19 November 2019
Entrepreneurs' Relief (ER) is a capital gains tax relief bestowing a 10% rate of tax on up to £10m lifetime limit of gains stemming from qualifying business sales. The headlines for relief are that the seller has a 5% ownership interest in and is an officer or employee of a trading business for the two years leading to the sale.
Sounds good, but it’s not without its problems
One such problem was that the true entrepreneurs in a start-up often failed to secure relief since the process of raising funds by issuing share capital often saw their ownership percentage diluted to beneath the required 5%.
Since April 2019, two elections are available in these circumstances and we’re now starting to see clients in a position to consider them:
Election 1
The first election enables a shareholder who would be eligible for ER immediately before a fund-raising issue of share capital, but who is diluted to below 5% by that fund-raising, to trigger an imaginary capital gain as at that date. The election pretends that the shareholders has sold their shares and then immediately bought them back, in both cases at a market value calculated with no minority holding or similar discounts.
The effect being that the gain, up to the date of dilution, is crystallised and the 10% rate of tax can be locked in as regards that gain. And that the future gain on a later actual sale of shares will be taxed only as regards growth in value subsequent to the election.
Election 2
Given that election 1 would create a ‘dry’ tax charge (a tax charge when the taxpayer has not received any cash inflow) the second election enables the taxpayer to defer the gain created by election 1 from crystallising until such time as the shares are actually sold. As and when the shares are actually sold, election two also serves to treat the 5% test as met in respect of the deferred gain.
Good, but not perfect
The lion’s share of the value growth for a start-up can often happen at or near to exit. As such it is quite possible that the gain ‘locked in’ at the 10% tax rate when the founder is diluted below 5% is only a fraction of the gain realised on an actual exit, ER not being available on that later gain.
Further, if only election 1 is made and the gain is crystallised and the tax paid, there are problems if a later actual exit results in a loss (a drop in value between election 1 value and actual exit value).
If elections 1 and 2 are both made, election 2 does not preserve entitlement to ER as such, and only treats the 5% test as having been met. If, for example, the shareholder is no longer an employee or officer at the date of actual sale ER will be unavailable despite the 5% test being treated as met.
Accordingly any founder who is anticipating being diluted below 5% by a raising of funds needs to consider the pros and cons of each election and make an informed decision as to which combination best suits their circumstances. To find out more please contact me or your local UHY tax specialist.
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