Entrepreneurs' Relief and Growth Shares Introduction This fact sheet deals with the Entrepreneurs' Relief ("ER") on the disposal of shares by individuals. It includes two case studies illustrating how incentive arrangements can be structured using growth shares which qualify for ER. ER also applies to disposals of businesses and assets used in businesses but these are not dealt with here. The rate of capital gains tax is 28% (or 18% for individuals with income and chargeable gains below the higher rate income tax threshold). An individual who qualifies for ER, by contrast, is taxed 10% on chargeable gains up to a lifetime limit of 10 million. ER is therefore a very valuable relief as it enables individuals to save up to 1.8 million of capital gains tax. Conditions For an individual to qualify for ER, throughout the period of one year ending with the date of the disposal, the following conditions must be met: a) The company must be the individual's "personal company" A personal company is a company in which the individual holds at least 5% of the ordinary share capital (when tested by nominal value) and exercises at least 5% of the voting rights by virtue of his or her holding. Ordinary shares are (broadly) all shares in issue other than fixed rate preference shares 1. The test does not relate to economic rights so it is possible to create a class of shares with less than 5% economic rights that still qualify. There is no need for the shares to be paid up so nil paid or partly paid shares can qualify. ER applies to "interests in shares" as well as shares so jointly owned shares can qualify. The legislation requires an apportionment, however, where shares are held jointly so as to treat the holder as the beneficial owner of only so many shares as is "proportionate to the value of the individual's share" for the purposes of the 5% test. If a company has shares under option these are often exercised immediately before an exit by way of a sale. The issue of additional shares immediately prior to completion may cause other holdings to be reduced to below the 5% threshold immediately prior to disposal. The 5% test must be met for one year prior to "the date of" disposal. HMRC have confirmed (at ICAEW Tax Faculty Guidance Note, Example A7) that they do not consider the test to be failed in these circumstances. b) The individual must be an officer or employee of the company (or a company in the same trading group) There is no minimum number of hours that an employee is required to work to qualify. An office is any position which has an existence independent of the person who holds it and is capable of being filled by successive holders. Case law indicates that the position should be a permanent, substantive position. c) The company must be a trading company or the holding company of a trading group 1 A fuller definition of "ordinary shares" (although still paraphrased slightly) is all the company's issued shares by whatever name called other than shares which give the holder a right to participate in a dividend at a fixed rate but which have no other right to share in the company's profits.
A "trading company" means a company carrying on trading activities whose activities do not include (to a substantial extent) non-trading activities. HMRC have issued guidance (at CG64090) which suggests a company is a trading company if no more than 20% of turnover is from investments, no more than 20% of assets on the balance sheet are nontrading assets and no more than 20% of management time is spent on non-trading activities. HMRC apply the guidance "in the round" so, for example, HMRC will usually accept the test is satisfied where cash exceeds 20% of assets on the balance sheet if the cash is necessary working capital. It is also possible to add goodwill and intangible assets not shown on the balance sheet to expand the denominator for the purposes of the guidance. We also understand (despite what a strict reading of the guidance would suggest) HMRC are prepared to accept a company is a trading company where it has cash in excess of necessary working capital if it has been generated from trading activities. A "trading group" means a group of companies in which one or more members carry on trading activities and the members' activities, when taken together, do not include (to a substantial extent) nontrading activities. "Trading activities" include not just activities carried on by a company in the course of its trade but in preparing to carry on a trade or with a view to starting or acquiring one or where it proposes to acquire a trading company or the holding company of a trading group in circumstances where it will become a subsidiary. A company is also a trading company if it owns or is proposing acquire an interest of between 10% and 50% of the ordinary share capital of a "joint venture company" (being a trading company or the holding company of a trading group which is at least 75% owned by five or fewer people). It is possible to apply to the HMRC Clearances Team to request confirmation in advance of a disposal as to whether a company meets the trading company tests. Key Points Special rules apply to shares acquired pursuant to "Enterprise Management Incentive" options. The one year ER holding period runs from the grant of the EMI option and the personal company test does not apply. The relaxation of the ER rules as they apply to EMI options makes these very attractive. A separate fact sheet is available on EMI. ER must be claimed on or before the first anniversary of 31 January following the tax year of disposal. If an individual disposes of shares in 2014/15, for example, he or she must claim the relief by 31 January 2017. It makes more sense, however, to claim ER when the tax is due so tax is only be paid at 10%. Once an individual satisfies the ER conditions, it can be claimed on the disposal of any securities or interests in securities in the same company. It would be possible, for example, for an employee who qualifies for ER (because he or she has held sufficient shares for more than one year) to acquire further shares and sell these within a year and to claim ER on the sale of the shares held for less than a year. ER also applies to disposals made within three years after a company ceases trading providing the conditions were met in the year prior to cessation. Planning Opportunities Share-based awards to employees should generally be structured as EMI options where possible as the ER conditions are easier to satisfy. Where the EMI conditions are not satisfied careful structuring may be necessary. Case Study "Growth Shares"
We implemented a growth share arrangement for a venture owned company in the healthcare sector to allow four key members of the management team to qualify for ER. The investor held over 90% of the voting rights in the company and agreed to dilute its voting rights to 80% to allow the four key members of the team to qualify. We created five classes of growth shares, four with voting rights of 5% per class and a fifth non-voting class for other employees. The growth shares were entitled to a specified percentage of exit consideration achieved above a threshold - the percentage increased depending on the exit value achieved. The investor held some preference shares with a relatively high nominal value but these were not "ordinary share capital" for these purposes (as their only entitlement to participate in profits was through a fixed rate dividend) so it allowed us to set the par value of the growth shares at an affordable price. Management made elections pursuant to section 431(1) ITEPA 2003 to pay income tax on the unrestricted market value of the growth shares. We agreed with HMRC the shares were worth no more than par so management had no income tax to pay on acquisition. Case Study "Joint Venture Company" We implemented a more sophisticated arrangement for another venture owned company which allowed 14 employees to qualify for ER by satisfying the "joint venture company" test. The investor held 94% of the voting rights of the trading company and the remaining 6% was held by a minority shareholder. Neither investor gave up any voting rights under this arrangement. We established a management company ("Manco") which subscribed for a class of non-voting growth shares in the trading company representing 10% of the ordinary share capital. We created 14 classes of growth shares in Manco each of which was entitled to 5% of the voting rights of Manco as a class and each of which had different nominal values so as to ensure each employee satisfied the 5% by nominal value test. The series 1-14 growth shares were "streamed shares" in that the economic rights mirrored the economic rights of the growth shares in the trading company owned by Manco. The balance of the share rights in Manco were held by the investor which also had extensive shareholder consent rights. Participants subscribed for the series 1-14 shares in Manco and were appointed as directors of Manco. They will qualify for ER on the disposal of their shares in Manco (assuming the disposal occurs more than a year after they acquired their Manco shares). The arrangement requires any purchaser of the trading company to buy shares in Manco to be effective but, in our experience, secondary sales of this sort are more common than is often supposed. This paper is based on the law as at 15 April 2014.
About Bird & Bird Bird & Bird is an international commercial law firm with more than 1,100 lawyers in 26 offices worldwide. Bird & Bird's UK employee incentives and benefits team is ranked in the UK's editions of Chambers and the Legal 500. The team: "is known for its capacity in handling complex international mandates, particularly on behalf of technology sector clients" "is adept at implementing new share scheme plans and at advising upon the share plan aspects of corporate transactions" "contains a number of quality individuals and is doing some impressive international work" "are pragmatic in their advice [and] recognise what we need to do in order to get to a favourable outcome" "are very knowledgeable about the different alternatives open to us and provide us with very appropriate advice" For more information or a free initial meeting please contact: Chambers and Partners 2014 Colin Kendon Partner and Head of UK Employee Incentives & Benefits D: +44 (0)20 7905 6312 colin.kendon@twobirds.com Fleur Benns Legal Director D: +44 (0)20 7415 6114 fleur.benns@twobirds.com Dan Sharman Associate D: +44 (0)20 7905 6343 dan.sharman@twobirds.com
For information on tax issues more generally please contact: Mathew Oliver Partner & Head of UK Tax Group D: +44 (0)20 7905 6258 mathew.oliver@twobirds.com This document gives general information only as at the date of first publication and is not intended to give a comprehensive analysis. It should not be used as a substitute for legal or other professional advice, which should be obtained in specific circumstances. twobirds.com Bird & Bird LLP is a limited liability partnership, registered in England and Wales with registered number 0C340318 and is authorised and regulated by the Solicitors Regulation Authority. Its registered office and principal place of business is at 15 Fetter Lane, London EC4A 1JP. Bird & Bird is an international legal practice comprising Bird & Bird LLP and its affiliated and associated businesses and has offices in the locations listed on our web site: twobirds.com. The word partner is used to refer to a member of Bird & Bird LLP or an employee or consultant, or to a partner, member, director, employee or consultant in any of its affiliated and associated businesses, who is a lawyer with equivalent standing and qualifications. A list of members of Bird & Bird LLP, and of any non-members who are designated as partners and of their respective professional qualifications, is open to inspection at the above address.