Iain Rankin discusses how the principal shareholders of a family-owned company might plan for a comfortable retirement by utilising their entitlement to entrepreneurs’ relief.
The potential to work in and eventually take over a family business is a very attractive proposition to young entrepreneurs. An existing family-owned company is often able to benefit from the skills offered by a new generation and their ability to potentially support diversification into profitable new areas.
Background
Entrepreneurs’ relief (ER) is a capital gains tax (CGT) relief designed to foster entrepreneurship and encourage business investment. However, like many other tax reliefs there are tax traps seemingly designed to catch out the unwary small business owner.
ER currently enables qualifying shareholders to pay just 10% tax on any capital gains realised on the disposal of company shares up to a lifetime maximum limit of £10 million. Thereafter, gains are taxed at the full rate of CGT, which is currently 28% (or 18% if the gains plus all your other income fall within your basic rate band).
Whilst successive governments have been broadly supportive of ER, recent criticism by the Office of Tax Simplification, plus the need to look for additional tax revenues, suggests that restrictions to ER might be on the horizon.
The importance of planning
Any business exit strategy should be carefully planned, ideally from day one, to ensure that the outcome is tax efficient. In the case of a disposal between family members, whilst it may not be a ‘sale’ in the conventional sense, there remains the potential for older family members to receive market rate consideration for their shares by extracting funds built up within the company. A retirement of this kind also provides the opportunity to benefit from ER.
We shall look at an example presenting a common scenario facing small business owners we will highlight how shareholders are able to pass their company to younger family members whilst benefitting from funds built up within the company and qualifying from ER.
Retiring shareholders
Mr and Mrs Brown are the sole shareholders of their accountancy firm (Brown Books) offering traditional bookkeeping and accountancy services to local businesses. The business was incorporated as a limited company in 2010 and has been broadly profitable for the last ten years. Their daughter, Ms Brown, recently qualified as a tax adviser and has used her skills to launch a separate cloud accounting firm, which operates online as a complementary sister business to Brown Books.
The new company is trading profitably by offering additional services to clients who are seeking more than traditional accounting services. Long-term growth prospects for the second business are greater than those of the other business, although it continues to be profitable. Mr and Mrs Brown are hoping to retire and want to find a way of transferring their shares to their daughter whilst receiving value for those shares. Unfortunately, Ms Brown has no funds to pay market value for the shares.
Is it feasible, in a situation such as Mr and Mrs Brown’s, for them to exit their company and receive value from it, whilst transferring ownership to their daughter and utilising their entitlement to ER? The short answer is yes - there are a number of ways in which the transfer can be effected whilst enabling Mr and Mrs Brown to be paid for the value of their shares using company funds. This could ensure they qualify for ER and it can also be planned to ensure the resulting group is structured tax-efficiently for Ms Brown. However, there are a number of potential pitfalls that must be avoided.
Check the relief conditions
In order to qualify for ER, Mr and Mrs Brown must each own at least 5% of the shares and voting rights in their company, and they must have held their shares for a minimum period of 24 months. The transaction is treated for CGT purposes as a disposal at market value, since the disposal is between connected parties.
For family companies, often there is more than one class of ordinary share capital, with the decision of which share class will receive a dividend, and how much, at the discretion of directors. Unless the company’s Articles give a particular class of shares a right to dividends, nothing prevents the directors from distributing the profits as they wish. Consequently, no share class may be said to carry an entitlement over the distributable profits, and all share classes will, therefore, potentially fail the relevant ER test.
Recent changes (introduced in FA 2019) require Mr and Mrs Brown to have at least a 5% entitlement to:
- profits available for distribution to equity holders; and
- assets available for distribution to equity holders in a winding up.
Suppose that Mr Brown owns 50 ‘A’ ordinary shares and Mrs Brown owns 50 ‘B’ ordinary shares; their shares rank equally in voting power and assets in a winding up. There are no other shareholders. The company’s Articles permit dividends to be voted independently between the two classes of share, but there is no minimum entitlement. In this scenario, neither shareholder will qualify for ER, as they have no absolute right to receive at least 5% of the dividends. This is the case even if, historically, actual dividends have been paid equally between them.
Surplus cash
As is the case with many businesses, a good deal of surplus cash has built up in Brown Books through many years of trading, and some of this cash has been placed in a bond. The trade remains in a healthy state with good profits and a healthy (if modest) turnover. The surplus cash is a significant asset on the balance sheet and it, and the bond, are generating investment income.
Given the significant cash balance:
- be careful that funds held in bonds do not form a significant investment activity (see Potter v Revenue and Customs [2019] UKFTT 554 (TC));
- ensure where possible that retained cash is not significantly more than would be expected for day-to-day requirements.
In most cases, HMRC will accept that a company with surplus accumulated cash is a trading company and its shares will qualify for ER.
The key point in planning of this nature is the importance of taking tax advice early in the process.
There are other factors to consider when planning a company disposal of this nature; one additional element is whether the purchase price can be paid in one lump sum or whether there will need to be an element of deferred consideration. The inclusion of a staged payment agreement in a share sale also has potential tax implications for the tax payable and the ER available. Expert tax advice should be sought in this case.
The relevant clearances should be obtained in advance from HMRC to approve the purchase as a commercial, capital transaction. HMRC regularly enquire into ER claims so Mr and Mrs Brown must retain the appropriate information to prove all the qualifying tests are satisfied, and also retain that HMRC clearance letter. This can make the difference between extracting value and qualifying for ER and paying 10% tax on the transaction or paying tax at a much higher rate.
In addition, Mr and Mrs Brown should, if the companies were part of a group:
- Assess whether a holding company could provide asset protection from the trading company;
- Consider whether a demerger would be advisable.
Practical tip
Any family business owners hoping to retire now or in the immediate future should consider measures to ‘bank’ the ER now, ahead of any future changes. The ER rules are widely drafted and subjective. It is alarmingly easy to fall foul of the rules (for example) where there are multiple share classes with different nominal values and/or rights.
