At the time, the government was intent on imposing an 18% flat rate on all capital gains, whether business or non-business assets.
However, after a period of lobbying from business, the government backtracked (or actually listened?) on their original decision.
Quite rightly, business pointed out that the new 18% rate was an 80% increase over the old 10% rate that applied to business assets that had been held for a certain number of years.
Entrepreneurs’ Relief was introduced with a 10% flat rate on all qualifying business gains up to £1m. Following the March 2010 budget, the lifetime allowance doubled to £2m (and increased to £5m by George Osborne in the Emergency Budget on June 22, 2010 – the exact implementation date is yet to be announced).
The relief can be claimed any number of times up to the limit and a business disposal can apply to the whole business or only part of it.
In order to qualify for Entrepreneurs’ Relief, you must satisfy certain criteria:
the business must meet the definition of a trading company, that is it must not undertake “to a substantial extent activities other than trading activities”
this is referred to as the “20%” test; 20% is a measure of the maximum non-trading activities that can be ignored for the purposes of Entrepreneurs’ Relief
the shareholding must be in the individual’s “personal company”. In other words, you must hold at least 5% of the ordinary share capital (which will entitle you to 5% of the voting rights)
you must be an officer or employee of the company
One possible trap that could lead to an individual losing the relief is if they hold too much cash in the company.
For example, let’s say that at the time of winding up/selling the business the value of the company’s net assets is £3m. At the time the company ceases to trade, it is holding £750,000. There is one owner holding 100% of the ordinary shares carrying all the voting rights.
Only £120,000 of this amount was earmarked for business purposes. The surplus £630,000 in cash amounts to 21% of the company’s net assets, assuming net assets have remained broadly the same.
As this example fails the “20% test”, it is likely that the conditions have not been met to qualify for the relief.
The Capital Gains calculation would be (assuming the shares were originally acquired for a nominal amount):
2010/11 gains – £3m
Annual Exemption – £10,100
Taxable Gain – £2,989,900
CGT – £538,182 (18%)
Effective Tax Rate – 17.94%
Net Proceeds – £2,461,818
One Possible Solution
One idea is for the company to contribute to a pension scheme on behalf of the 100% shareholder (the owner).
For example, if the company contributes £100,000 to a pension scheme more than a year before the cessation of trade, the situation looks like:
as long as it receives 28% corporation tax relief on the pension contribution, its net assets will reduce by £72,000 (£100,000 x 28% = £28,000. £100,000 – £28,000 = £72,000)
corporation tax relief is available provided the contributions are made “wholly and exclusively” for the purposes of the business
the effect of the pension contribution is that the company’s net assets will reduce by £72,000, to £2,928,000
the result is that the company’s level of surplus cash would reduce to £558,000 (£630,000 – £72,000), which is below 20% of its net assets (£558,000 / £2,928,000 x 100% = 19.06%)
as long as this remains the case for at least one year before the date the company ceases trading, Entrepreneurs’ Relief will be available
Let’s have a look at the calculation now:
2010/11 gains – £2,928,000
Entrepreneurs’ Relief (4/9 x £2,928,000) – £1,301,333
Gain after relief – £1,626,667
Annual Exemption – £10,100
Taxable Gain – £1,616,657
CGT – £290,982 (18%)
Effective Tax Rate – 9.94%
Net Proceeds – £2,637,018
For this example, I have assumed that the business owner’s relevant income is below £130,000 for the current and previous two tax years. This is to ensure the company is not restricted by the amount of pension it can make for the owner because of the temporary anti-forestalling measures that apply in respect of contributions to pension schemes for high earners.
Entrepreneurs’ Relief is a valuable benefit that could save you a sizeable amount of tax, providing that you qualify. The pension contribution option may be worth considering, however make sure you speak to your professional advisers before taking any action.
If you are within a few years of contemplating the sale of your business, speak to your accountant now to ensure that your affairs are structured in such a way that you are likely to qualify in full for Entrepreneurs’ Relief.