Satwaki Chanda discusses the proposed ‘dilution’ rules, which are intended to preserve entrepreneurs’ relief for business owners seeking to raise new capital.
Entrepreneurs' relief is a capital gains tax relief designed to encourage individuals to set up and grow their own businesses. If the relevant conditions are satisfied, any capital gains arising on the sale of the business are taxed at a rate of 10%.
For a business owner who operates through a company, the relief is available on a disposal of his holding provided that the following conditions are satisfied (TCGA 1992, ss 169I(6)(a), 169S(3)):
- The company must be a trading company or holding company of a trading group;
- The business owner must be an employee or officer of the company or of another company in the same group;
- He must also hold at least 5% of the company’s ordinary share capital, together with the associated voting rights (the ‘personal company’ test).
All these conditions must be satisfied throughout a continuous one-year period up to the date of the disposal.
Raising capital – how entrepreneurs’ relief can be lost
One of the ways in which the relief can be lost is when the company issues new equity in order to raise funds from outside investors. This will inevitably lead to a dilution in the stakes of existing shareholders unless they also take part in the fundraising.
If a person’s stake falls below 5%, the company ceases to be his personal company and entrepreneur’s relief will no longer be available on a subsequent sale.
This is where the new dilution rules will come into play.
What are the dilution rules about?
The proposed dilution rules are set to come into force from 6 April 2019 upon enactment of Finance Act 2019. These rules were first published in July’s draft Finance Bill, and will apply in the following circumstances:
- The fundraising is for commercial reasons and does not form part of any tax avoidance arrangements;
- The company issues new shares for cash only;
- As a consequence of the share issue, an existing individual shareholder’s stake falls below the 5% threshold;
- The individual’s shares are standing at a gain that would have qualified for entrepreneurs’ relief had he sold his interest in the company immediately prior to the fundraising.
If these conditions are satisfied, the individual may elect to be treated as if he had sold and reacquired his shares immediately before the date that his stake was diluted. The price for this notional sale is set at market value. This will enable him to crystallise any gains already accrued, in order to benefit from the 10% rate.
Entrepreneurs’ relief is no longer available when the individual comes to sell his shares ‘for real’, but due to the market value rebasing, only the subsequent growth in value is taxed.
How does the individual pay the tax if there’s no money to pay it?
A major drawback to making an election is that the notional sale does not generate any liquid funds to pay for the tax liability.
However, by making a second election, it will be possible to defer the tax until the shares are subsequently disposed of for a cash sum.
Practical Tip:
It should not be assumed that the new rules provide a complete solution to the risk of losing entrepreneurs’ relief when a company raises new capital. The 10% rate only applies to the pre-dilution gain – this needs to be significant in order for there to be any benefit to making an election.
Business owners should, therefore, take no chances. The company’s share register should be reviewed regularly in order to identify ‘at-risk’ shareholders, so that they may consider whether any remedial steps can be taken.
