11:17 on 21 Mar 2018

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At the RM2 Partnership, we noticed that, as part of the recent Spring Statement, the government has decided (under the guise of a consultation process) to consider certain proposals that are likely to result in the introduction of legislation in Finance Bill 2018-2019. These proposals, if enacted, would allow individuals who no longer hold a 5% interest in a company to claim Entrepreneurs’ Relief (“ER”), where the reduction in their percentage shareholding is due to that company issuing shares to raise capital for the purposes of its trade.

The government believes that the current loss of entitlement to ER could be seen as a perverse consequence of the growth and success of the company in question. They note in the consultation document that, in some cases, the risk of losing ER acts as a disincentive for seeking the appropriate finance that would allow the company to grow.

The government proposes to address this issue by allowing individuals to elect to crystallise gains on their shares immediately before their holding is diluted. The individual can choose to defer the accrual of the gain on the elective disposal so that ER may then apply to the deferred gain when the claimant comes to dispose of the relevant shares.

The government also notes in its consultation that (to ensure effective targeting of the extension of the relief) the dilution of the individual’s shareholding must be a consequence of an issue of shares made by the company “for genuine commercial reasons”.

Hold on a second here !! – surely the issue of shares following the exercise of an option under an employee share plan, as part of a “genuine” employees’ share scheme is also, to most people’s mind, a genuine commercial purpose.

It seems having read the consultation that the government has no current intention to extend the availability of ER to a situation involving dilution where employee share options have been exercised.

But why not? – surely this is socially and commercially desirable. An element of targeting could be introduced as well (for instance by limiting to option exercises arising in the context of a sale transaction). In addition, the government could curb the potential manipulation of legislative rules by perhaps introducing financial limits.

So, come on HM Revenue & Customs – we all want to see our entrepreneurs moving away from making perverse decisions. Such counter-productive decisions include not having larger employee share option pools to incentivise, recruit and retain employees just because an entrepreneur’s own ER relief position (or that of his or her senior management team) might be detrimentally affected.