RSM’s Jo Gibbons, corporate tax partner and Briony Courtiour, personal tax manager explore why the answer to this frequently asked question is not as straight forward as it first appears.
For many business owners the sale of your company is likely to be a once in a lifetime event. Unsurprisingly it is easy to fall in to the trap of assuming that tax will automatically be paid at 10% on the gains realised.
Capital gains tax and entrepreneurs’ relief
Capital gains tax (CGT) is payable at a rate of 10% on a disposal of shares provided the company being sold and the individual shareholder meets the conditions for a relief known as entrepreneurs’ relief (ER). ER is available on the first £10 million of qualifying gains realised during an individual’s lifetime. CGT is payable on gains above the lifetime limit at 20%, as is CGT for gains that do not qualify for ER (for higher rate and additional rate tax payers).
To qualify for ER the following criteria need to be met for a period of 12 months prior to a sale:
- The company must be:
- a trading company, or
- a holding company of a trading group.
- The shareholder must:
- be an officer (essentially a director or company secretary) or employee of the company or group company; and
- hold 5% of the ordinary share capital and voting rights in the company.
On the face of it, this all looks very straight forward. However, there are several areas that you should review and if appropriate, act on. Failing to do so at least 12 months prior to a sale could prove to be a costly mistake.
Is your company a trading company?
HM Revenue & Customs (HMRC) consider that a company is trading if it’s non-trading activities are ‘not substantial’. For this purpose, they broadly mean not more than 20 per cent of the following should relate to non-trading activities:
- assets base;
- expenses; and
- time spent by employees and management.
Recent cases suggest that the test needs to be applied ‘in the round’ and greater weight will be applied to activities, turnover and profitability rather than capital employed in each activity.
One of the largest potential non-trading assets held by otherwise trading companies tends to be cash generated from trading activities. Where this cash is not actively managed, for example, simply placed on short term deposit HMRC will not generally treat it as a non-trading asset. Any cash clearly surplus to the current or future needs of the business should be extracted to avoid a potential loss of ER.
If the company holds other investment assets such as rental properties, investment portfolios, or non-trading subsidiaries, these assets could be demerged from the main group to protect the company or groups trading status.
Does your shareholding qualify?
We have seen cases where shareholders thought they did hold the requisite 5% of the shares in a company to qualify for ER. However, they did not qualify because the nominal value of their shares had been swamped by preference shares, or the rights attaching to their shares have been restricted in some way, for example, not being able to vote on appointment of directors. Similarly, we have seen cases where family members hold shares, but they have not had a role in the business and so have not been able to claim ER.
Planning for a future sale?
If you are thinking of selling your business in the short to medium-term future, we would recommend you take the following actions:
- check the company’s articles of association to confirm share rights and nominal value of all shares in issue;
- review the impact of a future exercise of any share options as these will dilute the existing shareholdings; and
- check employment or directorship status of shareholders and for family shareholders.
ER is a valuable relief, so reviewing the above at least 18-24 months prior to a sale should give sufficient time to rectify any problems and avoid nasty surprises at a time when you are likely to be busy negotiating the sale itself.