In the third in our 4-part series on some of the tax-efficient investment strategies that help plan for and mitigate capital gains tax (“CGT”) liabilities, we’re looking at Entrepreneurs’ Relief (“ER”) – a key relief available on the disposal of business assets.
Introduced by the Labour government a decade ago, Entrepreneurs’ Relief was designed to encourage people to go it alone in business and so, ultimately, diversify and boost the UK economy through the creation of additional industries and jobs. In short, the relief works by reducing the tax burden on those selling a business or business asset, rewarding them for having been entrepreneurial in the first place.
During its short lifetime, the mechanics of Entrepreneurs’ Relief have been continually altered, from the relief calculation to its overall scope, but throughout, the theme has remained constant: a 10% CGT rate for qualifying disposals.
However, Entrepreneurs’ Relief has not been without its critics and recent reports suggest that the relief, which was originally budgeted to cost the public purse hundreds of millions per year, is costing billions of pounds per year; funds that many believe could be better spent elsewhere. With the budget due to be delivered at the end of this month (29 October), time will tell if the relief (and this article!) has much longer to live, or at least in its current form.
One of the criticisms of Entrepreneurs’ Relief has been the breadth of its scope, as it was previously felt that it was too easy to manipulate circumstances in order to claim the relief. Recent changes have scaled back the scope, including restricting relief on incorporation of an existing business, and it is now more focused on that ‘final event’, when a business changes hands and the entrepreneur realises the fruits of their labour.
In its current form, in order for a disposal to qualify for Entrepreneurs’ Relief it must fall within one of three classes of qualifying disposal:
- A ‘material disposal’ of business assets;
- A disposal which is ‘associated’ with a material disposal; or
- A disposal of trust business assets (which is not covered further in this article – please contact us for more information).
So, what is a ‘business asset’ and what counts as being a ‘material disposal’ for ER purposes?
The tax legislation splits the definition of ‘business asset’ into three categories:
- the whole or part of an unincorporated business;
- an asset used in a business at the time the business ceases to be carried on; and
- stocks and shares in a personal company.
So, if you’re disposing of one of the above types of asset, it’s possible that it could qualify for ER.
It is, however, important to note that although the legislation refers to ‘business’, it later restricts the definition of business to mean, “a trade, profession or vocation…conducted on a commercial basis with a view to the realisation profits”. This is an important distinction to the term ‘business’, as, by its omission, it implicitly states that those businesses which tax legislation considers to be of an investment nature, such as rental property businesses and those holding stocks and shares investments, do not fall within the definition and so a disposal of such a business cannot qualify for ER.
The next step is to assess whether or not the disposal of the qualifying business asset is ‘material’.
For each of the three categories of business asset, there are varying qualifying conditions that must be met in order for the disposal to count as being ‘material’. However, there is one common condition that must be met in all cases: the disposer must have owned the business asset for the 12 months immediately preceding the date of disposal.
The other conditions include:
- the whole or part of an unincorporated business
As well as the business having been owned by the disposer for the 12 months prior to disposal, in order for the disposal of part of an unincorporated business to qualify for ER, the part disposed of must be a going concern, meaning that it must be capable of being carried on as a business in its own right after separation from the previous business in whole.
- an asset used in a business at the time the business ceases to be carried on
The key point here is the asset being used in the business when it ceases. The asset can be disposed of up to three years after the cessation of the business and still qualify for ER.
- stocks and shares in a personal company
Throughout the 12 month period immediately preceding the disposal, the shares must also meet three additional conditions. First, they must be in a company that is a trading company, or holding company of a trading group. Second, to be the disposer’s personal company, they must hold at least 5% of the ordinary issued share capital of the company and with it 5% of the voting rights. Third, the disposer must be an officer (commonly a director or company secretary), although there are no minimum working time requirements.
There are separate rules relating to shareholders who acquired their shares through an Enterprise Management Incentive (“EMI”) scheme, whereby some of the standard rules are relaxed. For further information about EMI schemes or the availability of ER in respect of EMI shares, please contact us.
In addition to the above rules for a direct disposal of business assets, a complementary set of rules help to bring ‘associated disposals’ within the scope of ER. The associated disposal rules are available to those making a material disposal of an interest in a partnership or company, but aren’t relevant to sole traders disposing of their business. The rules are designed to apply in circumstances where the disposer is making a withdrawal from the ownership of a business.
By definition, in order for a disposal to qualify for ER under these rules, it must be associated with a pre-dating material disposal, i.e. you can’t have an associated disposal without first having made a qualifying material disposal of business assets.
The rules can be quite complex, but can be summarised as follows:
- the taxpayer’s material disposal (to which this disposal is being associated) must represent at least 5% of a company’s issued share capital and voting rights or a partnership’s total assets.
- there must be a link between the material disposal and the associated disposal, such that the transactions as a whole constitute a withdrawal from the business by the disposer. There is no requirement for the disposer to stop working or reduce their working hours at the business, but they must withdraw from participation in the business.
- given that the transactions should be linked, there should not be a significant interval between the disposals.
- the asset being disposed of must have been used in the business throughout the 12 months immediately preceding the original material disposal, or the cessation of business.
- for assets purchased after 13 June 2016, the individual must have owned the asset throughout the three year period preceding the disposal.
The classic example of an associated disposal is the disposal of a property owned privately but used in the business of the disposer’s personal company, of which he has also made a material disposal.
“Mr A owns 100% of ABC Limited. The company is a trading company that he has owned and been a director of for many years. The company trades from a commercial property that Mr A owns personally and has never paid rent for the property. The property has always been used for this purpose throughout Mr A’s ownership.
In April 2018, Mr A sells his entire ownership of ABC Limited to an unconnected buyer. At the same time, the buyer also purchases the commercial property from Mr A.
The disposal of the shares in ABC Limited qualifies as a material disposal of a business asset and so Mr A can claim ER and pay 10% CGT on the gain. The disposal of the property is associated with the material disposal and so also qualifies for ER and the 10% CGT tax rate.”
Given that the assets are only associated with a material disposal, the relief is subject to restrictions if the asset hasn’t been used purely for business purposes, or hasn’t been used purely for business purposes throughout the taxpayer’s ownership period. Relief can also be restricted if any amount of rent was paid to the taxpayer in respect of an associated disposal asset.
Claims for ER are time limited and so it is vital that they are made within the specified timeframe. The claim should be made on the self-assessment tax return relating to the year in which the disposal(s) is made. It therefore follows that a claim can be made within the ‘normal’ self-assessment return submission and repair deadlines, meaning that it is possible to make a claim by repairing a tax return within one year from its original submission due date.
Claims for ER are ultimately restricted by the “lifetime limit”, which is the maximum value of aggregated eligible gains that can qualify for ER during a taxpayer’s lifetime. Since 2011, the lifetime limit has been £10m per taxpayer.
Although the standard rate of CGT has fallen in recent years, in many circumstances savings can still be made if the appropriate planning has been put in place. ER presents many such tax planning opportunities for those holding business assets:
- Utilising a spouse’s allowance – given that ER has a lifetime limit, it can be prudent to introduce a spouse into the ownership structure of a partnership (including turning a sole trade into a partnership) or a company. Provided that there are bona fide business reasons for bringing a spouse into the business, this process can potentially double the value of ER available on a disposal. Care should be taken, however, as such transfers of ownership do have implications with other taxes.
- Utilising family members’ allowances – in much the same vein, introducing other family members, including adult children, can be a good way of spreading any potential gains and utilising as many ER limits as possible. Any new business owners will have to meet the qualifying conditions in their own right and, again, care should be taken and consideration given to other tax implications before undertaking such a change.
- Asset ownership – for a multitude of reasons it is always important to regularly review asset ownership to ensure maximum tax-efficiency. With ER, it is important to consider the associated disposal rules and how asset ownership could impact on the availability of relief. Take, for example, the scenario above where Mr A made an associated disposal of a property used in his personal company. Assuming all other facts were the same but for the ownership of the property which, instead, Mr A owned 50/50 with his wife, Mrs A. In that scenario, Mr A’s 50% share of the gain on the property disposal would qualify for ER, but Mrs A’s wouldn’t as she has no material disposal to associate the property disposal with. That could result in Mrs A paying double the CGT that Mr A does.
- Paying rent – as we’ve seen above, paying any form of rent for an asset subject to an associated disposal claim can mean a restriction to ER – and sometimes a full restriction. On the other hand, rental income can be a tax-efficient source of income and profit extraction method, and so it is always worth weighing up the advantages and disadvantages of paying rent for assets used in the business.
With all forms of tax planning, it goes without saying that any arrangements made purely for tax-saving reasons may be at risk of challenge by HMRC and professional guidance should be sought beforehand.
If you’re interested in understanding more about Entrepreneurs’ Relief, or have more general questions about the disposal of business assets, contact us today for an initial, free-of-charge meeting.