- Impact on sole traders
- Impact on partnerships
- Shareholders in companies
- Associated disposals
- Capital gains tax calculator
Entrepreneurs' relief provides relief for disposals by smaller business owners. It produces a net tax rate of 10% on the disposal.
The relief is available on material disposals of business assets which covers businesses operated as a sole trader, partnership or through a limited company. There is also a form of relief for businesses owned within a trust, by reference to the beneficiaries of the trust, although this will not increase the amount of relief available over and above that for an individual owner.
The maximum gain to which relief can apply is currently £10 million, this rate applying from 6 April 2011 (prior to that the following limits applied: £2 million up to 22 June 2010, £5 million from 23 June 2010). This is a lifetime limit so an individual making a number of disposals of businesses during his lifetime may exceed the limit. The value of the relief from 6 April 2011 is therefore £10 million x 18% (the reduction in tax) = £1,800,000. This should be borne in mind when considering appropriate planning steps, as they may have negative consequences.
The conditions for relief and operation of the relief differs slightly for the three types of business entity, so they will be considered separately. For more information on the following, use the links below:
Entrepreneurs' relief - impact on sole traders
The relief is available in two situations applying to sole traders :
- The sale of all or part of the business, and
- The sale of assets which were used in a business which has ceased trading within the last three years.
What is a business?
The law defines business as any trade, profession or vocation, carried on on a commercial basis with a view to profit, and extends this definition to include furnished holiday lettings, which normally attract the more beneficial treatment accorded to business assets by capital gains tax rules. It is important to note, therefore that other letting activities, whether residential or commercial do not qualify as business activities for the purposes of this relief.
The relief includes a condition that the business has been operated for at least 12 months prior to the disposal.
All or part of the business
The relief is intended to meet the needs of those disposing of businesses, and not those merely selling assets so the qualification is that the trader either sells the whole business, or a distinct part of the business as a going concern, or ceases trading completely, or in one particular aspect of his business activities and sells the assets relating to that.
In considering whether a particular business activity has separable parts, it is likely that HMRC will use test cases under an old relief known as retirement relief. Although this relief was withdrawn a few years ago, the new relief is very closely modeled on the terms of retirement relief, so the old cases will very likely be a good place to start.
A farmer has made extra money over the last few years by selling off small plots of land to adjoining properties as extra garden. He has been able to take taper relief on these disposals. However, under the new rules, no relief will be available, as he is not selling all or a distinct part of his business. He would need to cease trading completely to qualify for relief.
As an alternative, he may have some established stabling and livery activities on a small field. If he were to either sell this part of his farming activity as a going concern, or to cease this activity and sell the field and stables (possibly for redevelopment) he would be able to claim relief in relation to the cessation or disposal of a distinct part of his business.
There is no restriction in relief if the business is sold to a connected party, so Entrepreneur's relief will be available on the sale of the business as a going concern to a company owned by the individual. Any gains on assets - and particularly on goodwill generated in the business - would therefore benefit from the relief. However, as is always the case with goodwill, the valuation basis is likely to be closely scrutinised by HMRC, and therefore careful thought must be given to arrive at an appropriate value, and to ensure that "free" (i.e. transferable) goodwill actually exists. The goodwill can then be amortised against the company's profit, which may be an allowable deduction for tax purposes, depending on when the business commenced.
Entrepreneurs' relief - impact on partnerships
The sale of all or part of a partner's share of his interest in a partnership will attract Entrepreneur's relief to the extent that the sale generates a capital gain. The treatment of goodwill in partnerships is a complex issue and subject to HMRC guidance, so making general comments about this area is a little risky, but provided such a sale is taxed as a capital gain, the entrepreneurs' relief will apply to the disposal.
As for sole traders, the partnership can be carrying on any trade, profession or vocation, including furnished holiday letting activities, but the relief will not be available when the partnership is merely an investment vehicle, such as one which lets property other than as furnished holiday lettings. The partner making the disposal must have been a member of the partnership for at least 12 months prior to the sale to qualify for relief.
There is also relief available in a partnership environment for the sale of an asset owned personally by one or more partners (i.e. not by the firm as a whole) when they withdraw from the business. This is termed and "associated disposal" and is dealt with separately here. It provides extended relief when for example, the partnership premises are owned privately by one partner, who disposes of the premises on his withdrawal from the partnership.
Entrepreneurs' relief - shareholders in companies
Relief is available on the disposal of shares and other securities in limited companies provided that the various conditions relating to this type of disposal are met.
The company must be a trading company or the holding company of a trading group in the 12 months leading up to the date of disposal. The definition of a trading company is based on the activities the company carries on. A trading company is a company which carries on trading activities and to no substantial extent carries on activities other than trading activities.
This test has been in use for some time, and we have had guidance about the interpretation of the test from HMRC for a number of years, although the interpretation of the guidance has never been tested in court. Essentially if a company carries on only trading activities and has no investments on the balance sheet it will meet the definition. Once there are assets on the balance sheet which constitute investments, the company must consider the "to no substantial extent" test. The guidance indicates that this is a 20% test, and that in considering it HMRC will consider the time spent by the directors of the company on the various activities, the income received from the activities and the value of assets held in relation to those activities. Large cash balances were considered to be a problem historically, but if the cash is not actively managed and is derived from the trade it is possible to argue that this does not constitute an activity as such.
The difference with the new rules is that the test only has to be met for at least 12 months prior to the disposal rather than 10 years as was the case with taper relief, so if there is concern about a company, then appropriate action can be taken well before sale to ensure that at the point of sale the company has met the trading activities test for at least 12 months.
The ownership of the company
In order to qualify for relief the disposer must own at least 5% of the ordinary share capital of the company, which must entitle him to at least 5% of the votes. The disposer must also be an officer or employee of the company, and all conditions must be met for at least the 12 months leading up to the disposal.
Once the conditions have been met, the disposer is at liberty to dispose of any shares or securities (including loan notes) in the company provided these meet the definition of securities, however long they have been held. Relief would extend to shares owned for a much shorter period, provided that the base level of 5% has been owned for a minimum of 12 months (and the officer / employee test has also been met for the same period).
Winding the company up
Where it is intended to cease trading and wind the company up by striking it off as inactive, the relief can still apply provided:
- the distribution of the assets is taxed as a capital distribution and not income
- the distribution takes place within three years after the company ceased trading
- the relevant conditions were met in the 12 months prior to the cessation of trade by the company.
This allows those with smaller businesses operating through limited companies to take relief when winding up their company through a striking off and distribution of the assets. Such distribution is taxed as capital if less than £25,000 and as income if more than that amount. This applies to striking off only. If the distribution of assets exceeds the £25,000 limit, a liquidator must be appointed in order for the capital treatment to be secured.
Special rules in relation to shares
Where the owner of a company is bought out by another company in which he receives shares in exchange, the relief may in future be compromised when the shares received are less than 5% of the share capital of the new parent company.
In this case, the terms of the new relief allow the disposer to elect that the rules on take-overs should not apply. This would mean that the disposal of his shares would be treated as triggering a capital gain to which entrepreneurs' relief could apply, rather than being treated as rolling the cost of the old shares into the new shares.
This convenient election means that if he chooses, a company owner might elect to pay the tax due on the initial disposal to ensure that he benefits from relief. However, he would be faced with a tax bill of 10% of the gain, which he may not have the funds to meet. The election would not allow him to defer the tax payable, so this is one of the key downsides to this provision.
Disposal in return for qualifying corporate bonds (QCBs)
Further business reorganisation provisions allow for a disposal which qualifies for entrepreneurs' relief but under which QCBs are acquired to be treated as if the entrepreneurs' relief is applied to the gain on the initial disposal, so that on a subsequent disposal of the QCBs the gain treated as arising at that point is the gain after entrepreneurs' relief.
Where premises occupied by the company are owned personally by a shareholder then relief may also be available on the gain on disposal of the property, provided the disposal is made after the shares have been sold and the individual withdraws from the company. This is a very common scenario and is an important aspect of the relief. More details of this are here
Entrepreneurs' relief - associated disposals
The relief available on associated disposals is more complex than the basic relief, and is applicable after the relief available in respect of the disposal of shares or of the partnership interest.
An associated disposal of business assets is the disposal of assets owned by an individual and used in a business carried on by a company or partnership in which the owner of the asset has made a material disposal as a result of withdrawing from the business.
It is very common when trading through a limited company to retain the premises from which the company trades in private ownership. This is quite often the only way in which finance to purchase the premises can be secured.
The disposal of the premises (or other asset) must take place after the material disposal - that is the disposal of the business itself - otherwise no relief will be available. Once the disposal of the business has been made, then provided for the period of 12 months ended with the earlier of the disposal of the interest in the business, or the cessation of business of the partnership or company the asset was in use for the business of the company or partnership then relief may be available.
Restrictions on relief
Full relief would be available on the gain (subject to the £10 million limit) only where the asset has been used wholly in the business rent free throughout its entire period of ownership. If the asset has been used for other purposes, or rent has been charged, then the relief may be restricted.
Where the asset has been used for other purposes either in part or in full at some time during its period of ownership, the gain on disposal will be apportioned to exclude from relief the amount relating to the non business use - either on a time basis or another apportionment if only part of the asset was used for the business.
With regard to rent, only rent charged on or after 6 April 2008 will be taken into account when restricting relief, but where rent has been charged since that date the rent actually charged will be compared to the market rent for the property. A pro rata adjustment will then be made to block relief on the part of the gain represented by the proportion of rent charged.
If the rent charged after 6 April 2008 was full market rent, then none of the gain after that date would qualify for relief. The gain would need to be time apportioned, and the amount relating to the post April 2008 excluded from relief.
If the rent charged after 6 April 2008 represented only 20% of the market rent, then 20% of the gain post April 2008 would be denied relief.
As a result, owners of property used by their company or partnership will need to consider whether it is appropriate to continue to charge rent on the property. This is a very complex issue which warrants detailed study based on the full facts and intentions of the business owner.