Entrepreneurs Relief on selling your business
Eight Ways you can lose your Entrepreneurs Relief on selling your business.
Entrepreneur's Relief is often the biggest tax break the government offers. Given that 99% of business are SME's this is worthy of attention if you are disposing of your business.
Capital gains tax entrepreneurs’ relief has been with us since 2008. You need to be aware of its main features, most of which will need to be satisfied in a 12-month run-up to a disposal.
Gains of £10m in an individual’s lifetime can qualify for the 10% rate of capital gains tax rather than the normal 28%. The stakes are high with up to £1.8m of tax (£10m gains at the differential of 18%) at stake. So you need a good adviser to arrange matters carefully and plan in advance.
This article sets out 8 problem areas and how you may resolve them with expert advice.... in good time before a disposal.
KEY ISSUES TO ADDRESS
The criteria for ensuring that a company is trading.
Problems with property: how is it held and what is it used for? The definition of ordinary share capital and voting rights.
Income tax advantages can result in increased capital gains tax.
Ensure that claims are made within time limits - it is a complex area of tax so speak to an an expert advisor like Cloud Accounting NI well in advance
1. Is the company trading?
The question of whether a company is trading has long been a moot point for advisers and for capital gains tax purposes. A trading company is defined as a “company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities”.
It has always been understood that HMRC will regard any activity as not being substantial if it comprises less than 20% of the company’s activities.
It is important to look at the company’s balance sheet and level of assets. Also consider turnover, profit and the number of employees engaged in trading and non-trading activities.
Sometimes it will be abundantly clear that there are non-trading activities where, for example, the company has purchased investment property or quoted shares. In other cases, it will be less easy. For example, when substantial levels of cash have built up from successful trading activities.
It may be easier to justify that this cash surplus is needed for trading operations in the case of a longer established or growing business. The need for the retention of cash for future business use can then be more easily justified.
Fore example Business consultancies where expenses are minimal may fall foul of HMRC. In this case, the shareholder may be well advised to take dividends from the company to reduce the cash balance. Generally indicating that cash is needed for future trading activities in both the directors’ report and directors’ minutes will be helpful.
2. The right type of trusts
Many families have chosen to use discretionary trusts to maintain flexibility and preserve wealth. These trusts will never be entitled to entrepreneurs’ relief. This exclusion also applies to the estates of deceased persons.
However, in this scenario, advisers should be proactive. They may choose to recommend to their clients that they change the status of discretionary trusts to a life interest trust. Perhaps on a revocable basis to maintain flexibility and to maximise the relief.
This matter needs to be treated with some care because there are several other conditions to satisfy. However no immediate tax charges should arise under this scenario.
3. Review that structure!
For historic reasons, a family may have chosen to hold, say, agricultural land through a limited company with a view to perhaps keeping taxation of rents or other farming income at a low level.
Limited companies long term will be paying corporation tax at only 20%. Hence gains on land sales (eg for development) will be taxed initially at a relatively benign rate. Further significant tax charges occur on distribution to shareholders (perhaps by way of dividend).
In that scenario, clients have chosen in some cases to distribute land from the property company by means of a dividend in specie (free of SDLT). This way longer-term growth accrues for the benefit of individual shareholders who, with planning, can claim entrepreneurs’ relief.
4. Furnished holiday lets
Historically, significant tax benefits have arisen from the ownership of furnished holiday lets. Losses incurred can be offset against other income and gains.
There are still other advantages from holding furnished holiday lets, including the claiming of entrepreneurs’ relief.
Possibly, the property owner also uses the holiday let as a second home. In that instance and with appropriate elections, it may also be possible to claim a measure of only or main residence relief . This way the overall tax rate on sale is less than 10%.
5. Avoid charging a rent?
Many business owners will often choose to own the business premises outside the risky trading venture. Quite possibly, they will have borrowed to fund the purchase and need funds to service the mortgage.
It is tempting, therefore, for the business to pay a rent to the property owner. However, to the extent this has been done since 6 April 2008, entrepreneurs’ relief will be reduced.
A review is required in this situation to consider other more tax-effective means of withdrawing funds from the business to pay for the interest.
If there are other properties and no rent is charged, the excess interest on the business premises could, for example, be offset against the other rentals from the proprietor’s property business.
6. The definition of share capital
To claim entrepreneurs’ relief, an individual must have at least 5% of both the ordinary share capital and voting rights. It is important that advisers focus on the definition of “ordinary share capital”. It may include not only shares described as “ordinary” but also embrace participating preference shares.
A careful review may be needed in some cases to ensure that the 5% test is met.
The settled view of HMRC is that they will look at the nominal value of the shares concerned rather than the number of shares in issue.
Share capital for this purpose is defined in TCGA 1992, s 169S(5) as having the same meaning as in ITA 2007, s 989 namely:
“‘Ordinary share capital’, in relation to a company, means all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits.”
The adviser may use this mechanism to the shareholder’s advantage. It may be possible to plan such that, although an individual receives less than 5% of the sale proceeds of a company sale, entrepreneurs’ relief is available because they have 5% or more of the ordinary share capital, as defined, and indeed have 5% or more of the votes.
The 5% test will need to be met right up to the point of disposal. The adviser will need to take care that, say, the exercise of share options on the day of a disposal does not reduce his client below the vital 5%.
7. A spouse’s shareholdings
A key requirement for the 12-month period before a disposal is that the shareholder has at least 5% of the ordinary shares and voting rights and is a director, office holder or paid employee.
There may be a temptation in the family company for the shareholder to transfer shares to a spouse, perhaps with a view to minimising tax on dividend income. It is important in that scenario that the transferee spouse is a director, officeholder or paid employee.
In addition, shareholdings of spouses are not aggregated at all and if, let’s say, the husband earns 4% and the wife 4%, although the combined holding is 8% this is not sufficient for either to claim the relief.
Our view is that it is important that, if the shareholder is an employee rather than an officeholder, the employment is paid to add reality and substance to the arrangement. Unpaid employments are rare, except in the not-for-profit sector.
8. Claim on time
As with most reliefs, entrepreneurs’ relief must be claimed within the statutory time limit of the first anniversary of the 31 January after the tax year in which the qualifying disposal is made.
It is therefore of the utmost importance to provide information in good time otherwise the time limit may be missed.
Ensuring that assets qualify for capital gains tax entrepreneurs’ relief can result in substantial tax savings, but it is a complex area and advance planning with an expert advisor like Cloud Accounting NI is required to ensure that the relief will definitely be available on disposal.
Delaying a consideration of the relevant factors until the asset is about to be sold or gifted may mean that it is too late to ensure that the tax rate is reduced from 18% or 28% to a more attractive 10%.