28 January 2019
In the Autumn Budget 2018, the Chancellor announced that the entrepreneurs' relief ("ER") legislation would be amended in the Finance Bill to introduce, with effect from 29 October 2018, two new conditions to the definition of 'personal company' for ER purposes (in addition to the existing 5% ordinary shareholding and voting rights requirements).
The new conditions would require an individual to be beneficially entitled to at least 5% of the company's distributable profits and 5% of the assets available for distribution on a winding up, in each case throughout the relevant qualifying period (presently twelve months, usually running up to the date of sale or other exit, but due to change with effect from 6 April 2019 to two years). Read our previous summary of the additional requirements.
At the end of last year, amendments were proposed to the new conditions. As explained further below, it will (again with effect from 29 October 2018) instead be possible to qualify for ER (assuming the existing conditions are met) if an individual would, throughout the relevant qualifying period, have an entitlement to 5% of the disposal proceeds on an exit.
The new formulation is expected to preserve ER for many individuals in such circumstances, whilst still addressing the Government's concern that individuals were able to benefit from ER in circumstances where their holding in effect did not give them a 5% economic stake in a company.
The introduction of the new condition prompted concerns that, in many situations, it would be difficult to discern whether ER would be available and that, particularly in companies with a diverse investor base and multiple share classes, founders and other individual shareholders could fall below the new 5% thresholds, particularly in relation to entitlements to assets on a winding up, because of preferential rights held by other investors (despite maintaining an effective economic interest of 5% or greater, looked at in the context of an exit).
On 21 December 2018, the government proposed amendments to the Finance Bill including the introduction of an alternative test for the definition of 'personal company' which can apply instead of the new conditions mentioned above. This alternative test is based on an individual's entitlement to a share of disposal proceeds in the event that the company is sold.
With this new amendment, the Finance Bill changes will mean that an individual must hold 5% of the ordinary share capital in the company, have 5% of the voting rights, and meet one of the following two new conditions:
To establish whether the test for the second condition is met, it should be assumed that the ordinary share capital of the company is sold at market value on the final day of the qualifying period, and that the individual's share of the proceeds is the amount that is it reasonable to expect they would have been beneficially entitled to in the circumstances in place at the time.
It should be noted that the changes already announced in the Autumn Budget to the minimum qualifying period (extended to two years for disposals on or after 6 April 2019) have not been amended.
The intention of the new condition appears to be to look at an individual's actual sale proceeds and establish whether they entitle them to 5% of the value of the company. The effect of the test is that an individual may qualify for ER where their 5% entitlement is only actually determined on completion, for example due to an exit "waterfall" or ratchet structure. By looking to the market value at the end of the qualifying period (which in most cases may be expected to be the actual sale proceeds for a sale) and applying that value to the whole of the period, the intention seems to be to avoid the need for the "watching brief" that the other test requires over the qualifying period (whether 12 months or 2 years) to see if the individual is continuously entitled to both 5% of the profits available for distribution and assets on a winding up.
Helpfully, by referring to a share of proceeds from the disposal of the "ordinary share capital" it also avoids the need to consider rules in other sections of legislation which may result in, for example, certain loan note holders diluting the entitlement (these rules do need to be considered for the alternative condition of profits available for distribution and assets available on a winding up).
In summary, this welcome amendment may allow individuals still to qualify for ER in circumstances where their entitlement to profits and assets of the company has been diluted or cannot be substantiated. This amendment in effect allows individuals to use their entitlement to exit proceeds as evidence of their economic stake instead.
If you have any questions regarding these changes please contact a member of the Taylor Wessing tax team or your normal Taylor Wessing contact.