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Entrepreneurs’ Relief: Chancellor sets new parameters

Posted: 24/11/2017

The proposed change to Entrepreneurs’ Relief to “encourage long-term business growth” was buried in the Government’s response, released on Budget day, to the Financing growth in innovative firms review. It aims to address the problem of employee shareholders being diluted below 5% by further equity investment and losing their eligibility for the relief.

Entrepreneurs’ Relief is often an important component of incentives for employees and directors with a significant shareholding in a company – often those who are driving the company forward, such as founders or senior executives. They can benefit from a tax rate of 10% on their gains on eligible shares (as opposed to the normal capital gains tax rate of 28%) which applies on gains of up to £10,000,000 over the entrepreneur’s lifetime.

One of the key conditions (though this is relaxed for shares acquired through EMI options) is that the individual must hold at least 5% of the shares and voting rights at the time of sale (and for a 12 month period beforehand). This can be problematic where individuals are diluted through further equity investment or indeed the issue of other employee shares and fall below the 5% threshold. That hardly incentivises founders to take on the investment needed to make their business a success and is especially an issue in capital intensive sectors, such as life sciences.

Sometimes this can be addressed by granting shares through EMI options – the 5% test does not apply and the period in which the option is held counts towards the twelve month test. However, this doesn’t help with shares acquired outside EMI, for example as founder shares or by way of cash investments. And EMI may not always be available, for example because the company becomes ineligible to grant EMI options or the individual would hold options over the individual grant limit. Depending on the circumstances, it may instead be possible to give rights to relevant individuals which protect their 5% shareholding position but this is not always practicable.

A number of responses to the consultation pressed this point and the Government has accepted that some change is necessary. It announced:

“The rules will therefore be changed to ensure that entrepreneurs are not discouraged from seeking external investment through the dilution of their shareholding. The proposed change will take the form of allowing individuals to elect to be treated as disposing of and reacquiring their shares at the then market-value.” 

So the individual will trigger an Entrepreneurs’ Relief tax charge at 10% of the gain based on the market value at that point and only the subsequent gain (after the dilutive event) would be subject to normal CGT rates. 

The Government is going to consult on the technical detail but there appear to be a couple of key problems which mean this may not achieve what it hopes:

  • The individual triggers an actual tax charge without generating any cash to pay it. If the value of the shares subsequently falls – not unusual in high-growth, high-risk companies – they may not be able to recover the tax paid.
  • This only protects the gain up to the point of the dilutive event. If you exit shortly afterwards that may be OK. However, if we are looking at a situation where the company is taking on additional equity finance, it’s more likely that any exit is at least two-three years away and you would hope to make significant further gains in that period (which would be taxed at capital gains tax rates). So it’s not clear that this deals with the bulk of the problem.

We shall see what comes out of the detailed consultations but this seems like it may be a bit of a damp squib so it may still be necessary to see what use can be made of EMI options or other structures to seek to protect Entrepreneurs’ Relief.

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