ER is a very important relief to consider and companies will need to make sure that, as far as possible, the conditions for the relief are considered in good time so that the ability to claim the relief is not jeopardised simply because the company or the relevant employee negligently fails to consider it in advance resulting in any of them failing to ultimately comply with any of the relevant conditions for the relief.
If any of the conditions for the relief are not complied with by both the company and the individual then the relief will not be available and the individual will have to pay CGT on any gain realised from the sale of the shares in the company at the current rate (or the prevailing rate at the relevant time) of 20% rather than the reduced rate of 10% after a successful claim is made for ER.
What is ER?
ER is a relief that reduces the rate of capital gains tax (CGT) payable by individuals on a disposal of qualifying business assets.
Capital gains on disposal of shares are now taxed at 10% (basic rate taxpayers) and 20% (higher rate taxpayers). If ER applies, capital gains tax is reduced to 10% in respect of the amount of any qualifying capital gains not exceeding £10 million. The current lifetime limit of £10 million applies to disposals which have occurred in the period from 6 April 2011.
The relief was introduced in 2008 with a lifetime limit of £1 million. The lifetime limit was then doubled to £2 million with effect from 6 April 2010 and then increased again to £5 million for disposals occurring on or after 23 June 2010. Any claim in previous periods under the previous lifetime limits counts towards the current lifetime limit of £10 million.
Any gain that exceeds that amount will be subject to CGT at the full rate that applies to that gain. For example, if shares are sold for £20 million and the gain on that disposal is £18 million, then, subject to other reliefs and allowances that may apply to that disposal, the relevant individual may claim ER in respect of the first £10 million at the rate of 10% and the balance will be subject to CGT at the full rate of 20%. In that case, the individual has exhausted the lifetime limit of £10 million so any future disposal of a qualifying business asset will not qualify for the relief. Any amount not claimed up to the lifetime limit of £10 million can be claimed on any future disposal of qualifying business assets.
The relief is not automatic and must be claimed on or before the first anniversary of the 31 January after the end of the tax year of disposal. For example, if a disposal of shares occurs in the tax year 2018/2019, a claim for ER can be made by 31 January 2021. The relief is claimed by the individual by completing his or her self-assessment tax return for the relevant period.
The term ‘lifetime’ could be confusing. ER replaced the old taper relief. It is not uncommon for various reliefs and allowances to be withdrawn, replaced or generally amended. It is important to bear in mind that, whilst it is termed as a lifetime limit, it may no longer be available after the next budget or in the next few years. If one is entitled to claim the relief then one ought to claim it and don’t leave it for a future disposal on the basis that it is there for life as it may no longer be available.
What is a qualifying capital gain?
Not all capital gains qualify for ER. As far as shares are concerned, the relevant individual disposing of shares in the company needs to ensure that the gain on disposal is, indeed, a capital gain and is not reclassified by HMRC as an income of that individual due to the application of any relevant anti-avoidance provision and therefore subject to income tax at the relevant income tax rates which, at current rates, are higher than the CGT rates.
Otherwise, before the individual can claim ER in respect of disposal of shares in the company, all of the following conditions must be satisfied throughout the period of 24 months (with effect from 6 April 2019 the period has been extended to 24 months. The period was 12 months before that date) ending with the date of disposal:
The company is a trading company or the holding company of a trading group;
The individual holds at least 5% of the issued share capital in the company allowing him or her to exercise at least 5% of the voting rights in that company. With effect from 29 October 2018, the individual must, in addition to having a 5% voting rights, be beneficially entitled to 5% of any distributable profits available to shareholders on a winding up of the company or on a sale of that company;
The individual is an employee or officer of the company (whether full or part time) or any other company that is a member of a trading group.
Important points to note in connection with the above conditions:
The company must be a trading company or the holding company of a trading group. A group is defined to include the holding company and its 51% subsidiaries. 51% means that more than half of the ordinary share capital of the subsidiary is directly or indirectly owned by another company.
Whether or not the relevant company or group is a trading company, for the purpose of ER, may not be so easy to ascertain. On the face of it, one may assume that the company is a trading company on the basis that it is involved in what is generally understood to be a trade. However, legislation defines a trading company as a company that carries on trading activities and does not carry on other non-trading activities to a substantial extent. The same applies to a trading group so that, looking at the activities of the group as a whole, the non-trading activities of the group must not be substantial.
What is the meaning of substantial?
In order to clarify the position so that it is not open to too many arguments about what is substantial, HMRC have confirmed their interpretation of the phrase ‘substantial extent’ to mean more than 20%. So effectively, if a trading company’s non-trading activities amount to more than 20%, that company, whilst a trading company in the eyes of its founders and shareholders, may not be classified as a trading company for the purpose of ER.
How can we measure non-trading activities?
This is the point where it potentially gets complicated. We know the non-trading activities must not exceed 20% but by reference to what? Are we going to measure those activities by reference to the company’s gross profits? Gross assets value? And the activity itself, how can we assess whether it is a trading activity or a non-trading activity?
In assessing activities of the company, HMRC will be looking at various indicators, each on its own may serve as a clear indication that the company is not a trading company for the purpose of ER. In some cases, more than one indicator may be needed in order to assess the situation. It is ultimately a question of fact which will be based on the circumstances that are relevant to each company.
Some indicators to be considered whereby the company may not be a trading company include:
The company’s income receipts from non-trading activities as opposed to trading activities. If income receipts from non-trading activities exceed that of the company’s trading activities, the company may not be trading;
The company may have a large portfolio of non-trading assets such as office blocks that it keeps as an investment. If that portfolio exceeds the trading asset base of the company, the company may, again, not be a trading company;
If the company’s directors devote a substantial part of their time to managing non-business activities or assets of the company, this, by itself, may be an indication that the company’s non-trading activities are substantial.
However, the above indicators may need to be looked at along with other indicators that may be relevant to the company, the company’s history, the way it conducts its business etc. in which case the final determination may be reversed so that the company is classified as a trading company. Compare the above with the following:
A company has generated large amount of cash and is proposing to expand its trading business. For a while, the cash has been invested until such time that an expansion is possible. The holding of cash will not prevent the company from being classified as a trading company;
A company may require an office building or factory for the purpose of its trading activities. The acquisition of what seems to be an investment asset may not jeopardise the company’s trading status.
The employee or officer of the company:
Provided that all the conditions referred to above are satisfied so that the relevant individual is able to validly claim the relief on any gain arising on disposal of shares or other securities, any additional shares acquired by that individual over the 5% holding will also qualify for the relief even if the additional shares have been held for less than the requisite period. However, if the individual holds less than 5% of the ordinary share capital, the two years period is not relevant and is not counted until the 5% holding is achieved. Therefore, the date of acquisition of any additional shares, which, for the first-time results in the holding of shares being equal to, or exceeding the qualifying 5% holding, will start the clock on the two years period.
Jointly owned shares may result in the relief not applying on disposal of those shares. This is because, for CGT purposes, each of the joint owners is treated as having an equal proportion of the shares and each is entitled to claim the relief separately from the other. Consider the following, not so uncommon situation, whereby a husband and wife together own 6% of the ordinary share capital in the company. For the purpose of the example we can assume that all other conditions are satisfied for the relief to apply. However, as each of them is treated as owning 3% of the ordinary share capital in the company, the relief will not apply. In order to secure the availability of the relief in such circumstances one of the joint owners will need to transfer his or her shares to the other joint owner. Once the relevant conditions have been satisfied in relation to the shares (more particularly, the period of ownership after such transfer) the relief may be available.
With effect from 6 April 2013 but in relation to shares acquired on or after 5 April 2012, and only in relation to the Enterprise Management Incentive Scheme (EMI Scheme):
The 5% requirement is relaxed on disposal of any shares acquired following an exercise of EMI options so, effectively, they can benefit from the relief even if their holding of shares on exercise is less than 5%;
The two years requirement includes the period in which the EMI option was held. So, effectively, if an individual holds an EMI option for a period of, at least, two years and then that individual exercises the options, on, say, a sale of the company to a third party, by acquiring shares in the company for a very short period of time, as that individual will be required to sell the shares along with the other shareholders, the period of holding of the EMI option is aggregated with the holding period of shares. If the combined period of holding, immediately before disposal of the shares, exceeds two years, then the two years requirement will have been satisfied in relation to that individual.
However, given that the favourable treatment is limited to shares acquired under the EMI Scheme and cannot be extended to any other shares in the company, any other shares held by that individual (not under an EMI Scheme) will be subject to all the qualifying conditions for the relief to apply.
The combination of the above conditions for the individual to hold 5% of the ordinary share capital and be employee of the company immediately before disposal means that on a disposal of shares in the company, the individual must be an officer or employee of the company at that time.
It is not unusual, when a dispute arises within a company, for officers or employees who are also shareholders in the company to resign and then commence negotiations for the sale of their shares in the company whether by way of a share buyback by the company directly from the relevant individual, to an employee benefit trust or to another shareholder in the company. In such circumstances, the individual will lose his or her right to claim ER on the basis that the relevant individual is no longer an officer or employee of the company on the date of disposal of the shares. It is therefore important to remain an officer or employee of the company until the shares are sold by that individual.