Capital Gains Tax (CGT) is chargeable on the proceeds received for the disposal of chargeable capital assets by UK residents. For tax year 2012/13, a basic rate taxpayer will suffer CGT at 18%, and for an individual with taxable income or gains over £34,370 (and so subject to higher or additional rates of income tax) the CGT rate is 28%.
However, Entrepreneurs’ Relief (ER) reduces the rate of capital gains tax payable on disposals of “qualifying business assets” down to 10%. This relief can apply to the first £10 million of qualifying gains that an individual realizes in his or her lifetime, and because the top rate of CGT that would otherwise be paid is 28%, ER can currently give a total potential tax saving of £1.8 million.
ER is a very important relief for a business owner, and this article describes how it applies for tax year 2012/13 in more detail below.
What is a ‘qualifying business disposal’?
Only the disposal proceeds from a “qualifying business disposal” can get the benefit of ER. The following are qualifying business disposals:
- a material disposal of business assets
- a disposal associated with a relevant material disposal, and
- a disposal of trust business assets
What is a material disposal of business assets?
This is probably the main type of disposal that can qualify for ER, and it takes three potential forms:
- a disposal of the whole or part of a business where the individual has owned the business (or been a member of a partnership that operates the business) for the year leading up to the date of disposal
- a disposal of assets in use for the purposes of the business where the business ceases to be carried on – if the disposal is made within three years and the individual owned the business (or was a member of a partnership operating the business) for the year preceding the cessation, and
- a disposal of shares or securities of a company – where either Condition A or Condition B below is met:
Condition A – that throughout the year preceding the disposal:
- the individual owns at least 5% of both the ordinary share capital and the voting rights in the company (such ownership makes this the “personal company” of the individual)
- the company is a trading company or holding company of a trading group, and
- the individual is an officer or employee of the company (or of one or more companies that are members of the trading group).
Condition B – where the company has, within the three years preceding the disposal of the shares, ceased to be either a trading company or a member of a trading group, ER will still be available if Condition A had been satisfied throughout the year preceding the cessation.
For either a company or a group to be considered as “trading”, it must not carry on any non-trading activities to any substantial extent. The accepted meaning of this is that if the non-trading activities of the company or group comprise more than 20% of overall activity, it will not be “trading” for the purposes of ER.
What is an Associated Disposal?
An associated disposal can occur where an individual sells an asset that is owned by him or her personally, but used for the purposes of a business carried on by the “personal company” of the individual (see above) or by a partnership of which he/she is a member.
For the asset sale to be an Associated Disposal:
- the individual must also make a material disposal of business assets that comprises the disposal of the whole or part of their interest in either the partnership or the shares or securities in the company (as appropriate)
- the asset must be disposed of as part of the individual’s withdrawal from the relevant business, and
- the asset must have been used for the purposes of the relevant business for the period of one year prior to the disposal
The asset sale and the material disposal must be linked with a withdrawal from the relevant business, but there is no specified time limit within which these disposals must occur for ER to be available. HMRC do say, however, that they would not expect to see a significant interval between the share/partnership sale and the asset sale if an ER claim for an associated disposal is to be successful.
Note also that the amount of the capital gain that qualifies for ER in respect of an associated disposal can be restricted. For instance, if there has been any non-business use of the asset during its ownership, or if the seller was involved in the business for only part of the relevant time, or if (after 6th April 2008) rent was paid by the business for the use of the asset then the resulting gain will not all be attributed to the disposal of a business asset. Any part of the gain that is attributed to non-business use will be subject to CGT at the normal rates.
What is a disposal of trust business assets?
The Trustees of certain trusts can also benefit from ER on the sale of qualifying assets where particular conditions are met. The broad purpose of this rule is to give ER to the Trustee in circumstances where the beneficiary of the Trust would have qualified for relief had he or she sold the assets directly. If you are considering the use of a Trust to hold business assets, you should seek appropriate specialist advice first.
How is Entrepreneurs’ Relief given?
Where a claim for ER is made, all the losses which are made in any given tax year on the disposal of qualifying business assets are first netted off against any gains arising in that year and which qualify for ER. Any resulting gain– up to a lifetime limit of £10 million – is then charged to tax at 10%. Individuals can claim ER for gains made on multiple occasions up to the cumulative total of £10 million after which they will pay CGT at the standard rates of either 18% or 28% on any further gains. Disposals before 6th April 2008 do not affect the lifetime limit. Any other allowable losses (either in the same year of assessment or brought forward) and the annual exemption (currently £10,600) are deducted before calculating the tax at 10%.
Each individual is entitled to their own lifetime limit of £10 million. Where there is a qualifying disposal of trust business assets the trustees can make use of the individual beneficiaries’ limits. The beneficiary’s £10 million limit will be reduced where relief is given to the trustee.
A claim for Entrepreneurs’ Relief must be made on or before the first anniversary of 31st January following the tax year in which the disposal is made.
How does ER apply on share exchanges?
Where one company is sold to another, it is common for part of the consideration to take the form of shares or securities issued by the buyer. The precise capital gains treatment of an exchange of securities will depend on whether the consideration takes the form of Qualifying Corporate Bonds (QCBs), non-Qualifying Corporate Bonds (non-QCBs) or shares.
In general however, the typical position is that – subject to conditions – there will be no charge to CGT at the time of the exchange, whether loan notes or shares are given in consideration. Where QCB’s are received, the gain accruing up to the exchange is “frozen” and is brought into the charge to tax at the time the QCB’s are sold. Where the consideration is non-QCB’s or shares, the old and new securities are treated as the same asset for CGT purposes, and are subject to CGT on their subsequent disposal.
In either case however, it is unlikely that the ER ownership conditions will be met at the time of the subsequent sale of the securities. So, it is possible to elect for the capital gain that has accrued on the shares up to the time of the exchange to be brought into the charge to tax – with the benefit of ER – at the time of the exchange. Such an election has to be made before the first anniversary of the 31st January following the tax year in which the disposal takes place.
Note that different rules operated for QCB exchanges made between 6th April 2008 and 22nd June 2010, with transitional rules applying for QCB’s received before that time. So, if you currently hold QCB’s obtained in the course of a share sale you should seek specialist tax advice on them.
Are there any other planning points to be aware of?
An ER claim could save a great deal of tax on the disposal of a business, and so it makes a great deal of sense to protect a potential ER claim on a future sale.
Note firstly that ER is available to an individual who sells qualifying shares in his or her personal company, but it will not be available to the company itself. So, where a business is run through a corporate vehicle, the sale of the business by that corporate vehicle will not get the benefit of ER. An exit by way of share sale is likely to be the most efficient exit for this reason.
The ER ownership conditions for share sales mean that the seller will need to have the minimum interest of 5% and be an officer or employee of the company for at least a year prior to the disposal. It is not necessary for the seller to be employed by the company on a full time basis, but shareholdings will not be aggregated between family members. This means that shares held by an individual’s spouse (for instance) will not count toward that individual’s 5% holding.
It will also be important to monitor the company’s activities regularly to ensure that non-trading activity does not approach the 20% limit if a share sale might occur. HMRC say they approach this 20% test by looking at a balance of indicators: the history of the company; the types of income it receives and expenditure it incurs; its asset base and the time spent by officers and employees in trading versus non-trading activity. Failing the 20% test on any one of these indicators should not cause the company to be regarded as non-trading if every other indicator points toward trading, but these indicators should be kept under review. If, for instance, the company were to build up higher cash reserves than normal (which, depending on circumstances, could be regarded as non-trade assets) then it may be prudent to consider either utilizing these in the trade or extracting them from the company to protect a potential ER claim in the future.
Finally, in negotiating the terms of an exit by share sale, the availability of ER will likely be a critical factor in structuring the consideration – particularly where any deferred consideration, or any non-cash consideration, is proposed. If part of the consideration for the sale is to be an exchange of shares or debt securities in the buyer company, the seller should give serious consideration to triggering an immediate tax charge to benefit from ER, rather than deferring a gain which is likely to suffer greater tax in future. Similarly, where consideration itself is deferred it will not be possible to claim ER on the deferred element unless this is properly structured.
Tax can be a complicated area for any business, and appropriate specialist tax advice should help to ensure that all available tax reliefs, including ER, are fully utilised.
Graham Brough is a corporate tax solicitor at Rosetta tax. Graham has many years of experience providing tax advice and planning on all UK and many international tax issues.