How to achieve Entrepreneurs' Relief (10% tax) for option holders?
In the good old days of Business Asset Taper Relief (BATR) the effective rate of CGT payable on the sale of shares could be reduced from 40% to 10% just two years after the grant (note, grant, not exercise) of an EMI option.
The abolition of BATR and introduction of Entrepreneurs' Relief (ER) has however preserved an attractive 10% tax rate for the few, whilst making the arrangements less attractive for the many. Eligibility for ER requires an individual to (i) be an officer or employee of the Company, (ii) have 5% of shares carrying 5% of the votes and (iii) have held those shares for at least 12 months prior to sale. If all of these conditions are satisfied then the tax rate reduces from 28% (for a higher rate tax payer) to an effective rate of 10% on up to 10 million of gains in a life time.
If a company embraces the concept of employee ownership and cascades ownership participation widely throughout the organisation it is unlikely however that many employees will own the requisite 5%. If a plan is designed to deliver equity benefits only on attainment of an exit event such that share options are only exercised at the time of sale then the 12 month holding test will not be satisfied.
So for employee shareholders who hold less than 5%, and participants in employee share schemes holding options rather than shares it is not usually possible for them to qualify for ER. If, however, you consult us, we can share our developed Voting Share Scheme which potentially makes the relief available to any employee shareholder or option holder after a one year qualifying period.
Without giving away too much (this advice really is worth paying for!) a closer look at the legislation reveals that the 5% limit refers only to voting shares. The other rights normally attaching to shares, in relation to dividends and capital, are not mentioned. This raises the possibility that employees could be issued with shares having 5% of the voting rights, but very limited rights in other respects. These shares would still count towards the 5% threshold for ER.
Obviously, even shares with voting rights but very limited other rights would have some residual value. The recipient would have to pay tax on that value, either through PAYE when the shares were received or (if there is no market for the shares) through self-assessment. However, if the value was likely to be significant then the shares could be acquired on deferred terms. This would still provide full beneficial ownership but without the employee having to make a significant up-front cash commitment (for further details on deferred share purchase schemes see here).
Any changes to a company's share capital need to be made carefully - there may be legal, tax and other implications and changes may be needed to any shareholder or subscription agreements.
This Voting Share Scheme solution will not be appropriate for every company and involves certain costs and risks which will not be reversible if the legislation changes. It is also only appropriate if you are happy for key management to be directly involved in the Company as they will have 5% of the voting capital. It is therefore advisable that this Voting Share Scheme is only made available to a maximum of 5 people in order that the main shareholders still hold 75% of the share capital and can still pass a special resolution. If successive 5% issues are made, the later issues will dilute the earlier ones and possibly cause them to cease to qualify for ER. Finally, it must be recognised that this is a"technical" solution. It is possible that the authorities may decide that the legislation was not intended to work in this way and change the rules. It is also not impossible that they could make the change retrospective, so that shares issued now would later become ineffective for the purposes of ER. The costs of issuing the shares (including any tax costs) would however already have been incurred.
If you would like to discuss the Voting Share Scheme in more detail and how it works please call the office on 020 8949 5522.