Cassandra Graham, Tax manager at Bates Weston, explains the elections you can make to protect your Entrepreneurs’ Relief on dilution of your shareholding.
As ever, this article is general in nature and you should take no action based upon it without first consulting your professional advisor.
From 5 April 2019, shareholders who are about to be diluted below the 5% required (of the voting rights, nominal share capital and economic rights) to be able to qualify for Entrepreneurs’ Relief by a new share issue, can choose to protect their 10% tax rate. Two new elections have been introduced in the shareholders’ favour in this scenario.
Firstly, an election can be made which allows the shareholder to trigger a disposal of a shareholding that qualifies for Entrepreneurs’ relief if they are to be diluted. Previously, the shareholder was powerless in these circumstances and could have been subject to an additional 10% on a disposal overnight due to circumstances outside of their control that caused the dilution.
The election mechanics mean that the shareholder is effectively treated as selling the shares for their market value then buying their shareholding back immediately and Entrepreneurs’ Relief can be claimed on the sale. This would trigger tax before cash on a real sale and therefore cause a ‘dry tax charge’ albeit at 10% if it wasn’t for the second election.
A second election can then be made in the tandem with the first (if relevant) to defer the tax liability until a real sale is made and proceeds are available to fund the tax.
The first election is particularly important for the exercise of share options on an exit which causes existing shareholders to be diluted. It is understood that HMRC no longer accept that having 5% on the day of disposal is sufficient to claim Entrepreneurs’ Relief if at the time of the sale the share option holders have caused dilution of existing shareholders. As such the election in this circumstance would be vital.
The market value of a minority shareholding on which the gain is assessed on the notional disposal is considered to be the value as if the company was sold immediately before the new share issue, ignoring any discounts. This maximises the potential Entrepreneurs’ Relief claim. However, valuations would be required at the time to substantiate the claims made. The share valuation methodology used will be key to this as valuation challenges from HMRC are likely where the motive will be to consider the highest value possible to maximise the claim.
In an age where the fear of Entrepreneurs’ Relief extinction is real, diluted shareholders may have an advantage to preserve their 10% tax – we can assist with advice on the application of these new elections, Entrepreneurs’ Relief advice and the preparation of share valuations for these purposes, so please do not hesitate to get in touch.