By way of a quick refresher, entrepreneurs’ relief offers business owners the opportunity to pay 10 per cent tax on the first £10 million of gains instead of paying capital gains tax at the usual rate of 18 per cent or 28 per cent, depending on income levels.
Strict qualifying criteria apply to be eligible for entrepreneurs’ relief and while these can appear straightforward, it is advisable to plan ahead since the conditions have a minimum 12-month qualifying period attached to them.
Last month, we explained the qualifying criteria for entrepreneurs’ relief. This month we look how to ensure your business meets the ‘trading business’ conditions – especially relevant for property businesses; the rules for different share types and assets; and, how employees can benefit from entrepreneurs’ relief too.
1. How to ensure your business meets the ‘trading business’ conditions
This is of particular relevance to property and investment businesses because, for the purposes of this relief, investment activities and ordinary property letting activities (whether commercial or residential) do not qualify as trading activities. However, companies trading as furnished holiday lettings businesses may qualify.
If you have a trading business, which also holds investments, such as property, shares or cash, you should ensure the level of investment does not compromise its trading status.
HMRC specifies that non-trading activities should not comprise more than 20 per cent of total business activities. This is especially relevant for the immediate 12 months prior to a business disposal.
Therefore consider the extent to which your business might be adapted to allow you to qualify for entrepreneurs’ relief on the sale of your shares. Can the business be restructured to separate investment activities from trading activities? Can the investment activities be minimised in the final 12 months of ownership so that they don’t prejudice the extent of the trading activities in that period and hence the availability of the relief?
2. Current qualifying rules for furnished holiday letting businesses
Since 6 April 2011, furnished holiday letting properties must be let and available for letting for longer time periods than previously. The current specified timeframes are: the property must be actually let for 105 days each year (previously 70 days) and it must be available for letting for 210 days each year (previously 140 days).
This will exclude a significant number of properties from the relief for a variety of reasons. If you own a property that no longer qualifies under the furnished holiday letting rules, there may still be aspects of your business or other properties that do qualify for entrepreneurs’ relief provided you take advice and plan ahead for the eventual sale.
Alternatively, you may have a property, which does not qualify and which you are seeking to sell in the future, are you able to let it as a furnished holiday letting for the last 12 months of ownership to enable the gain on disposal to qualify for entrepreneurs’ relief?
3. What are the rules for different share types and assets?
One of the critical conditions to enable a sale of shares to qualify for entrepreneurs’ relief is the 5 per cent ownership rule. This requires exiting shareholders to have owned at least 5 per cent of the company’s share capital and 5 per cent of the voting rights throughout the 12 months prior to the shares being sold.
Problems can arise where directors do not own enough shares, possibly because share options have been issued which dilute their holding to below the 5 per cent threshold, or possibly because they are employees who have acquired their shares under a share option scheme.
If your company has employees or director shareholders owning less than 5 per cent of the share capital, they will not qualify for entrepreneurs’ relief; therefore tax planning should be undertaken at least 12 months’ prior to a sale to consider ways in which this can be rectified. The difference in tax rates between 10 per cent with entrepreneurs’ relief and potentially 28 per cent without, mean this is well worth considering.
The second critical condition is the requirement to be an officer or employee of the company for at least 12 months prior to the sale.
If your company has shareholders who are not officers or employees, and where they own at least 5 per cent of the share capital and voting rights of the company, consideration should be given to appointing them as such to enable them to qualify for the relief.
4. How can employee share-option holders benefit from entrepreneurs’ relief?
This is relevant for companies with an active share option scheme; where a share option scheme exists, it is usual that employees will exercise their options immediately prior to a sale and will pay capital gains tax on the difference between the exercise price and sale proceeds.
In this situation they will not have held the actual shares for the minimum qualifying period of 12 months, and will not therefore qualify for entrepreneurs’ relief even though they may satisfy the qualifying criteria of holding a 5 per cent minimum shareholding and being employees of the company.
This aspect should be considered in connection with all employee share schemes and consideration given to finding ways in which share options can be exercised at least 12 months prior to a sale.
In essence, the entrepreneurs’ relief rules can appear deceptively simple; it can be dangerous to assume that all business assets qualify for the relief and this should be regularly checked. In addition, there are ways in which the relief can be maximised with forward planning.
With the recent increase in the top rate of capital gains tax to 28 per cent, it is a valuable relief and worth arranging your business affairs to ensure it is maximised.
Read more about entrepreneurs’ relief in Part 1 of this article, which discussed ways to maximise the lifetime value of the relief; and the treatment of different business structures, including partnerships and sole traders.