Peter Rayney.

The original pre-Budget report (PBR) 2007 proposals for capital gains tax (CGT) effectively introduced a level playing field for both business and non-business/investment gains. This would be achieved by ensuring that, after 5 April 2008, all capital gains would be taxed at a flat rate of 18%.

Recognising that businesses formed the 'backbone' of the economy, owner-managers and entrepreneurs have hitherto enjoyed a favourable CGT regime. With the benefit of business taper relief, they have normally been able to sell their companies/businesses at an effective CGT rate of 10%. It was therefore not surprising that the proposed substantial rate increase to 18% created a massive backlash from business groups. Although there appeared to be an 11th hour reprieve on 24 January 2008 when Alistair Darling announced the new-style entrepreneurs' relief, the following day's press coverage shows that he did not go nearly far enough to placate the business community.

While the CGT reform package was announced under the banner of tax simplification, the PBR 2007 Red Book (Table 1.2) revealed that these measures were expected to yield some £350m in 2008/09, rising to £900m per year by 2010/11 (albeit now reduced by some £200m a year due to the entrepreneurs' relief). There are clearly strong arguments for tax simplification measures being seen as broadly 'revenue neutral' but these changes represent a tax-raising measure, and the increased revenues appear to be coming from owner-managers and entrepreneurs, who are the big 'losers' of the new CGT reforms.

This article builds on my previous analysis of the new CGT reforms (see Accountancy, December 2007, page 101) and reviews the main aspects of the new entrepreneurs' relief (based on Revenue & Customs' announcements as of mid February).

Following Darling's 24 January 2008 statement, the key aspects of the post-5 April 2008 CGT regime for individuals and trustees have now been finalised as follows:

•    For post-5 April 2008 disposals, a single rate of 18% applies on all assets (irrespective of the taxpayer's marginal tax rate), except gains qualifying for entrepreneurs' relief. Held-over gains coming into charge after 5 April 2008 are also subject to the 18% flat rate.

•    Both taper relief and indexation relief will be completely abolished.

•    March 1982 rebasing of assets held at that date will be compulsory. This means, for example, that it will no longer be possible to use the original cost if that produces a lower gain.

•    The special 'halving relief' provisions that applied to gains held over or rolled over between March 1982 and April 1988 will be withdrawn.

•    A new style entrepreneurs' relief provides a reduced rate of 10% on qualifying business gains up to £1m - the £1m threshold operates (from 6 April 2008) as a cumulative lifetime limit (although Darling indicated that he will 'seek to do more' and therefore keep this threshold under review). The relief can therefore apply on more than one disposal but is capped at the £1m lifetime limit.

The introduction of entrepreneurs' relief means that owner-managers making gains of up to £1m will generally retain the benefit of an effective 10% rate. This will be achieved computationally by reducing relevant gains up to the £1m limit by 4/9ths! Thus, for example, a capital gain of £450,000 arising on the sale of a 25% shareholding in a trading company would be reduced by 4/9ths - £200,000. This leaves a gain of £250,000 taxed at 18% - £45,000 (which equates to £450,000 at 10%).

A comparative example between the CGT treatment on the sale of an owner-managed company under the existing business taper rules and the post-5 April 2008 regime (showing how entrepreneurs' relief is given) is provided in Table 1.

Entrepreneurs' relief is far more restrictive than the current business taper regime. For company shareholders, the key conditions which must be satisfied throughout the 12 months before the disposal are:

•    the shares must be held in a trading company or holding company of a trading group;

•    the shareholder must be a director or employee of that company/fellow group company; and

•    they must hold at least 5% of the ordinary share capital (carrying at least 5% of the voting rights).

All this sounds very much like the old (pre-April 1999) retirement relief regime - which perhaps is not surprising since the entrepreneurs' relief is modelled on it! However, there are a few key differences:

•    There is no minimum age requirement (and there is no need to retire!).

•    The relevant shareholding only needs to be held for at least one year to obtain the full relief (in contrast to the 10 years required under the old retirement relief regime).

•    Part-time employment or directorships will suffice - there is no need to demonstrate full-time working.

Furthermore, the trading company/group test is based on the current business taper rules. This means that a company/group only qualifies provided it exists wholly for the purpose of carrying on one or more trades (on a commercial basis), subject to the disregard rule for insubstantial non-trading activities. The Revenue takes the view that non-trading activities may be regarded as 'substantial' if they represent more than 20% of the company's business. In marginal cases, the 20% test will be applied to various measures, such as turnover, profits, assets employed, management time etc.

In certain cases, trustees will also be able to claim entrepreneurs' relief on share sales provided they fulfil the 5% voting share requirement (and a life tenant of the trust satisfies the relevant office/employment conditions).

Where an individual qualifies for the relief on the disposal of shares, they can also obtain relief on an 'associated' disposal of an asset that has been used by the company. This would normally cover any gain on a (broadly) concurrent disposal of a 'personally-held' property that has been used for the purposes of the company's trade.

Only some of the cases where business taper is currently available will qualify for the more restrictive entrepreneurs' relief. Certain categories of shareholder will not normally be able to qualify - this would include most employee shareholders and many AIM investors (since they are both unlikely to have a sufficient stake). Similarly, private equity executives will not be able to benefit from the entrepreneurs' relief on gains made through their co-invest or 'carried interest' funds. All these shareholders/investors will suffer significantly higher CGT liabilities under the post-5 April 2008 regime.

Furthermore, many owner-managers seek to sell for substantially more than £1m, above which gains are taxed at the flat 18% rate. Larger business gains (above £1m) will therefore still be taxed more heavily than under the previous business taper regime, as demonstrated by the comparative calculations in Table 2.

It would appear that entrepreneurs' relief will only apply to qualifying share sale gains arising after 5 April 2008. There is a transitional problem with gains held over against qualifying corporate bond (QCB) loan notes under s116(10)(a) Taxation of Chargeable Gains Act (TCGA) 1992. When a QCB loan note is repaid/redeemed under the current regime, business taper relief would generally be applied to the chargeable gain. This would often be taxed at an effective 10% rate (although the taper is based on the vendor's taper profile at the original sale date (para 16, Sch A1, TCGA 1992)).

However, since it is the (pre-tapered) chargeable gain which is being held over, where an encashment takes place after 5 April 2008, no taper relief will be available. Furthermore, it would seem that no entrepreneurs' relief would be given on the encashment (even though the vendor shareholder may have qualified for it if the entrepreneurs' relief had been in force before 6 April 2008). The result is that QCB held-over gains crystallising under the new CGT regime would normally be fully taxed at the 18% rate. Given the reasonable expectation that the loan note would have 'banked' (business) taper when it was received by the holder, this would seem to be inequitable.

Earn-outs straddling 6 April 2008 are also likely to be adversely affected. Under the current CGT regime, earn-outs are often structured so that they are satisfied in the form of loan notes. This enables the vendor:

•    to avoid incurring a CGT charge based on the 'up-front' value of the earn-out right (following the principles established in Marren v Ingles (1980) STC 500), and

•    to treat the earn-out right as a deemed debenture under s138A TCGA 1992, enabling a CGT 'reorganisation' style deferral of the CGT relating to the earn-out.

Through the s138A TCGA 1992 mechanism, the vendor would normally be able to secure business taper relief when the actual earn-out 'consideration' loan notes are encashed. On earn-out deals entered into before the PBR 2007, many vendors expected to obtain an effective CGT rate of 10% on their earn-out loan notes. However, earn-out loan notes encashed after 6 April 2008 will now be subject to an 18% tax charge. For various technical reasons, it is very unlikely that capital gains on encashment would qualify for entrepreneurs' relief.

In some cases, vendors should consider making an election to 'opt out' of the s138A treatment under s138A(2A) TCGA 1992. (By making the s138A(2A) election, the vendor becomes taxable on a 'Marren v Ingles' basis, and the value of the earn-out is taxed as part of the sale consideration for the shares.) This would mean that the vendor would effectively shift more of their overall capital gain on the transaction into the favourable pre-6 April 2008 (10%) regime. Supporting calculations (taking into account the quantum and the timing of the vendor's tax cash flows under each 'route') will need to be made in each case to determine whether a s138A(2A) election would be advantageous. The time limit for making the election is about 22 months after the end of the tax year in which the original share sale is made. This should normally give sufficient time for fairly firm figures to be determined for the purposes of the relevant calculations.

Many had hoped that the government would have allowed some form of 'rebasing' election to enable individuals to make a deemed disposal and reacquisition of their shares etc, (thus crystallising their CGT at 10%) but sadly there appears to be no appetite for this. Taxpayers should therefore consider making suitable planning arrangements to benefit from the existing favourable business asset taper rules before the 6 April 2008 deadline.

Owner-managers who are currently in negotiations to sell their company will generally wish to ensure that the sale contract takes place before 6 April 2008. Those that are not currently engaged in a sale but are planning to sell their companies in the short term might wish to consider 'banking' their business taper by transferring all or some of their shareholding to an appropriate (settlor-interested) trust. The basic objective here is to create a CGT disposal at market value (with the shares being rebased in the trustees' hands at market value). The owner-manager would be subject to a 'dry' CGT charge (since the transfer will not normally generate any cash to pay the tax). However, it may be possible to make an election under s281 TCGA 1992 for the CGT to be paid in ten equal annual instalments (although all the tax will become payable when the company is subsequently sold). There are a number of aspects to consider with this type of arrangement, including s684 Income Taxes Act 2007 and the potential inheritance tax cost of extracting cash from the trust, and therefore specialist advice should always be obtained.

In some cases, 'serial' entrepreneurs anticipating relatively small gains on the sale of their company may still find it worthwhile to crystallise their CGT at 10% before 6 April 2008, since they would leave their £1m lifetime allowance (under the entrepreneurs' relief rules) undisturbed. It is to be hoped that the Revenue will adopt a relatively benign approach to such arrangements!

Peter Rayney is BDO Stoy Hayward's national tax technical partner. He is author of 2006/07, published by Tottel.

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This article is abridged from a longer work by Peter Rayney, shortly to be published as a CCH Tax Digest, Getting to grips with the new CGT regime and advance planning (March 2008).

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