Capital Gains Tax – Qualifying For Entrepreneur’s Relief On Sales Of Businesses

No one should assume that Entrepreneur’s Relief will be available on the sale of a business or shares.  There are a number of very important qualifying conditions and in certain circumstances (and certainly without advance planning) it is perfectly possible that these conditions will not be met in a number of cases.

One of these reliefs is “Entrepreneur’s Relief". There have been a number of changes to this relief in recent years.  The Finance Act in June 10 changed the way Entrepreneur’s Relief worked.

For gains made after  23 June 2010 the rate of tax on qualifying disposals is specifically set at 10%, and is available for the first £10m  of qualifying gains claimed during an individual’s lifetime (NB in the case of married couples/civil partners each is entitled to the £10m limit). 

Importantly Entrepreneur’s Relief can be denied in a number of instances and this can be very costly. Hypothetically a client could pay an extra £1.8m in tax if condition are not met -  £10m max x 18% (28%-10%).

Points to watch out for in respect of Entrepreneur’s Relief are:

• Sole traders and partners must have carried on the trading business for at least 12 months prior to the date of sale or up to the date of cessation of trading and the trade itself must have been undertaken in a commercial manner with a view to the realisation of profits.
• Sole traders or partners must sell a trading business or a viable part of such a business capable of operation in its own right to qualify for the relief.  Selling an individual business asset will not qualify unless this happens after the business has actually ceased, and within three years of that cessation.
• Entrepreneur’s Relief will only be available on sales of shares where those are shares in a trading company or the holding company of a trading group.  Any significant assets or activities within the company or group which are of a non-trading nature (for example the holding of an investment property) could cause problems .
• Where a sale of shares is concerned, the company must also be the shareholders “personal” company.  This means that they must have at least 5% of the ordinary share capital of the company, 5% of the voting rights in the company and be an officer or employee of the company and they must satisfy those tests for at least 12 months prior to the disposal of the shares.  This does not mean that all the shares being sold necessarily need to have been owned for 12 months, provided that the 5% test has been satisfied for the 12 month period.  In a family company some shareholders may not be employees or small shareholdings may be held below the 5% requirement.  In these circumstances planning ahead of any sale of a company may be important to try and ensure that these requirements can be met in the crucial 12 month period prior to sale.
• If a gain arises on shares in a trading company/holding company of a trading group because it is wound-up after it has ceased trading, then the personal company conditions will have to be met in the 12 months up to the date that trading ceased and the gain will have to arise within three years of the cessation of trading.

Two other areas require special attention with regard to the availability of Entrepreneur’s Relief. 

Associated Disposals of Personally Owned Property, etc

It is very common for directors of limited companies or members of partnerships to own certain assets (usually a building) in their own name, but make them available for the use of their company or partnership.  Sometimes they charge the company or partnership a rent or they may simply make the assets available rent free. 
 
Entrepreneur’s Relief is only available on a gain made on the sale of such assets (usually land and buildings) where the sale is associated with the disposal of the whole or part of an interest in the partnership, or in the case of a company a sale of shares.  In either case the disposal must also be part of the individual’s withdrawal from the partnership or company.  Restrictions on a just and reasonable basis apply if the asset has not been used for business purposes for the whole period of ownership or has only been used partly for business purposes.  Furthermore the relief is restricted if a rent has been charged from 6 April 2008 for the use of the asset.  In these circumstances no relief is due against the proportion of the gain accruing after 5 April 2008 if a full commercial rent has been paid from that date until the date of the disposal or the date that trading ceased if earlier.  In cases where a full commercial rent has not been charged for some or all of the period post 5 April 2008 a proportionate amount of relief will be due in respect of the post 5 April 2008 period plus appropriate relief for the preceding period. 

Individuals who personally own property in this way and are now charging their partnership or limited company a rent for the use of it, may therefore have to consider whether they should stop doing so in order to protect the availability of Entrepreneur’s Relief on a subsequent sale of the property in the circumstances outlined above. The answer will not always be clear depending upon the likelihood of any future sale of the business in association with a sale of the property and whether the tax saving by obtaining Entrepreneur’s Relief will be sufficient to justify losing the national insurance contribution advantage and income/corporation tax deduction from charging rents on a yearly basis.

There should normally be little or no interval of time between the sale of the partnership interest or shares and the associated sale of personally owned assets given that they should form a single withdrawal from the involvement in the business.  However, HM Revenue have stated that they will accept an interval between these disposals if the asset in question is disposed of within one year of the cessation of a business whether or not a rent has been charged or the property used for other purposes during this twelve month period or within three years whether or not the business has ceased, provided the asset has not been leased or used for any other purpose at any time in the three year period.

Sales of Companies Partly for Loan Notes

It is not uncommon for part of the consideration for the sale of shares in a company to be in the form of loan notes which can be redeemed at some future date.  Normally the capital gains liability on this part of the consideration doesn’t arise until the date of loan note redemption so the question arises as to whether Entrepreneur’s Relief would be available at that point.  This issue is highly technical and involves complex tax legislation. 

Loan notes may sometimes be issued in connection with earn out arrangements on the sale of a company.  The tax treatment of earn outs is especially complex and expert advice should always be sought.

Other Matters

As indicated at the outset, these changes apply to individuals, although Entrepreneur’s Relief may be available in rather limited circumstances to certain trustees.  Companies can never qualify for Entrepreneur’s Relief and any gain realised by a company is subject to corporation tax which is calculated as before.

The conclusion to be drawn from all these changes to the taxation of gains on individuals is that no one should assume that any Entrepreneur’s Relief will be available on the sale of a business or shares.  As clearly demonstrated above, there are a number of very important qualifying conditions and in certain circumstances (and certainly without advance planning) it is perfectly possible that these conditions will not be met in a number of cases.