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FA 2015: Restrictions to entrepreneurs’ relief

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Entrepreneurs’ relief is a valuable tax relief for those holding equity in the business for which they work. Its relative simplicity gives rise to anomalies, but the FA 2015 changes do not suggest a clear pattern in HMRC’s views as to what is acceptable tax planning. Managers with minority equity stakes in joint ventures and companies which participate in partnerships are among those hit by these changes, along with persons disposing of their own assets used by a business and individuals that incorporate businesses carried on in partnership. No grandfathering is available, even for gains accruing before the changes were announced.

Entrepreneurs’ relief (ER) is the latest iteration of a longstanding feature of the capital gains tax legislation, namely a relief for those who develop or invest in a business – typically one in which they work. It follows on from business asset taper relief (BATR) and, before that, retirement relief.

Although the conditions of each of these reliefs differed, reflecting the priorities of the government in power, the essential feature remained the same: for individuals disposing of a business, at least part of the gain would be taxed at lower rate(s). For retirement relief, BATR, and, in its early years, ER, this was achieved by exempting part of the gain from tax.

Reliefs from other taxes pursue the same objective, with business property relief (from IHT) and income tax relief for interest on loans to acquire interests in businesses being good examples. Other reliefs – such as the enterprise investment scheme (EIS) and venture capital trusts – seek to encourage the provision of capital to small businesses, typically by those not involved in the running of the business, or provide rollover relief for certain business asset reinvestments.

The current relief for business assets

Occupying seven pages of TCGA 1992, ER has been in place since 2008. Readers will be familiar with the basic structure: a 10% rate of tax for gains (of up to £10m of gains, over the individual’s life), which are made on a ‘material disposal of business assets’, and a similar relief for certain disposals made by trustees. Business assets for these purposes include qualifying share disposals by directors/employees. The relief is also available for disposals (of assets) ‘associated with a relevant material disposal’.

It is these two concepts – the material disposal of a business asset and associated disposals –which were amended by FA 2015. The first is amended in three respects, the second in one respect. All of these changes restrict the scope for ER, and are the focus of this article.

However, there is some good news. ER is being extended (perhaps, more accurately, reinstated) by FA 2015 s 44 to certain held-over gains which fall back into charge when an investment in an EIS company or in a social enterprise is disposed of, etc. The main point to note about this change is that ER is only available if the gain which was held-over into the EIS company/social enterprise would itself have qualified for ER and would have arisen on or after 3 December 2014.

Qualifying business disposals: the 5% minimum shareholding

Being a relatively straightforward relief, it is inevitable that ER will produce some anomalies. One of the more striking of these is the distinction which the legislation draws between businesses carried on in partnership, and those which are carried on through a company.

In the former case, there is no minimum size threshold to qualify for ER. A very small percentage holding will qualify for relief and, provided that an interest has been held for the 12 month minimum holding period, any gain on the disposal of that interest will qualify for relief. This is the case even if the interest has increased significantly during that 12 month period, such as shortly before an exit.

By contrast, where the individual holds shares in a trading company (or the holding company of a trading group), not only must that individual be a director (or other officer) or employee of the company, but any gain on the disposal of those shares will only qualify for relief if the individual has held at least 5% of the company’s equity throughout the 12 months before that disposal. Including such a ‘minimum size’ threshold for relief can seem particularly anomalous to an individual holding a small shareholding in a trading company, who contrasts the position with that of a similar individual who is a member of a limited liability partnership.

However, this 5% threshold is a refreshingly simple test to apply: what is required is a shareholding which carries 5% of the voting rights and 5% of the ordinary share capital (making the company the individual’s ‘personal company’). The latter is calculated by reference to the total nominal value of the company. Therefore, any shareholders holding a class of share which has a greater nominal value find it easier to satisfy the 5% threshold than those with shares carrying a smaller nominal value.

Readers familiar with the group relief tests, which are incorporated into other aspects of the chargeable gains legislation, might be surprised by the absence of any economic ownership test. Indeed, in a joint paper on the GAAR, the CIOT and ATT raised the issue of the application of ER to shares with limited economic rights. In practice, the 5% voting rights threshold is an effective safeguard against abuse, because it limits the number of people who can claim ER in respect of any company to a maximum of 20.

Changes to joint venture companies and interests in partnerships

In practice, the limit is often far fewer than 20 individuals, particularly where an outside investor finances or invests in the business. In such a case, the amount of equity available for management shareholders is limited, and the outside investor may want the managers’ shareholdings limited to less than 25% of the voting rights in the company.

In such cases, the joint venture company rules in TCGA 1992 s 165A could provide assistance. In theory, they could allow significantly more than 20 individuals to qualify for ER on their shareholdings in a trading company, producing a more level playing field with those investing in a limited liability partnership. In practice, the need to have a workable corporate governance structure placed a lower limit on the number that could qualify.

How did the joint venture company rules work? They allowed managers, or a group of managers, to establish their own ‘management’ company (Manco), which then held a minority interest in the underlying trading company/holding company of a trading group (Tradeco). Because the 5% threshold is tested by reference to the company in which the manager owns shares, each Manco could be the personal company for up to 20 managers (provided that each had a 5% interest in that Manco and was a director of that company). Although the Manco would not itself be carrying on a trade, the joint venture rules – which are similar to those in the substantial shareholdings exemption (SSE) – deemed it to carry on a portion of the trading activities of the Tradeco. The Manco had to hold at least 10% of the Tradeco’s shares, and at least 75% of the Tradeco’s shares had to be held by not more than five persons. Assuming, as would usually be the case, that the Manco was UK tax resident, the 10% ownership of Tradeco also afforded SSE protection against an additional layer of tax from being introduced. In theory, up to six Mancos might have been possible, but anything more than a single Manco gave rise to commercial issues.

It is these Manco structures from which FA 2015 s 43 removed ER. It did so by introducing, in TCGA 1992 s 169S, a new sub-s (4A)(a), which states that the relevant provisions of the joint venture rules (that is, s 165A(7), (12)) are to be disregarded in determining whether a shareholding qualifies for ER. This change applied from 18 March 2015, without any grandfathering either for shares acquired before then or for gains accruing up to 18 March. This is not unusual for changes to capital gains tax, but it is arguably harsh for a change which applies regardless of whether or not the joint venture structure was put in place to access ER.

A related change is made by new sub-ss (4A)(b)and (c), which prevent a company from deriving its status as a trading company (or trading group) by participating in a partnership which carries on a trade. Again, the change here came into force on 18 March 2015 without any grandfathering and without any reference to the size of the company’s interest in the partnership. Although interests in partnerships could be used to combine the (lower) corporate tax rate on retained profits with the absence of a 5% threshold for ER, there will undoubtedly be arrangements which were established in this way for non-tax reasons that no longer qualify for ER.

This change carries echoes of the FA 2014 provisions on mixed member partnerships, which also demonstrated HMRC’s dislike of taxpayers adopting a mix-and-match approach to the respective tax treatments of partnerships and companies.

Anyone tempted to trigger a disposal after the change was announced (albeit at a cash-flow cost), relying on the three-year grace period after a company ceases to be a trading company (see TCGA 1992 s 169I(7)), will be disappointed by FA 2015 s 43(4). This prevents taxpayers from relying on s 169I(7) if the company ceases to be a trading company by virtue only of the changes made by FA 2015 s 43.

Changes to associated disposals

The ‘associated disposal’ rule applies to individuals who already qualify for ER in respect of an interest in a partnership, or shares in a trading company/holding company of a trading group. They extend the relief to gains made on assets that the individual holds directly, provided they have been used for at least a year in the business carried on by the partnership/trading company. A classic example is property occupied by a trading partnership, but owned by one of the partners. Another example might now be a piece of art; until the changes made by FA 2015 s 40, such an asset might otherwise have been exempt as a wasting asset.

ER only applies to disposals of such assets as part of the individual’s withdrawal from participation in the business carried on by the partnership/company, and the individual must also make a disposal of some of his partnership interest/shareholding.

HMRC’s stated concern is about individuals qualifying for ER in respect of such assets where there is no ‘genuine’ reduction in the individual’s participation in the business. Accordingly, it is primarily the requirement that the individual disposes of an interest in the partnership/shareholding which has been made more stringent. FA 2015 s 41 replaces this with a requirement that the individual disposes of at least a 5% interest in the partnership/shareholding in the company in question. For a person disposing of securities, only 5% of the company’s total securities must be disposed of. This requirement is set out in three new sub-ss (1A), (1B) and (1C) of TCGA 1992 s 169K, for partnership interests, ordinary shares in a trading/holding company and securities in a trading/holding company respectively.

Significantly, the disposal must be of 5% of the partnership/company, rather than just 5% of the individual’s interest in that partnership/company. Therefore, although a member of a partnership does not need a minimum size of interest to qualify for ER in respect of that interest, a 5% partnership interest is required to qualify for ER in respect of privately held assets which are made available to the partnership.

Another change requires that neither this disposal nor the individual’s withdrawal occur at a time when there are arrangements under which the taxpayer (or any person connected with the taxpayer) is ‘entitled to acquire’ a partnership interest (including an increased partnership interest) in the partnership which carries on the business; or – where the business is carried on by (and the individual has disposed of shares in) a company – shares in or securities of either the company whose shares/securities have been disposed of, or any other company in the same trading group (or certain other companies which it is ‘reasonable to assume’ will become part of that trading group). This is very wide, given that ‘arrangements’ carries its customarily broad meaning. As well as extending this to connected persons, it is notable that a person who disposes of shares cannot be party to arrangements to acquire securities, or vice versa.

ER is also denied for associated disposal if the disposal of shares takes the form of a capital distribution by the company (as opposed to a sale of shares to a new, or existing, shareholder), unless that distribution is in the course of the dissolving or winding up of that company.

As with the changes to s 169S, these changes took effect on 18 March 2015 without any grandfathering protection.

Changes to transfer of goodwill on incorporation

As ER is available for disposals to connected persons, the 10% tax rate is available to an individual who transfers a business to a company owned by that person.

Clearly, there is a concern about such a transaction, particularly if the company then claims corporation tax relief – at the 20% rate for the same, or a greater, amount – and the outstanding purchase price is used to extract funds from the company without further personal taxation. FA 2015 s 42 addresses the ER position, by inserting a new s 169LA into TCGA 1992. This denies ER for gains attributable to goodwill (but not other assets) which is transferred to a close company by a person who is a ‘related party’ (using the definition from Part 8) to that company.

There is an exception to this rule, which permits retiring partner(s) to claim ER on the transfer of a partnership’s business to such a company, but this exception is limited. Furthermore, ER is only preserved for such an individual if that person is not a participator in the close company (or another company with a ‘major interest’ in it) and there are no arrangements under which that person could become a participator in the close company.

This new restriction is backed up by a TAAR, which denies ER for gains on disposals of goodwill by a person who is a party to ‘relevant avoidance arrangements’. Readers may be depressingly familiar with the width of this TAAR. All that is required is a main purpose of securing that the new restriction does not apply in relation to the goodwill or that the person is not a related party in relation to the company to which the goodwill is disposed of.

This change was announced at the Autumn Statement, along with a related restriction on companies claiming the corporation tax relief referred to above under the intangibles regime in CTA 2009 Part 8. It applies to disposals on or after 3 December 2014, rather than the 18 March 2015 commencement date for the other ER changes mentioned above.

Still here, but less generous

ER remains a valuable tax relief, but it is not surprising that in an age of austerity HMRC finds Parliament receptive to concerns about perceived abuses.