The popularity of the enterprise investment scheme (EIS) as a vehicle for raising investment finance amongst small companies and the resulting dilution of shareholdings has meant that in some cases, director shareholders have lacked a sufficient shareholding to claim entrepreneurs’ relief (ER) when it comes to a final exit.
To qualify for ER, a shareholder must hold at least 5% of the ordinary share capital in the company amongst other qualifying criteria.
In order to raise EIS (or SEIS) finance, companies will issue new shares to incoming investors. This dilutes the percentage shareholding of other shareholders and in extreme cases may result in founder shareholders holding less than the required 5%. In financial terms, this means that when the shares in the company are eventually sold the resulting capital gain will not qualify for ER and the 10% capital gains tax rate. Instead, CGT will be payable at the higher 20% rate.
This situation may also arise where shareholders are selling a large percentage of their company to outside investors but are retaining a small minority shareholding personally whilst continuing to work for the company.
Benefits of proactive tax planning
The government is currently consulting on a potential solution to this problem, since it wants to encourage both entrepreneurialism and ongoing investment in small companies through EIS and/or SEIS. The proposals would provide shareholders with an opportunity to elect that their shareholding is sold and immediately re-acquired immediately before it is diluted below 5%. This would enable the gains arising to that date to qualify for ER, and the 20% tax rate to apply only to gains made after that date. There would also be the opportunity to elect for the gain on the deemed disposal to be deferred until the shares are actually sold, and funds are available to pay the tax. If the shares have reduced in value when they are actually sold, the loss arising would be able to be offset against the previous gain.
Is it prudent to wait for the outcome?
If these proposals become legislation, that legislation is likely to be effective for any shareholder dilutions that take place on or after April 2019. Therefore, shareholders who are considering whether to offer shares in their company between now and the next Budget in autumn 2018, and who will have their own shareholding diluted below 5% as a result, may, depending on commercial issues, be wise to await the outcome of the consultation.
If you have any questions about these potential changes or wish to discuss any aspect of selling your company, please email Lesley Stalker via las@rjp.co.uk.