What do I need to know about the new rules regarding Entrepreneurs’ Relief and Alphabet Shares?

Last year the Chancellor of the Exchequer was expected to abolish Entrepreneurs’ Relief (ER). This is a relief which reduces the rate of capital gains tax on the sale of shares in a personal company from 20% to 10%.

Instead of abolishing ER the Chancellor made the following changes:

  1. Extending the period of ownership of the shares & application of the rules from 12 to 24 months (from 6 April 2019);
  2. Changed the definition of a “personal company” stating the shareholder must own or control more than 5% of the company’s share capital, be entitled to at least 5% of its distributable profits and at least 5% of its net assets if it were wound up (from 29 October 2018).

How does this affect Alphabet shares?

The application of these rules to alphabet shares initially led to significant debate in the industry. Alphabet shares are different share classes which allow a company to assign different rights to each class, the most notable right being to allow a company to change the rate of dividends or only declare dividends on certain classes and not others.

This right could cause problems when applying the first of the two new economic tests as it does not give a shareholder an absolute beneficial entitlement to any part of a company’s distributable profits.

As the legislation was not intended to penalise companies that have an alphabet share structure, in December an alternative test was included in relation to the percentage of sale proceeds entitlement. There are now 3 tests:

  • that an individual holds 5% of the ordinary share capital and votes of the company

and for tests 2 and 3, that the individual must also be ‘beneficially entitled to’ either:

  • 5% of profits (dividends), and assets available for distribution to equity holders on a winding up of the company, or
  • 5% of the sale proceeds should the whole of the ordinary share capital of the company be sold on the day of the disposal.

Any individuals who sell shares without satisfying these 5% tests (either tests 1 and 2 or tests 1 and 3) will not be eligible for ER.

The policy intention reflected by the Finance Bill 2018/19 is that an individual should have a 5% ‘economic interest’ in a company in order to qualify for ER. This addresses an anomaly or “an identified abuse of the current rules” whereby individuals could hold 5% of the votes and nominal value of the company but not have a commensurate economic interest.

This change is principally designed to affect the eligibility for ER for those who hold shares that have voting rights that are disproportionate to the entitlement to economic benefits in the company. Although, we predict there will be possibly unintended consequences for others.