Entrepreneurs’ Relief: what is the point of no return?26 Nov 2015
You have worked hard to build up your business. You have made sacrifices and taken risks. You are a business owner that has helped drive the UK economy, providing employment and contributing to the country financially through corporation tax, payroll taxes and VAT.
So, when the time comes to let go of the reins and sell the business, taking that long retirement you’ve always dreamed of, you deserve to be the “entrepreneur” who benefits from Entrepreneurs’ Relief (ER). ER is the generous 10% tax rate applied in the UK to proceeds of sale of a business. Without this relief, your capital gains tax rate could be as high as 28% on those sale proceeds. This makes a significant difference to how enjoyable your retirement might be!
As with all taxation matters, the devil is very much in the detail. Indeed, some can find that, when it comes to the time of sale, their anticipated tax relief can turn into something more akin to a tax shock.
Whether you are immediately considering a succession/exit or not, Kuits has a team ready to carry out a free Entrepreneurs’ Relief MOT on your business and shareholder structure, and advise on issues that can impact on availability of ER in the future.
The Shareholding Requirement – What is “Ordinary Share Capital”?
As a condition to qualify for ER, a shareholder needs to have held shares comprising at least 5% of the “Ordinary Share Capital” of the company for at least a year up to the date of sale. By virtue of this shareholding, the shareholder also needs to have been able to exercise 5% or more of the shareholding voting power.
“Ordinary Share Capital” is defined in tax legislation as “all the company’s issued share capital (however described), other than capital holders of which have a right to a dividend at a fixed rate, but have no other right to share in the company’s profits”. Under this definition, it is generally considered that “preference shares” would be excluded from Ordinary Share Capital. By their nature, preference shares tend to carry a fixed rate of return and do not participate in dividends over and above that.
It is clear that any preference share which is “participating” – so has a further right to participate in profits over and above the fixed rate – would constitute “Ordinary Share Capital”. However, what is not commonly known is that preference shares, which do not have any right at all to a dividend, can also constitute “Ordinary Share Capital”.
The point of no return?
On a recent transaction, we sought clarification from HMRC, ahead of a proposed sale, as to the treatment of some preference shares held by an associated company in the capital of the target company (which made up the vast majority of the overall nominal value of the issued shares). In this case, the preference shares did not have any reference to a fixed rate of return, but simply had no right to a dividend at all.
Despite tax advisors’ expectations that these would be treated as not “Ordinary Share Capital” (therefore not affecting availability of ER for individual holders of the ordinary shares), HMRC took a very literal approach and treated them as “Ordinary Share Capital”. Their view was that no return was not “a fixed rate” of return. This resulted in the individuals either having to pay 28% tax rate (as opposed to 10%) or undergo some last minute and expensive tax planning to restructure the deal. If identified earlier, the impact would have been minimal.
As in this example, a company will often put in place preference shares to strengthen its balance sheet by capitalising shareholder loans (perhaps in the context of taking on bank debt). This is a relatively simple process and one which is often done without professional advice.
When considering restructuring a company’s balance sheet or share capital, one should always bear in mind the impact not just on the company’s tax position, but also the tax position of the shareholders when they come to exit. In particular:-
• one should always provide for a “fixed rate” of return on all non-participating preference shares, no matter how small that return is. There is no point in providing for a zero return if it’s going to impact negatively on ER now or in the future
• one should always carry out a regular review on at least an annual basis (particularly where the shareholder structure of the company is changing on a fairly regular basis) to ensure that shareholders who expect to get ER on sale will not be prevented from doing so by virtue of the shareholder structure. Bear in mind that law changes over time.
Please contact us or call Peter Allen on 0161 832 3434 to discuss to take advantage of our free Entrepreneurs’ Relief MOT service on your company and shareholder structure.