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HMRC was recently successful in a case at the First Tier Tax Tribunal in relation to the denial of a claim for Business Asset Disposal Relief (“BADR”) (formerly Entrepreneurs’ Relief). The case might be of interest to a number of businesses which are employee-owned or operate employee share schemes and of course the employee shareholders themselves. BADR is a valuable relief that, when the qualifying conditions are satisfied, reduces the Capital Gains Tax (“CGT”) rate from 20% to 10% up to a total lifetime allowance of £1m of capital gains.

To recap the rules, BADR is generally available on the disposal of business assets by an individual which has been held for at least two years at the date of disposal. Business assets can include an interest in a partnership or a sole-trader business, however, it applies most commonly to shares in trading companies. For a shareholder to qualify for BADR on a sale of shares they must have, for two years prior to the sale, owned a shareholding which entitled them to:

  • 5% of the ordinary share capital by nominal value, and
  • 5% of the voting rights, and either (or both)
  • 5% of the profits available to distribution or 5% of the proceeds available for distribution on a sale or winding-up

Collectively, these 5% requirements are known as the “personal company” test.

The case concerned a shareholder who claimed BADR on the disposal of shares in a qualifying trading company. There was no dispute as to whether the company was a trading company or that he had held the shares for two years. However, based on the share capital structure of the company, the appellant had ownership of 4.997285706531% of the voting rights and the share capital by nominal value.

It should be noted that on the sale of the business, the appellant did in fact receive exactly 5% of the sale proceeds. The appellant’s representatives argued that it was always the intention, and was understood and agreed between all parties, that the appellant was entitled to 5% of the business and that the remaining 0.002714293469% required to take him to his 5% shareholding was effectively held on trust for him by the other shareholders. HMRC were not swayed by this argument, and nor was the Tribunal, citing a lack of any indication that any of the shareholders held their registered shares as anything other than full legal and beneficial holders of those shares registered to them.

It might not come as a surprise to many that HMRC would apply the personal company test so stringently, particularly when approximately £273,000 of tax was at stake. It might nevertheless be interpreted by some as harsh, given that the tiny shortfall in the required shareholding by the appellant likely arose through rounding because of the share capital structure of the company.

However, opinions on the ruling notwithstanding, there are some key take-aways from this decision to consider for employee shareholders and owner-managed businesses operating employee share schemes:

  • It might sound obvious, but make sure that anybody who is expected to qualify for BADR meets the personal company test unequivocally. If but one extra share needs to be issued to take a shareholder from 4.999% to 5.000%, make sure it is issued!
  • Plan your share capital structure carefully to avoid any ambiguity with regard to the entitlement of shareholders to voting rights and entitlements to distributable profits and sale proceeds. Share capital structures can often be complicated by the presence of different share classes, priority returns and the dilutive effect of share options to be exercised before a sale. It is crucial to keep track of the economic rights of each shareholder to ensure there are no nasty surprises on a claim for BADR. If shares are to be diluted such that the shareholding would fall below 5%, consider making a S169SC election to crystallise the BADR gain at the dilution point to avoid loss of the relief altogether.
  • Document agreements between parties insofar as possible. The Tribunal might have reached a different conclusion on the existence of a trust over the shortfall in the shareholding had there been any documentary evidence in place between the shareholders that the remaining shares were held on trust for the appellant. Creating an audit trail can be hugely helpful across the whole tax system in the event of an enquiry or challenge from HMRC.
  • Wherever possible, benefit from HMRC-approved share option schemes. The personal company test does not apply to holders of EMI-qualifying shares or share options, and the EMI scheme will be available to a huge number of SMEs.
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