Entrepreneurs’ relief withdrawn for alphabet shares?

The issue

Before 29 October 2018 (budget day) it was fairly common knowledge that various conditions needed to be met for a year up to disposal if a shareholder was to qualify for Entrepreneurs’ Relief (ER). The main conditions were:

  1. The company must be a trading company or the holding company of a trading group.
  2. The shareholder had to be an officer or employee of the company.
  3. The shareholder had to hold 5% of the nominal share capital.
  4. The shareholder had to hold 5% of voting rights.

This allowed shareholders to benefit from ER when they commercially held much less than 5% of the company’s share capital. The point here is that nominal share capital can be fairly worthless. Take an extreme example whereby a class of shares is issued which only has voting rights and rights to the nominal share capital on an exit:

 

Example

Clive owned 3% (or 30 £1 ordinary shares) of a company’s share capital and 3% of votes. The company is worth £50M and has share capital comprised of 1,000 £1 ordinary shares. Clive was then issued with 25 £1 B ordinary shares which have pro rata voting rights but only have capital rights to nominal share capital (ie £25). Suddenly Clive found himself with 5.37% (55/1025) of nominal share capital and 5.37% of voting rights and therefore would benefit from ER for a disposal after a year. If the company was then sold after a year (assuming a negligible base cost) Clive would make a gain of £1.5M and have a tax liability of £150,000 rather than £300,000 which would have applied without the availability of ER. Put simply a trivial investment of £25 saved £150,000 of tax!

Perhaps unsurprisingly this loophole was removed from 29 October 2018. There are now two additional conditions:

  1. Shareholders must be entitled to at least 5% of the company’s distributable profits
  2. Shareholders must have a right to at least 5% of the net assets of the company available to equity holders on a winding-up.

Furthermore from 6 April 2019 conditions will have to be met for two years up to the point of sale (rather than a year).

All this tinkering with ER rules seems fair enough to counteract the ‘mischief’ in the example above but we are worried that they may have a more widespread impact…

 

Alphabet shares

How many shareholders can say with certainty that they are ‘entitled’ to 5% of the company’s distributable profits? For simple single class share structures the answer here can be quite straightforward because generally a holder of over 5% of the shares would be entitled to 5% of the company’s distributable profits. What about a company with two 50% shareholders who respectively hold 50 £1 A shares and 50 £1 B shares where it would be common for the articles to allow differential dividends to be paid to the different share classes? This can mean that (at least in theory) over 95% of distributable profits could be paid to either the A or the B shareholder. It logically follows that neither shareholder can truly say that he has an entitlement to 5% of the company’s distributable profits and therefore no alphabet shareholder will be able to benefit from ER!

 

Final word

We are hoping that the above analysis will not be applied in practice, although our first look at the recently issued legislation suggests that it does stand. Hopefully some sense will prevail over the coming months but this can be a slow process. In the meantime shareholders should be reviewing company articles and considering the insertion of clauses which put the ER position beyond doubt. However, this approach will not help long-term shareholders who want to sell their companies within two years.

 

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