The Chancellor’s announcements in this week’s Budget relating to changes to the qualifying conditions for Entrepreneurs’ Relief (ER) - the 10% capital gains tax rate for qualifying disposals - have a wide reaching impact.
The announcements can be summarised as follows:
The change was announced to deal with a specific perceived avoidance arrangement involving the issue to an individual of a class of share which sought to entrench the rights of the holder to 5% of the share capital and voting rights in a way which was inconsistent with the other economic rights of the shares. As is common in these circumstances, the provisions reach far wider and impact on genuine commercial arrangements.
We predict that an unintended casualty of the changes will be founders in VC-backed companies. This will arise in circumstances where the founder holds just over 5% of the share capital and voting rights, but is not entitled to 5% of the distributable assets because of the distribution waterfall set out in the company’s articles. It is not uncommon for a VC investor to require that the first part of any distribution is used to pay each shareholder an amount equal to the issue price paid for their shares. This favours an investor who will have paid significantly more for their shares then a founder (who is likely to have paid a nominal sum only). This means that a founder with just over 5% of the share capital may not be entitled to 5% of the distributable assets, depending on the value on the liquidity event. Even if the valuation on a liquidity event results in the founder being entitled to more than 5% of the distributable assets, this condition may not have been met throughout the period of two years ending with the disposal (which is the period during which this test must be met) depending on the valuation throughout this period which will impact on the total distribution to the founder.
Growth share schemes may also be affected as often the class of growth share doesn’t carry entitlements to dividends, only participating in liquidation/sale proceeds, and so this could cause the holders of those shares to fail the personal company requirement even if they would previously have done so (eg because they did carry 5% of voting rights and share capital).
Until the legislation is finalised, it is difficult to know whether there will be any protection from this change to the ER qualifying conditions. In particular, nothing has been announced about the treatment of any reorganisations of share rights for those who qualified for ER prior to the announcement in order that their shareholding can continue to qualify. Without any specific saving provisions, any amendments seeking to achieve this are likely to trigger tax charges for the employee shareholder.
Although new legislation is to be introduced from April 2019 to allow founders to bank ER relating to gains made in the shares prior to dilution below 5% on a funding round, we don’t see that this will do much to alleviate the concern we have set out above. Although this is a welcome change, it only allows the 10% rate to apply to gains made prior to the funding round which diluted the founder below 10%. VC-backed companies often go through many funding rounds prior to reaching a valuation which will encourage the investors to sell the company and seek a return on their investment. In practice, the valuation at the time of an exit is likely to far exceed the valuation at the time that the founder was diluted, so the vast majority of the founder’s gain will be taxed at the higher 20% capital gains tax rate. In addition, the new legislation will not assist where a holding ceases to qualify for ER because of the changes outlined above.
Although the changes to the holding period will apply to shares acquired pursuant to an EMI scheme, we understand that the additional personal company tests will not. This means that an individual who has acquired shares through an EMI scheme will qualify for ER on a subsequent disposal, provided that the option was granted at least two years before the disposal of the shares and the individual has been an officer or employee throughout that two year period. That is regardless of the individual’s entitlement to the distributable assets of the company throughout that period.
This creates what is perhaps an unsatisfactory outcome where an employee granted options over 0.5% of the share capital of the company may be in a better tax position then the founder who has dropped below a 5% holding as the company has grown.
This substantially increases the benefit of an EMI scheme in relation to any equity incentive planning for employees, including founders of EMI eligible companies. EMI options should be considered for all employees and directors who are eligible where these new tests would otherwise restrict the availability of entrepreneurs relief.