Won’t get fooled again!

Peter Rayney highlights six potential traps that can lead to claims for business asset disposal relief being rejected on company share sales. 

Business asset disposal relief (BADR) is an important and valuable capital gains tax (CGT) relief. However, the relief conditions are such that BADR can be easily lost. Here is a selection of potential ‘traps’ for the unwary.  

1. Avoid being caught out by adverse shareholder ‘dilution’ 

One of the key BADR conditions on share sales requires the shareholder/owner-manager to hold at least 5% of the ordinary share capital, 5% of the voting rights and 5% of the relevant economic rights (being the personal company conditions in TCGA 1992 s 169S (3)) throughout the relevant 24-month period.  

Owner-managers would never expect to have any difficulties satisfying this three-pronged test. However, there have been many cases where the main shareholders have run into difficulties because they have been diluted by other classes of (often secondary/deferred) ‘ordinary shares’ – good case law examples of this are McQuillan v HMRC [2017] UKUT 34 and Castledine v HMRC [2016] UKFTT 145.  

Unexpected dilution can also arise in a number of other ways; for example, as a result of the exercise of employee share options. 

Example: The dilution problem 

The current issued share capital (showing nominal values) of The Tickling Stick Co Ltd is as follows: 

All three classes of shares constitute ‘ordinary share’ capital for BADR purposes since they all are entitled to dividends (other than at a fixed rate) (TCGA 1992, s 169S(5) and ITA 2007, s 989). 

However, while the founding shareholders have sufficient voting control, they have less than 5% of the ordinary share capital (measured in terms of nominal value). Without corrective action, they would not qualify for BADR on a future sale of the company 

2. Ensure that employment and/or directorship exists throughout the relevant 24-month period 

Shareholders can get into difficulty if insufficient care is exercised with this requirement. When examining BADR claims, it is understood that HMRC always examines to see whether the claimant shareholder holds a PAYE record. While there is no statutory requirement for an employee to be paid for their services, it generally helps to get them off ‘first-base’ if HMRC sees that they have been paid via PAYE.  

It is also recommended that documentary evidence is prepared and retained to evidence the shareholder’s employment. There is no requirement for the employment to be full-time. 

3. The employment and/or director status must remain until the CGT disposal date 

This potential banana skin arises when a director or employee is leaving the company in a hurry.  

A typical scenario is where a director is asked to leave, and the company buys back their shares. Even if all the relevant conditions for a capital-based purchase of own shares are satisfied, they will not be able to make a competent BADR claim where they have resigned before the date the POS is executed. This is because they would not be employed or in office throughout the 24 months ending on the CGT disposal date; see Moore v HMRC [2016] UKFTT 115 for a good example of this point. 

4. A spouse must satisfy the relevant BADR conditions in their own right 

With the recent reduction in BADR capacity to a lifetime gains limit of just £1 million per shareholder, more owner-managers may wish to introduce their spouses as shareholders to increase the overall amount of BADR.  

However, there is a trap. Where this is done shortly before a sale, the recipient spouse will not normally have satisfied the ‘personal company’ requirement throughout the 24 months before the sale.  

In contrast to a number of other CGT provisions, there is ‘no stepping into the shoes’ of the transferor spouse for BADR purposes. This means that the recipient spouse will only qualify for BADR once they have satisfied all the relevant 5% tests in their own right in the 24-month period before the sale. Furthermore, the spouse must also be genuinely employed (which can be on a part-time basis) and/or be a director for that period (see point 2 above).  

On the other hand, if the spouse already holds sufficient shares to satisfy the ‘personal company’ conditions (see point 1 above) and is employed/an officeholder, they may already have a qualifying BADR period.  

5. Don’t forget to make the relevant election to obtain BADR on loan note consideration 

Where the purchaser issues standard (qualifying corporate bond) loan notes as part consideration for the acquisition of the company, the seller’s capital gain on the loan notes is calculated at the time of the share sale, which is then deferred. The CGT relating to the deferred gain subsequently becomes payable as and when the loan note is repaid. Unfortunately, since the purchaser is unlikely to be the seller’s personal company for BADR purposes, the repayments of the loan note held will not qualify for BADR.  

However, assuming the sellers have sufficient BADR capacity, they may wish to make a special election to enjoy BADR on their loan notes. This election (which must be made within 12 months of the first anniversary of the 31 January following the tax year of disposal) effectively taxes the loan note at the date of the share sale, thus enabling the loan note ‘gain’ to qualify for BADR. It is not possible to restrict the election to the BADR element of any gain; it is made on an ‘all or nothing’ basis. The election must be clearly stated on the shareholder’s tax return. 

All too often, we have seen cases where the seller has lost out on a potential BADR/entrepreneurs’ relief claim because the TCGA 1992, s 169R election has been missed or overlooked. Similar issues arise for non-QCB loan notes.   

6. BADR is unlikely to be available on a sale of shares to a connected company 

In the vast majority of cases, this arrangement does not work, as such transactions offend the ‘Transactions in securities’ provisions (in ITA 2007, Pt 13, Ch 1). Following the precedent set by Cleary v CIR [1967] 44 TC 39, HMRC would view this type of transaction as a way of extracting monies from the connected company at a beneficial BADR rate of CGT, which could have been taken as dividends subject to income tax. Broadly, such transactions would be countered by HMRC taxing the relevant ‘capital’ sale proceeds at penal dividend income tax rates. Since the relevant sale proceeds would fall within the charge to income tax, they would not be eligible for BADR. 

Practical tip 

Care should always be taken when structuring transactions around BADR. HMRC will often enquire into BADR claims and attempt to deny relief where the exact conditions of the legislation have not been satisfied.