Claiming Business Asset Disposal Relief on share disposals
The devil is in the detail when claiming Business Asset Disposal Relief on share disposals. This article discusses the conditions that need to be fulfilled and those pitfalls to avoid.
Overview
Entrepreneurs' Relief (ER) was renamed Business Asset Disposal Relief (BADR) by Finance Act 2020. BADR is a Capital Gains Tax (CGT) relief that reduces the rate of tax paid to 10% on the disposal of business assets. This relief is capped at a lifetime limit of £1 million worth of capital gains, making it a significant consideration for business owners and shareholders contemplating a sale.
It can apply to disposals of a sole trade and its assets, partnership interests and assets, shares in your own company, joint venture interests and business assets held by a trust. However in this post we're going to focus on the rules applying to the disposal of share sin your own company.
Qualifying conditions generally
Understanding the qualifying conditions for BADR is vital if you're claiming Business Asset Disposal Relief on share disposals . Meeting these conditions determine whether the significant tax advantages of BADR can be applied. BADR will apply to capital gains made on the disposal of shares or securities in a company when either of the two conditions A or B covered below, apply.
Condition A:
Throughout the period of two years prior to the disposal, the company is either a trading company or a member of a trading group
For two years prior to the disposal, the individual owns:
Condition B:
Within three years immediately before the disposal, the company ceased to be either a trading company or a trading group, and Condition A applied throughout the two years before that cessation.
There is no requirement for the company to be in the UK, meaning disposals of shares in overseas companies by UK resident shareholders can qualify provided the conditions are met.
Examples
To provide some further context here's some examples.
Qualifying shares
Trading or investment company shares?
BADR is primarily aimed at trading companies, which are actively engaged in commercial activities. For shares in a trading company to qualify, the company must be a trading company or the holding company of a trading group.
Conversely shares in companies primarily dealing with investments, for example rental properties or holding shares in other companies, generally do not qualify for BADR. The distinction lies in the company's main activities. HMRC have detailed the circumstances where they consider a company is likely to be considered an investment as opposed to a trading company.
Definition of ordinary share capital
Ordinary share capital is defined for the purposes of BADR as “all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits”.
Care must be taken when assessing whether you hold 5% of assets available for distribution on a winding-up if there are loans that are not normal commercial loans; shares that appear to qualify for relief may not. There is currently no guidance from HMRC on this point.
It's also important to check your shares if they have unusual or bespoke rights attached to them. Additionally where you are disposing of shares in a non-UK company you'll need to confirm that the company actually has share capital. This might be an issue with some overseas entities that the UK views as transparent even though they are viewed as companies locally.
Potential issues with claiming BADR
We cover below some potential issues that need to be considered when claiming Business Asset Disposal Relief on share disposals.
Dilution of shareholding after commercial fundraising
Where your shareholding is diluted below the 5% threshold after a commercial fundraising and a future sale would not qualify for BADR you can elect to treat your shares as disposed of and immediately reacquired at market value (a notional disposal) and claim BADR.
However a condition of the election is that you ceased to hold shares in a personal company (in other words your stake falls below 5%) as a result of a cash share issue for commercial purposes and the purpose of this was not obtaining a tax advantage.
Additionally your shareholding must have met all the qualifying conditions for BADR had your shares been disposed of immediately before the fundraising event.
You can elect to defer the capital gain arising on the deemed disposal and this will crystallise on a future disposal. Where only part of the shares are disposed of, that proportion of the deferred gain will crystallise.
Trading company and trading group
In order to qualify a company must be carrying on trading activities whose activities do not include to a substantial extent (i.e. in practice, more than 20%) activities other than trading activities.
A company’s trading status is considered by reviewing all its activities and particular circumstances 'in the round'. Investment businesses, such as property rental businesses are often unlikely to meet HMRC's conditions.
A company or business is not regarded as trading if it has substantial non-trading activities when the following is considered:
It should also be mentioned that activities are viewed in terms of what the company is actually doing rather than based on time spent by the employees as determined in this tax case here.
Surplus Cash and your company's trading status
A surplus of cash on your company's balance sheet may be unlikely in isolation to remove trading status from a company; However, a large surplus cash balance combined with substantial investment activities following a cessation of trading activities may indicate that the company has become a non trading company. Shares in such a company do not qualify as business assets for BADR.
If your company has a large temporary cash balance, perhaps on the sale of a property, and be waiting to reinvest in another trade-related property. This may temporarily affect its trade-to-investment ratios, but it would be unwise to automatically say that this means it is not wholly carrying on a trade.
This would be a different scenario to a company that has just been building up cash over the years and is then using that cash as an investment asset.
If your company is sitting on a large cash balance as a result of disposing of its trade or business will be invariably liquidated or dissolved. BADR should apply for the return of capital to shareholders provided that conditions A or B (referred to above) are met and your company is wound up and distributions are made within three years following its disposal.
If you do require certainty, HMRC operates a clearance service which companies can use in order to determine trading status, this may be useful for cash-rich companies.
Inadequate record keeping
Maintaining detailed records of share ownership, roles within the company, and the nature of the company's activities is crucial. Inadequate record-keeping can lead to challenges in proving eligibility for BADR.
Officers and employees
There is no requirement that an employee should work full-time, and an officer can include a company secretary and a non-executive director. Where an officer or employee is leaving they should remain in post until the day of the share disposal and not resign, for example, a day earlier.
Multiple shareholders or employee share schemes
One of the many advantages for Enterprise Management Incentive (EMI) option holders is that they qualify for BADR regardless of the size of their eventual shareholding provided that they hold their options for 24 months.
However this is not the case for participants of non-EMI company share schemes who may start off with 5% of a company but due to further allotments to new shareholders may see their shareholding diluted to drop below 5%. This has also been noted to apply in the case of share reorganisations
Failure to seek professional advice
Incorrectly claiming BADR can result in significant tax liabilities and potential legal challenges. It's essential to understand the rules thoroughly or seek professional advice to ensure compliance.
In one tax case an individual failed to declare the gains on the sale of the shares in his company and as a result, suffered penalties for an incorrect return. . He had failed to take proper advice in respect of the transaction; once he had confirmation that BADR applied he did not want to pay further advisers fees. This was a costly mistake as the penalties imposed were in excess of £95,000.
Summary
In conclusion, while BADR offers substantial benefits for share sales, it's surrounded by complexities that require very careful consideration.
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