Entrepreneurship is seen as a key driver of our economy and creating a supportive ecosystem for entrepreneurs to scale up their businesses is a central tenet of government policy. It is reflected in HM Treasury’s recent publication on patient capital: Financing Growth in innovative firms; consultation response
Key to those objectives is a favourable capital raising environment and, separately, a tax regime which does not act as a disincentive to businesses raising capital potentially in multiple rounds and often involving the founders and other senior management shareholders taking substantial dilution.
The overall policy aim is to encourage long-term and sustained investment in entrepreneurial start-ups so that we create and nurture the Apples of tomorrow, thereby avoiding premature disposals to the Apples of today.
Since 2008, the central fiscal plank which supports the business entrepreneur has been Entrepreneurs’ Relief (ER). Tucked away in the Autumn Budget papers was a welcome government announcement that it plans to consult in early 2018 on a proposal to relax the ER rules to remove a provision which has in many cases caused an otherwise qualifying individual to lose ER as a result of dilution following a capital raise, which is at odds with the stated policy objectives.
In order to understand the issue properly, we need to rehearse the core principles around accessing the relief.
ER – The Background
ER currently offers individuals a lifetime allowance of up to £10 million of capital gains taxed at the reduced rate of 10%, provided certain conditions are met. When compared to the standard 20% rate of capital gains tax (CGT), ER therefore enables qualifying individuals to save up to £1 million of CGT. Given the substantial savings to be made, the preservation of the relief is often very high up in the hierarchy of considerations for business owners.
For an individual to qualify for ER, the following conditions must be met throughout the period of 12 months ending with the date of disposal of shares:
- the company must be the individual’s “personal company” (i.e. a company in which the individual holds at least 5% of the ordinary share capital and exercises at least 5% of the voting rights) (the “5% test”);
- the individual must be an officer or employee of the company (or a company in the same trading group); and
- the company must be a trading company or the holding company of a trading group.
Special, and helpful, rules apply to shares derived from the exercise of EMI share options. These rules remove the 5% test for these shares and the 12 month holding period includes the period during which the share option (and not just the shares) was held.
For qualifying individual shareholders who have non-EMI derived shares, the 5% test is a key consideration, and one which is often compromised by dilution arising from subsequent funding rounds.
For example, when an individual first becomes a shareholder he or she may well hold well in excess of 5% of the ordinary share capital, but due to subsequent funding rounds that holding may well dip below 5%, such that on a full exit the shareholder is precluded from accessing ER.
The potential loss of ER (either for the founder(s) or other important members of the senior management team) arising from a funding round may therefore become a material factor in the decision as to whether to scale up (through a dilutive funding round) or to exit (through a trade sale, for example).
Put simply, the choice can be between, on the one hand, tax inefficient proceeds from a potential, but not guaranteed, future disposal and, on the other hand, tax efficient, but potentially substantially reduced, proceeds from a certain disposal now.
For founders who hold more than 5%, even after multiple funding rounds, this is not of direct concern, but it can lead to a challenging “atmosphere” between any founder (who retains the tax advantages) and other senior members of management whose equity is rendered proportionately less valuable on an after tax basis by a funding round which sees their respective stakes sink below 5%.
The Government’s Proposed Solution
The specifics of the proposed consultation are very sparse on detail, however we understand that the Government has in mind a mechanism that allows an affected individual to elect to claim ER on the part of their gain that arose before their shareholding was diluted below 5%, even if they dispose of their shares after their holding ceased to qualify for ER.
The devil will, as ever, be in the detail and the technical aspects of the relief will be informed by the consultation exercise. However, the Government has stated that it anticipates any measures being implemented from April 2019. Whether the measure will apply to other events that result in dilution (such as an issue of new shares following an exercise of share options) remains to be seen.
Whilst the trend to sell up rather than scale up may be as much to do with an uncertain political and economic backdrop, as it is to do with a paucity of funding options, the Government’s focus on creating a supportive funding (and associated fiscal) environment is to be welcomed and, in that regard, the proposed change to the ER qualifying rules in the Autumn Budget is a small, but nonetheless, positive step forward.
Assuming implementation in full of the proposals, ER will be the most generous it has ever been, however, there remain plenty of traps for the unwary along the way and professional advice should always be sought in good time before any changes are implemented which could jeopardise access to, or the continuing availability of, the relief.
This article also appeared on the Daily Business news website www.dailybusinessgroup.co.uk.