CGT Entrepreneurs' relief - a New Year's resolution to the 5% test?
The Autumn Budget included an important change to CGT entrepreneurs’ relief (“ER”) which extended the 5% qualifying requirements beyond just voting rights and ordinary share capital (tests that were, and remain, relatively straightforward to apply) to a third test imported from elsewhere in the Taxes Acts and focused on entitlements to profits and rights to net assets. For more information on the Autumn Budget changes to ER, please see our previous updates here and here.
The policy driver behind the extended 5% qualifying requirement was straightforward – the previous tests did not limit ER to shareholders who had a substantive 5% plus equity interest in the company – nominal value and voting rights could be structured so that ER could be preserved for shareholders whose economic interests were, and may remain, well below that threshold level.
The solution proposed by HM Revenue & Customs was anything but straightforward – take tests used elsewhere in the Taxes Acts, write them into the ER legislation and require them to be met throughout the two year period before the shares were sold. This required an analysis of not just the ordinary share capital, but also certain classes of preference shares and non-commercial debt. It also potentially required the tests to be applied in hypothetical scenarios – something that would sit uncomfortably with a relief such as ER. The difficulties of applying the new test in practice soon became clear – particularly with private equity backed companies with multiple share classes designed to deliver structured returns for different classes of shareholder at different valuations.
An alternative third test
HM Revenue & Customs have listened to those concerns and on 21 December 2018 announced an alternative third test in place of the problematic requirement based on distributable profits and net assets.
This alternative test requires the individual in question instead to be beneficially entitled to at least 5% of the proceeds in the event of a disposal of the whole of the ordinary share capital of the company. It is intended to allow individuals to use their entitlement to sale proceeds as evidence of their economic interest in the company, in circumstances where entitlement to the profits and the net assets of the company cannot be demonstrated. Importantly, in contrast to the distributable profits/net assets test, the reference to “ordinary share capital” helpfully means that entitlements will not be diluted by certain types of preference shares or non-commercial debt.
The new alternative test must again be met throughout the one year (two years from 6 April 2019) period prior to disposal – however this requirement is deemed to be met where the test is satisfied at the time of disposal, and it would be reasonable to expect that the individual would have satisfied the test had a disposal of all the ordinary share capital taken place at the same market value throughout the preceding one (or two) year period, ignoring the effect of any avoidance arrangements in place. This may now give individuals holding so-called ratchet or growth shares the right to qualify for ER (assuming all other conditions are satisfied), even if the ratchet/growth hurdle only crystallises on exit.
The legislation is still draft; it contains the now customary tax avoidance qualification and there is little substantive guidance yet from HM Revenue & Customs on how it will be applied in practice. Further guidance on the changes is expected but in the meantime, care should be taken when assessing any individual’s current entitlement to ER and in particular when contemplating making any changes to articles to accommodate these changes.
As a wider comment, this process has demonstrated the obvious perils of introducing broadly applicable legislation with immediate effect and without any prior industry consultation or accompanying guidance. It became apparent soon after the original draft legislation had been published that it failed to address the issue identified by HM Revenue & Customs whilst giving rise to a number of unintended consequences for a broad variety of commercial ownership arrangements. As a result, costs have been incurred since the Autumn Budget as businesses have sought clarity regarding the application of the changes to their ownership structures. Following this latest amendment, in many cases this disruption and cost appears to have been entirely avoidable.
At a time when businesses have more than enough uncertainty to deal with in the wider economy, one of the Government’s New Year’s resolutions should be a more judicious approach to introducing new legislation without prior consultation.
For more information please contact James Carter or Robert Birchall.