Entrepreneurs' Relief - Will You Actually Qualify?

Entrepreneurs' Relief was introduced following the abolition of the Capital Gains Tax taper relief scheme in April 2008.

At the time, the government was intent on imposing an 18% flat rate on all capital gains, whether business or non-business assets.

However, after a period of lobbying from business, the government backtracked (or actually listened?) on their original decision.

Quite rightly, business pointed out that the new 18% rate was an 80% increase over the old 10% rate that applied to business assets that had been held for a certain number of years.

Entrepreneurs' Relief was introduced with a 10% flat rate on all qualifying business gains up to £1m. Following the March 2010 budget, the lifetime allowance doubled to £2m (and increased to £5m by George Osborne in the Emergency Budget on June 22, 2010 - the exact implementation date is yet to be announced).

The relief can be claimed any number of times up to the limit and a business disposal can apply to the whole business or only part of it.

In order to qualify for Entrepreneurs' Relief, you must satisfy certain criteria:

the business must meet the definition of a trading company, that is it must not undertake "to a substantial extent activities other than trading activities"
this is referred to as the "20%" test; 20% is a measure of the maximum non-trading activities that can be ignored for the purposes of Entrepreneurs' Relief
the shareholding must be in the individual's "personal company". In other words, you must hold at least 5% of the ordinary share capital (which will entitle you to 5% of the voting rights)
you must be an officer or employee of the company

One possible trap that could lead to an individual losing the relief is if they hold too much cash in the company.

For example, let's say that at the time of winding up/selling the business the value of the company's net assets is £3m. At the time the company ceases to trade, it is holding £750,000. There is one owner holding 100% of the ordinary shares carrying all the voting rights.

Only £120,000 of this amount was earmarked for business purposes. The surplus £630,000 in cash amounts to 21% of the company's net assets, assuming net assets have remained broadly the same.

As this example fails the "20% test", it is likely that the conditions have not been met to qualify for the relief.

The Capital Gains calculation would be (assuming the shares were originally acquired for a nominal amount):

2010/11 gains - £3m

Annual Exemption - £10,100

Taxable Gain - £2,989,900

CGT - £538,182 (18%)

Effective Tax Rate - 17.94%

Net Proceeds - £2,461,818

One Possible Solution

One idea is for the company to contribute to a pension scheme on behalf of the 100% shareholder (the owner).

For example, if the company contributes £100,000 to a pension scheme more than a year before the cessation of trade, the situation looks like:

as long as it receives 28% corporation tax relief on the pension contribution, its net assets will reduce by £72,000 (£100,000 x 28% = £28,000. £100,000 - £28,000 = £72,000)
corporation tax relief is available provided the contributions are made "wholly and exclusively" for the purposes of the business
the effect of the pension contribution is that the company's net assets will reduce by £72,000, to £2,928,000
the result is that the company's level of surplus cash would reduce to £558,000 (£630,000 - £72,000), which is below 20% of its net assets (£558,000 / £2,928,000 x 100% = 19.06%)
as long as this remains the case for at least one year before the date the company ceases trading, Entrepreneurs' Relief will be available

Let's have a look at the calculation now:

2010/11 gains - £2,928,000

Entrepreneurs' Relief (4/9 x £2,928,000) - £1,301,333

Gain after relief - £1,626,667

Annual Exemption - £10,100

Taxable Gain - £1,616,657

CGT - £290,982 (18%)

Effective Tax Rate - 9.94%

Net Proceeds - £2,637,018

For this example, I have assumed that the business owner's relevant income is below £130,000 for the current and previous two tax years. This is to ensure the company is not restricted by the amount of pension it can make for the owner because of the temporary anti-forestalling measures that apply in respect of contributions to pension schemes for high earners.

The Financial Tips Bottom Line

Entrepreneurs' Relief is a valuable benefit that could save you a sizable amount of tax, providing that you qualify. The pension contribution option may be worth considering, however make sure you speak to your professional advisers before taking any action.

ACTION POINT

If you are within a few years of contemplating the sale of your business, speak to your accountant now to ensure that your affairs are structured in such a way that you are likely to qualify in full for Entrepreneurs' Relief.

Entrepreneurs' Relief - Another Company Formation Advantage

There are many benefits of carrying out a company formation to run your new business. For those businesses with a great idea and the potential to grow their company into a large empire worth millions, there are many things to consider. Capital gains tax is one of them. For any business the future can be an exciting prospect.

You'll put blood, sweat and tears into your business and watch it grow. In the future, you want to make the most of all your efforts, without letting the taxman take a large slice. Luckily, with the current state of the economy, the government has noticed the importance of small business to the financial stability of the Country and as a result are keen to encourage growth. One of the measures they have put in place to do this is Entrepreneurs' Relief.

What is Entrepreneurs' Relief?

The Entrepreneurs' Relief scheme was originally started back in 2008 with the intention of giving some tax relief to SME's with regards to capital gains tax. An individual is given a lifetime limit (previously £1million - now raised to £2million under the new budget) under which they are given relief from capital gains tax.

What is Capital Gains tax?

Tax is charged at a rate of 18% on any capital gain made by an individual in the course of running or disposing of a business. "Capital gain" is defined by HMRC as "...the amount by which the disposal value of a chargeable asset exceeds its acquisition value." In layman's terms this means if when selling an asset you make more money than you actually paid for it, then you will be liable to pay tax on that profit at the current rate (18%).

How does Entrepreneurs' Relief help?

The Entrepreneurs' Relief scheme means that any individual making a capital gain, will not have to pay the full tax rate (18%) but instead will only be required to pay a lesser rate up to their lifetime limit. As long as they satisfy the necessary criteria.

The capital gains and capital losses must be balanced to come up with a net figure. That figure is then subject to relief, calculated thusly:

This 'net gain' is...reduced by 4⁄9 and the reduced figure is chargeable at the rate of Capital Gains Tax - 18% for 2009-10 but at an effective rate of 10%.

To clarify 4/9 is roughly 44%. So if you had a capital gain of £100,000, then you would find 44% of this figure (100,000 x 0.44 = 44,000) and that figure is then taxable at the standard capital gains tax rate, rather than the entire amount. You can see that this is quite beneficial for entrepreneurs as it provides substantial tax relief. With relief, you pay £7,920 tax on a £100,000 gain, without it you would pay £18,000! When you consider that Entrepreneurs Relief is now set to a lifetime limit of £2million you can see the Government are making a substantial subsidy for business people.

What are the qualifying criteria?

There are certain specific qualifying criteria which need to be satisfied in order to benefit from Entrepreneurs' Relief. Firstly the gain must have been made on assets used in/by the business or assets owned by the relevant person but used by the business. The claim must be submitted within a year of the disposal and apply to:

- Disposal of whole business - which the individual owned.
- Ceased business - assets sold 3 years after business ceased trading (?)
- Sale of shares of your personal company*
- Associated disposal - basically disposal from a partnership

*personal company is defined as a company in which a person holds at least 5% of the ordinary share capital (and the voting rights that go with it).

Getting there

If you've got a great idea and can see it being worth a lot in the future, then you'll need to be aware of things like this. Carry out a company formation with a formation agent and make sure you have the most tax efficient company possible. These are the first important steps to making the most of your business idea.