Threat to Entrepreneurs’ Relief for thousands of family businesses

Simon Warne

Simon Warne

In the 2018 Budget, Chancellor Philip Hammond amended the requirements needed for individuals to qualify for Entrepreneurs’ Relief (ER). 

This, it was announced, was brought in as an effort to protect the tax break from abuse. 

However, while the Chancellor declared that the relief was here to stay, the Finance Bill (No. 3) is set to introduce changes which are much wider than anticipated. 

Many entrepreneurs expected to be able to sell their businesses at a favourable rate of tax (10 per cent), thanks to ER. However, these changes proposed now threaten to deny this valuable relief to those who have a true material stake, potentially impacting a significant proportion of family businesses.

The new tests set out in the draft legislation were aimed at minority shareholders whose shares met the technical tests but were not true 5 per cent stakes.

The changes now require the individual to have at least a 5 per cent entitlement to: 

  • profits available for distribution to equity holders;
  • assets available for distribution to equity holders in a winding up. 

For family companies, the issue lies in the fact that, where there is more than one class of ordinary share capital, the decision of which share class will receive a dividend, and how much, is at the discretion of directors.

Unless the Articles give a particular class of shares a right to dividends, nothing prevents the directors from distributing the profits as they wish. Consequently, no share class may be said to carry an entitlement over the distributable profits, and all share classes will therefore potentially fail the new test. 

Take the following common example: Mr A owns 50 A Ordinary Shares and Mr B owns 50 B Ordinary Shares, and have been in business together for many years.

Their shares rank equally in voting power and assets in a winding up. There are no other shareholders.

The company’s Articles permit dividends to be voted independently between the two classes of share, but there is no minimum entitlement. 

Following the Budget announcement, neither shareholder will qualify for ER, as they have no absolute right to receive at least 5 per cent of the dividends. This is the case even if, historically, actual dividends have been paid equally between them.

There are other common examples where different share classes have been used for perfectly commercial, rather than tax efficiency reasons, such as those companies which have accepted venture capital funding.

Venture capital monies are often represented by a new share class and founders are happy to accept dilution in return for the equity funding needed to grow their business. Dividend entitlements will not have been designed with this change in mind and could easily fall foul of the new provisions. 

If the draft Finance Bill is not changed, business owners may feel aggrieved that these measures, which were introduced overnight, failed to give those who were not the target of the new restrictions any opportunity to amend company Articles in time to ensure their qualification status remained unaffected.