In the third of his four-part article, Peter Rayney outlines further Finance Act 2019 changes to the entrepreneurs’ relief rules.
This month, we turn to the welcome assistance for shareholders whose holdings are adversely diluted as a result of a commercial share issue.
In most of these cases, a substantial share issue is made to a venture capital provider or one or more ‘external’ investors. As a result of these large share issues, a number of main or ‘senior’ individual shareholders will typically fall below one or more of the relevant 5% entrepreneurs’ relief (ER) ownership/voting tests, thus preventing them from claiming ER on a future sale.
In some cases, it might be possible to rectify this by arranging for a sufficiently large bonus issue to be made out of the company’s existing reserves. However, this may not always be feasible, or may not be acceptable to the private equity fund/investor.
Election to protect ER
For share issues taking place after 5 April 2019, shareholders who lose their qualifying ER status as a result of being diluted on a commercial share issue can elect to protect their ER entitlement based on the value of their holding at the date of the share issue. These new rules seek to remove any disincentive for companies needing to seek fresh equity funding or investment.
As demonstrated above, shareholders could lose their eligibility to claim ER by failing one or more of the various ownership or voting tests. A new TCGA 1992, s 169SC enables shareholders who would otherwise be unfavourably diluted to elect to retain their ER up to the date of the share issue.
Shareholders can elect to ‘capture’ their ER-eligible gain immediately before the commercial share issue is made. By making this election, shareholders are deemed to sell and immediately reacquire their shareholding immediately before the relevant share issue is made. Consequently, the resultant gain will attract ER at that point.
It is important to stress that the ‘minority discounts’ that typically apply for fiscal share valuation purposes are ‘switched off’ here. The market value used for the deemed disposal effectively represents the shareholder’s pro-rata proportion of the total company valuation. In the vast majority of equity fund-raising exercises, a formal company valuation would normally have been prepared to calculate the terms on which the new shares are being issued to the venture capital provider.
To obtain this beneficial ER treatment, the ‘equity funding’ share issue must be wholly for cash and be made for commercial reasons and not as part of arrangements mainly driven by tax avoidance. Broadly, the election must be made by 12 months after the 31 January following the tax year in which the relevant share issue is made.
Further election to defer tax charge
Clearly, paying tax (albeit it at the 10% ER rate of capital gains tax) on a deemed disposal would normally be undesirable since this does not give rise to any cash realisation for the shareholders.
Fortunately, a new TCGA 1992, s 169SD provides a supplementary election that enables shareholders to defer taxing their qualifying ER gain until a subsequent actual disposal of the relevant shares.
Next month, we will look at a fully worked example to illustrate the mechanics of these ‘new’ ER elections.
Practical Tip:
Companies planning ‘substantial’ commercial share issues must be vigilant to the potential impact on shareholders’ ER entitlements. Those shareholders who are likely to be unfavorably diluted should be notified to ensure shareholders are in a position to consider making timely ER elections.
