In some cases, individuals (such as a business’s founder) may lose eligibility for entrepreneurs’ relief (ER) when their company’s fundraising efforts result in their own shareholding becoming reduced (or ‘diluted’) below 5% in the 12 months leading up to a business sale. This may act as a barrier to growth for some firms. For instance, in cases where an individual does not want or is not able to make further investment, they may choose instead to leave the company, or decline to seek funding which could help the business grow. Such an outcome conflicts with the intended purpose of ER, and the Government therefore intends to remove this barrier in a fair and proportionate way.
The Government has issued a consultation document outlining its view of how this will work so that individuals may remain entitled to ER on gains on shares in or securities of a company that relate to the time before the individual’s shareholding became diluted. The proposal is that this is achieved through:
- A new facility that allows individuals to elect to be treated as having disposed of and reacquired their shares at the then-market value, and
- Allowing individuals to defer the taxation of this gain until an actual disposal of the shares
One of the main options a company has for raising funds to finance its growth: issuing shares to new or existing shareholders. If an existing shareholder does not purchase any (or enough) new shares, then when a round of fundraising has been completed their stake in the company will have become diluted. This means that an individual who held over 5% of the company’s shares before a round of fundraising may fall below this threshold afterwards, even though they have not disposed of any shares. As a result of this dilution, the shareholder would no longer be eligible for ER when they come to dispose of their shares, unless they subsequently acquire more shares and retain the increased holding for a further 12 months. A shareholder in this position will therefore be required to pay the full rates of CGT on all gains which accrue when they come to dispose of their shares.
The proposals will in effect allow individuals to crystallise the gains on their shares at the point immediately before the holding is diluted, providing they meet the ER conditions at that time, and the dilution is in consequence of an issue of shares made by the company for genuine commercial reasons. The individual will need to make the election in their tax return for the year in which their shareholding is diluted and the normal self-assessment time limit for elections (31 January following the end of the tax year concerned) will apply. The individual will be able to make a claim to defer the accrual of the gain on the deemed disposal until the occasion of an actual disposal of shares, in order to avoid a ‘dry’ tax charge. This would mean that the gain will not be taxed until shares are disposed of. Where such a claim is made, entitlement to ER on the deferred gain will be preserved so that ER can be claimed under the then-current rules at the time the gain is treated as accruing. Where the individual has chosen to pay the dry tax charge at the time of the first election, subsequent losses will not be able to be set against the gain on the deemed disposal of the shares, and so will not give rise to an effective repayment of tax.
The Government does not currently intend to extend this new relief to shares held by Trustees, or to disposals ‘associated’ with a share disposal (such as personally held assets used in the business). Nevertheless, this will be a welcome relief for many business owners, who have been faced with the stark choice of selling part of their business to obtain increased investment but at a personal tax cost, or losing touch with the business they have built, in order to crystallise CGT relief.