Whether or not an employee shareholder will qualify for entrepreneurs' relief has never been certain because the relevant qualification tests apply at disposal (albeit with a look-back period) rather than acquisition. However, recent legislative developments have cast further doubt on the ultimate availability of the relief for such individuals by extending the qualifying period and clamping down on the potential manipulation of share rights.
On 29 October 2018, the UK's Chancellor of the Exchequer, Philip Hammond, announced a tightening of the requirements that those seeking to rely on entrepreneurs' relief must meet. The relief itself remains the same, with those that qualify being subject to UK capital gains tax at a reduced rate of 10 per cent.: half the usual rate for higher or additional rate taxpayers, on total gains over their lifetime of up to £10 million.
To encourage longer-term investment, shareholders intending to dispose of their shares on or after 6 April 2019, and looking to benefit from entrepreneurs' relief will now need to meet the conditions in respect of their shares for at least 24 months prior to disposal, double the current requirement of 12 months. This announcement adds further complexity for shareholders who may have hoped to benefit from entrepreneurs' relief on the disposal of shares acquired between April 2017 and April 2018. These individuals, depending on when their shares were purchased, may either consider selling their shares before 6 April 2019 or be left with no choice but to hold on to them for longer than they may have anticipated in order to be eligible for entrepreneurs' relief. Given that the purpose of this measure is to encourage longer-term investment, it seems somewhat ironic that its implementation may in fact encourage premature share disposal.
Effective immediately, in addition to the current requirement to hold at least 5 per cent of the company's ordinary share capital (by reference to nominal value), allowing the individual to exercise at least 5 per cent of the voting rights, shareholders must also be beneficially entitled to at least 5 per cent of the distributable profits and net assets of a company to claim the relief. This is intended to address a perceived abuse of the current rules where individuals can benefit from entrepreneurs' relief without having a material economic interest in a company. It has been relatively common, especially in the private equity context, to structure managers' equity interests with the intention of attracting entrepreneurs' relief by satisfying the 5 per cent test only by reference to voting rights and nominal value, rather than economic entitlements. The change will leave many managers outside the scope of the relief.
The rules outlined above follow changes proposed by the Autumn Budget 2017, which are intended to protect individuals who were eligible to benefit from entrepreneurs' relief prior to external investment leading to a dilution of shareholding. The proposed amendments allow an individual to qualify for the relief on the portion of the gain accrued prior to the dilution event, provided that certain conditions are met. The individual will be treated as disposing of and then reacquiring the shares at market value, with an additional option to defer the tax charge on the gain until a true disposal in future.
So long as there is a significant delta between capital gains tax rates and income tax rates, it will be attractive to structure incentive arrangements so as to attract capital gains tax as opposed to income tax. However, structuring purely for entrepreneurs' relief may well cause conflict with the parties' commercial objectives. Importantly, and as is evident from the recently announced changes, it is always uncertain whether the desired outcome will be achieved, particularly in the context of "growth shares" where there are equity value hurdles and the relevant company is operating in a volatile market.
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