Entrepreneurs’ relief - the devil in the detail
Obtaining entrepreneurs’ relief and a 10% capital gains tax rate for employee shareholders is not always straightforward. This can be the case especially where there are different classes of share in issue, or where additional share issues may dilute an individual’s 5% shareholding. In addition, changes in tax legislation may overtake and invalidate, from a tax perspective, previously established share plan arrangements.
Currently, the safest way for employees and directors to guarantee entrepreneurs’ relief is by way of the grant of Enterprise Management Incentive (EMI) share options, which overrides the usual requirements to obtain the relief.
This is illustrated by a recent case (McQuillan v Revenue & Customs Commissioners  UKFTT 0305 (TC)) which investigated in some detail the requirements for obtaining entrepreneurs’ relief. Broadly, the shareholder must be a director or employee in the company, and hold shares for at least 1 year before the sale. The individual must hold at least 5% of the ordinary share capital and at least 5% of the voting rights by virtue of that holding.
In this situation, there were four (husband and wife) shareholders in the company. Couple A held 34 voting shares and 30,000 redeemable, non-voting shares (which had been created to deal with a pre-existing loan, prior to the introduction of entrepreneurs’ relief legislation); Couple B held 66 voting shares.
In December 2009, the redeemable shares were redeemed at par. One month later, the 100 remaining shares were sold to a buyer and both couples exited the company.
Couple B claimed entrepreneurs’ relief on the sale of their 66 voting shares. HMRC disputed the claim, sayings that the redeemable shares had formed part of the ordinary share capital of the company. Therefore, Couple B had not held 5% of the ordinary shares for at least one year prior to the sale – for most of the previous 12 months, their 66 voting shares amounted to a tiny percentage of the total 30,100 share in issue.
Couple B appealed successfully. This was on the basis that “ordinary share capital” means all of the company’s share capital, except capital which has a right to a dividend at a fixed rate (section 989 Income Tax Act 2007). The redeemable shares had no right to a dividend, which is effectively a right to a dividend at a fixed rate (albeit that rate was 0%). Therefore, the redeemable shares did not form part of the ordinary share capital, Couple B had held 66% of the ordinary share capital throughout the required 12-month period and were eligible for entrepreneurs’ relief.
The decision as to whether no rights to a dividend was equal to a fixed right of zero was based in part on a tiny bracketed piece of HMRC guidance in their Employee Share Schemes User Manual (and discarded a contrary argument in a previous case). The Tribunal was sympathetic to Couple B, partly because the redeemable shares could have been restructured very slightly differently to achieve the same purposes – and doubtless would have been so structured had entrepreneurs’ relief legislation been in existence at the time they were created. However, the Tribunal also pointed out that their decision is applicable to the circumstances of this particular case. The decision should not be relied on for other situations.