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 [2016] 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.