Government waters down entrepreneurs’ relief rules

The government has amended the draft rules on entrepreneurs’ relief just weeks before Finance Bill 2018-19 is passed in the new year, with significant overhaul of the proposed ‘economic test’

The two amendments to Schedule 15 introduce an alternative test into the definition of ‘personal company’ which can apply instead of the original two tests introduced by the Schedule. This alternative test is based on the claimant’s entitlement to a share of disposal proceeds in the event of the company being sold.

‘The original proposed ‘economic interest’ provisions created considerable uncertainty.  Fortunately, after consultation with the various professional bodies etc, HMRC announced a revised ‘economic test’ on 21 December 2018,’ said tax specialist Peter Rayney.

Under the improved rules, shareholders are required to meet one of the two alternative ‘economic interest’ conditions – Economic Condition 1 and Economic Condition 2.

Economic condition 1 reflects the original proposed rule, which required the seller shareholder to be beneficially entitled to at least 5% of the profits available for distribution to the company’s equity holders, and the company’s assets available for distribution to its equity holders on a winding-up.

Under the revised rules, economic condition 2, the alternative (new) test is likely to be easier to apply. 

Rayney said: ‘Based on the assumption that the entire ordinary share capital of the company is sold, the seller must reasonably expect to obtain at least 5% of the total disposal proceeds.  This seller must meet this condition throughout the ER qualifying period.  However, in applying this provision, the sale value of the company is taken to be the market value at the end of that period.  In those cases, where the seller is selling as part of a disposal of the entire company, it is expected that the arm’s length sale price would be used. 

‘The allocation of the ‘market value’ sale price is based at any point in the qualifying period is based on the arrangements in place at any point in time.’

There was also some improvements to the treatment of so-called alphabet shares which are widely used by owner managed companies and the government’s proposals had met with strong opposition.

The way the rules were worded under the draft proposals, tax advisers considered that the original ‘economic test’ (ie,Economic Condition 1 above), which looks at profits available on a distribution, would have potentially prevented holders of ‘alphabet shares’ from being able make competent ER claims. 

This was largely due to a faulty design in the original ‘economic test’, since it was not HMRC’s policy intention to deny relief where a shareholder had a right to at least 5% of the total sale proceeds on a sale of the company.  

‘The alternative (new) Economic Condition 2 is likely to be the preferred test for holders of alphabet shares and similar share structures. If a shareholder holds a separate class of shares, they can meet this condition where (under the articles or shareholders’ agreement) they would obtain at least 5% of the proceeds on a sale of the company (and this entitlement exists throughout the qualifying ER period),’ Rayney said. 

‘Many owner managers will be pleased to see that HMRC has largely resolved the alphabet share ER debacle – a very welcome Christmas present from the taxman,’ he added.

Read Peter Rayney’s analysis article, Getting to grips with entrepreneurs’ relief makeover

Finance Bill 2018-19 Report Stage: Amendments 2 and 3 to Clause 38, Schedule 15: Entrepreneurs’ Relief issued 21 December 2018

Report by Sara White

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