Having considered how business relief works for inheritance tax purposes and the impact on it of cash held by companies, I now want to turn to the potential impact of such cash and investments on capital gains tax entrepreneurs’ relief.
I am grateful in this for the views and practical help of Peter Rayney of Peter Rayney Tax Consulting Ltd, someone who has worked closely with advisers to help them design and implement practical tax planning for SMEs.
First we need to consider what entrepreneurs’ relief delivers and what conditions need to be satisfied to qualify for it.
Entrepreneurs’ relief enables company shareholders to sell their company at a modest 10 per cent CGT rate on cumulative lifetime gains of up to £10m. With a main CGT rate of 20 per cent, this means entrepreneurs’ relief produces a maximum tax saving of £1m, that is, £10m x 10 per cent (20 per cent less 10 per cent).
Most companies will easily meet the entrepreneurs’ relief requirement to be a “qualifying trading company or holding company of a trading group” throughout the 12 months prior to the share disposal.
That said, some profitable companies seek to invest their surplus funds in property or other types of investment. If substantial amounts are directed towards investment activity, the relevant company may fail the relatively stringent entrepreneurs’ relief “trading” requirement in s165A TCGA 1992 (see also s169S (5)).
For entrepreneurs’ relief purposes, the relevant company must be entirely trading subject to an important de minimis rule that enables “non-substantial” investment activities to be ignored (s165A (3) TCGA 1992).
The assessment of a company’s entrepreneurs’ relief trading status can be a subjective exercise. However, HM Revenue & Customs has indicated it would apply a 20 per cent test when assessing whether the investment activities were substantial. This 20 per cent benchmark would be applied across a wide range of measures, including:
- Asset base
- Time spent by management and employees.
For example, the turnover/sales income from non-trading activities would be compared with the total turnover generated by the company and so on. It may be necessary to build up the correct picture over time, which might involve striking a balance between all these factors (IR Tax Bulletin, Issue 62, December 2002).
There is also a view that the profit and loss account provides a better measure of “activity” than the balance sheet, and therefore more weight should be given to a company’s turnover, income and employee costs.
But while the 20 per cent de minimis rule adopted by HMRC provides a helpful safe-harbour test to apply in practice, it should not be taken as a definitive statutory test.
In marginal cases, the precedents established by Farmer (Farmer’s Executors) v CIR  STC (SCD) 321 and HMRC v Brander (as executor of the will of the late fourth Earl of Balfour)  UKUT 200 (TCC) can be helpful. They essentially require us to look at the business in the round.
Interestingly, in the Brander case, the Upper Tier Tax Tribunal placed far greater weight on turnover, profitability and the activities of the employees rather than the capital employed on each business activity.
So holding substantial investments can be detrimental. The big question for companies with surplus cash is whether merely holding it is considered to be an investment for this purpose.
You will be able to appreciate how this can happen. You are running a successful business, you are wrapped up in it and it is going well. It is profitable and the all-important cash is flowing. But the business takes up all of your time. You are planning current resources, securing new clients and developing the existing relationships you already have. And then there is the need to spend some time on strategy, something too few business owners do but something everyone knows is vital.
I will conclude this look at the realities and tax consequences of having surplus business cash next week.
Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn