As announced in the Budget, draft legislation has now been published to amend the entrepreneurs’ relief rules as part of the Finance Bill 2018-19 which should extend the availability of the relief for senior and early employees of fast growth companies.
In brief, entrepreneurs’ relief provides for a reduced 10 per cent capital gains tax rate on qualifying disposals of shares on up to £10m of lifetime gains. There are several conditions which need to be met, but the trickiest is often the requirement for the taxpayer to hold at least 5 per cent of the company’s ordinary share capital and at least 5 per cent of the voting rights in the company throughout the 12 months prior to the disposal.
The aim of this draft legislation is to preserve entrepreneurs’ relief in circumstances where businesses take on external investment which dilutes the holdings of existing shareholders. This issue is particularly acute in the tech sector where fast growth companies (especially those with multiple co-founders) can find their shareholdings rapidly diluted by taking on venture investment. Fundraisings have traditionally required the establishment of more complex share structures to address this, and the opportunity could easily be missed by founders who were not well advised in their personal capacity.
The new draft rules seek to mitigate the impact of a dilution event on or after 6 April 2019 on shareholders who were previously eligible to claim the relief. Where the conditions are met, the draft rules allow an individual to “lock in” entrepreneurs’ relief on any gain which accrued up to the point at which the shareholding was diluted.
The shareholder makes an election to be treated as disposing of and reacquiring his or her shares at market value immediately before the relevant share issue. Entrepreneurs’ relief can then be claimed on any gain realised on that deemed disposal. Importantly, the taxpayer can then make a separate election to defer the tax charge on that gain until there is an actual disposal of the shares so as to avoid a “dry” tax charge.
This amendment addresses, but underlines, some of the risks that founders face when they assume that their personal interests and the company’s interests are perfectly aligned.