As a business takes off, the level of investment it needs in order to expand can significantly outpace growth in revenues and profits.
One of the options open to entrepreneurs at this stage in the development of a business is to issue new shares that secure new investment, without the financial pressures that come with loans.
However, until now, this has created the potential for a dilemma to arise over Entrepreneurs’ Relief, which significantly reduces Capital Gains Tax liabilities when selling or otherwise disposing of a business.
Business owners can only claim Entrepreneurs’ Relief if they own five per cent or more of the business, subject to several caveats.
When the issuing of new shares has reduced a business owner’s interest in a business to less than five per cent, that business owner has, until now, been unable to claim Entrepreneurs’ Relief.
This could equate to tens of thousands of pounds or more in additional tax. This has created a strong disincentive, in some circumstances, to businesses seeking investment by issuing new shares.
Under new rules included in the Finance (no.3) Bill, entrepreneurs will be able to make an election to HM Revenue & Customs (HMRC) when a share issue takes their interest below five per cent. When the entrepreneur disposes of the interest in the business later, they will be able to claim Entrepreneurs’ Relief on a pro-rata basis up to that date.
Shareholders should also be aware that the qualification conditions for shares in a ‘Personal Company’ have been widened. This means that where a company has multiple classes of shares all its existing shareholders may have lost ER if the shares do not rank on an equal footing (pari passu).
For ‘alphabet shares’, whether a particular class of shares receives a dividend is usually at the discretion of the directors, which means that unless agreements give a particular class of shares a right to dividends, nothing prevents the directors from distributing all the profits to one class of share. In this case, no share class carries an entitlement over the distributable profits, resulting in all of a company’s shares failing the new ER test.
The Government estimates that these changes will generate an additional £5 million in tax revenue from 2019/20 rising to £90 million by 2023/24.
The draft legislation in relation to alphabet shares has not yet been finalised and the accountancy profession is hoping that the final wording will avoid the apparently unintended consequences in relation to alphabet shares that were not reflected in the proposals which formed part of the government’s consultation.