Common Scenarios Preventing Claims for Entrepreneurs Relief
In this article, we are sharing the entrepreneurs tax relief procedure and what could stop you claiming in the future.
When can entrepreneurs relief be claimed?
Entrepreneurs’ relief is a reduction in capital gains tax to 10% when you sell or dispose of all or part of your business. In the context of a limited company, this means selling or disposing of your shareholding. In order to qualify you must:
- Hold at least 5% of the company’s shares in terms of voting rights.
- Have had the option to buy your shareholding for at least a year prior to the claim point.
- The company must not have ceased trading in excess of 3 years ago.
As stated above, in April 2016, HMRC changed its tax rules in order to narrow the circumstances under which entrepreneurs relief can be claimed in a members voluntary liquidation. In fact, if you fall foul of these rules, the monies received would be taxed at income tax rates rather than as capital gains. This could mean a heavy tax burden. HMRC may reclassify the funds as income if all of the following criteria are met:
- The company is a close company (meaning less than 5 shareholders).
- The shareholder is involved in a similar trade or activity within the 2 years after entering members voluntary liquidation.
- The main purpose of the voluntary winding up is the obtain favourable tax treatment.
As a consequence of these changes, we have had to advise several prospective clients against seeking the beneficial tax treatment through liquidation as HMRC would be likely to change the treatment to that of income.
One of the more common issues we find arising, is where shareholders have multiple companies running similar trades in tandem with each other. They often want to close one company, but keep the others running. Unless it can be shown that there is an alternative main purpose for winding up the company, which is likely to be difficult in these circumstances, this will generally fall foul of the above criteria.
An example of this could be a pair of software companies with the same ownership and management structures. They also boast the same description on companies house. One company focuses on distribution and development of existing bespoke software, while the other company develops new bespoke software. The sales company has been profitable and are selling on their existing software rights and winding up this company. However, they are continuing to develop new software with the other company. In this instance, this is likely to be classed as a similar trade. HMRC would then be likely to reclassify the distributions as income. This would mean a higher tax burden and entrepreneurs relief cannot be claimed.
If a case that can be put forward that the main purpose of the liquidation is other than that to obtain favourable tax treatment, there is the option to seek clearance from HMRC before entering members voluntary liquidation. In such circumstances, we can work with your accountant to assist them in preparing a report to HMRC to obtain this clearance. Thus giving you the peace of mind before starting the process.
Breakdown of relationship
Many companies we encounter are husband and wife owned, or owned by one of the parties. Relationship breakdowns are always unfortunate. However, if a decision is made to wind up the company to claim entrepreneurs’ relief, after a readjustment of shares in the separation, this can also cause problems with the claim.
As described above, the shareholding must have been available for a year prior to the winding up of the company. Couples are not classified as a single entity in this regard, so the separation redistribution will trigger the start of another period of a year necessary for the transferred shares. It will then likely be the case that only one partner may be able to claim entrepreneurs’ relief conditions on the capital distribution, whilst the other would have to pay the full rate of capital gains tax.
It is worth bearing in mind the corporate shareholders do not benefit from entrepreneurs’ relief or an alternative rates for capital gains tax. Any capital distributions in a members voluntary liquidation, or income distributions ahead of dissolution, will be taxed at the existing corporation tax rate. Consequently, a members voluntary liquidation will appear to be an unnecessary expense to these shareholders. If they hold a sufficiently large vote within the company, they may choose to block a winding up resolution.
As stated above, one of the criteria to claim entrepreneurs’ tax relief is that the company needs to have been trading in the last three years. Where the company has substantial income from non-trading activities, HMRC will disallow a claim for entrepreneurs relief. Whilst this does not preclude you from benefiting from the lower tax rate from a capital distribution in members voluntary liquidation, you will not benefit from the 10% rate for entrepreneurs’ relief. Non-trading activity includes:
- Income from investment portfolios.
- Rental income from properties.
- Licensing arrangements.
Substantial non-trading income is defined in the capital gains legislation as anything exceeding 20% of the business activity. The activity of the business is measured on the following basis:
- Business turnover.
- Proportion of activities by employees.
- Level of business expense attributed to activities.
- As level of asset base attributed to these activities.
Excess cash in a company bank account is not taken into account in measuring the overall asset proportion, but other investments will be.
Whilst the scope for benefiting from capital distributions in members voluntary liquidation and claiming entrepreneurs tax relief has narrowed in recent years, this leaves the majority of instances where this would be sought will still qualify. If you require assistance with the winding up process, or would like to discuss any of the above in more detail, please don’t hesitate to contact our business rescue experts.