ER: Does your shareholding meet the 5% test?

ER: Does your shareholding meet the 5% test?

You think you should benefit from Entrepreneurs’ Relief when you sell your business — but beware — the ‘5% test’ condition is catching people out.

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ER: does your shareholding meet the 5% test?

Entrepreneurs’ Relief (ER) provides a 10% rate of capital gains tax on the disposal of shares in a trading company. To benefit from this relief, a number of qualifying conditions need to be met throughout the 12 months prior to the date of disposal.

Ordinary share capital

One condition, known as the ‘5% test’, is that an individual must hold at least 5% of the ordinary share capital (tested by reference to the nominal value of shares in issue) and be able to freely exercise at least 5% of the voting rights.

Ostensibly, these are simple arithmetical tests, but dilution can easily occur. Share options exercised ahead of a sale are a common example of how a holding of ordinary share capital can be diluted.

Also, what counts as ‘ordinary share capital’? This is broadly defined to be all issued share capital other than shares that carry a right to a dividend at a fixed rate but have no other right to share in the company’s profits.

In effect, with the general exception of fixed rate preference shares, the ‘5% test’ requires consideration of all shares in issue, even those which, on the face of it, have little or none of the characteristics of an ’ordinary’ share.

Shares carrying limited economic rights (at least initially) may be issued for a variety of reasons, including incentivising key employees and/or facilitating succession of a family business. But recent Tribunal cases show how difficult this area can be.

In the first case, ER was denied as a result of a class of deferred shares in issue. These shares carried no voting rights and no rights to dividends and in reality were economically worthless. However, they were regarded as ordinary share capital for ER purposes diluting the claimant’s interest below the 5% threshold.

A second recent case also looked at a class of preference share with no dividend rights, but came to the opposite conclusion. It was decided in this case that a preference share with no right to dividends did represent a dividend at a fixed rate. The Tribunal had sympathy for the unfairness of the taxpayers’ position and concluded there was enough flexibility in the definition to find in the taxpayers' favour, but was very careful to emphasise that this finding was strictly on the facts of this case.

With such uncertainty in how the law will apply in a given situation it is best to ensure that your shares meet the ‘5% test’ on any interpretation, if you can.

Direct and indirect?

The March 2016 Budget confirmed and restored the qualifying criteria for ER for disposals of holding companies of trading groups and companies holding an interest in a joint venture (JV) or partnership. Such disposals continue to qualify for ER provided an individual’s total direct and indirect interest is at least 5%.

The previous restrictions in this area introduced in March 2015 now have a narrower scope and only apply to individuals with only a small indirect stake in a trading business.

Conclusion

An awareness of the qualifying conditions for ER and a thorough ‘check-up’ at least 12 months in advance of a potential sale is imperative for individuals hoping to secure this relief.

Contact: 

Beatrice Friar. Associate Partner, Private Client

Lisa Travers. Manager, Private Cient

 

Personal Perspectives - July 2016

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