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Joe and the dragon

Entrepreneurs’ relief is on the face of it a very simple relief. Most people who have considered it will tell you that it delivers an effective rate of 10 per cent on chargeable gains of up to £1m made on the disposal of a qualifying business asset. Most will also probably know that the £1m limit is a cumulative lifetime limit.

It is actually a little more complicated than that. There is no 10 per cent rate as such. The relief operates by taking the gain – without the benefit of indexation allowance or taper relief, of course – and then reducing it by a fraction of four-ninths. The remaining five-ninths will remain taxable at the new flat rate of 18 per cent.

For example, Joe sells his trading business and makes a chargeable gain of £450,000. It is a qualifying disposal, so four-ninths (£200,000) is not subject to tax. The balance of £250,000 is subject to tax at 18 per cent. This leaves a liability to capital gains tax of £45,000, assuming that the annual exemption is being used elsewhere. This £45,000 equates to 10 per cent of the gain.

Joe will have used up £450,000 of his £1m lifetime allowance as this relates to chargeable gains not exempt amounts.

Unlike business assets taper relief, there are two important personal conditions to satisfy for the disposer to qualify for entrepreneurs’ relief.

The owner of an unincorporated business needs to be the one carrying on the business that is disposed of. Most sole traders and partners will satisfy this test.

However, for the shareholder in a trading company who is disposing of shares, those shares need to be in the shareholder’s personal trading company.

To qualify, the individual making the disposal must:

  • Be an officer or employee of the company or of a company in the same group of companies andl Own at least 5 per cent of the ordinary share capital of the company, with that holding enabling the individual to exercise at least 5 per cent of the voting rights in the companyIt is these conditions that will hit most uninvolved shareholders and employees with small shareholdings.

    In some cases, company shares will be owned by a trust. How does entrepreneurs’ relief work in these circumstances?

    Where a trust owns business assets that could qualify for entrepreneurs’ relief, the relief will be available where three conditions are satisfied:

    i) The trustees dispose of settlement business assets.

    ii) An individual is a qualifying beneficiary of the settlement andiii) One of two relevant conditions, depending on the nature of the business asset being disposed of, is satisfied.

    In more detail, the critical terms are as follows:

    i) Settlement business assets are:

  • Shares in or securities of a company or interests in such shares and securities orl Assets that have been used for the purposes of a business or interests in such assets.

    ii) A qualifying beneficiary must have an interest in possession in the whole of the settled property or in a part of the settled property that contains the settlement business assets disposed of.

    iii) In the case of shares in a business, the relevant condition is the condition that the qualifying beneficiary (the one with the interest in possession) would have to satisfy if he or she were an individual claiming entrepreneurs’ relief, throughout a period of one year ending within the three years up to the date of disposal:

  • The company is the qualifying beneficiary’s personal company, that is, the shares supporting the individual beneficiary’s interest in possession represent at least 5 per cent of the voting rights in the company.

  • The company is a trading company andl The qualifying beneficiary is an officer or employee of the company.

    Where the assets are not shares, they need to have been, throughout the period of one year ending within the three years up to the date of disposal, used for the purposes of a trade carried on by the qualifying beneficiary and the qualifying beneficiary ceases to carry on the business at some time in the three-year period up to the date of disposal.

    Provided all the usual tests are satisfied by the beneficiary with the interest in possession, any relief given will be set against the £1m lifetime limit of the qualifying beneficiary although the tax actually due will be paid by the trustees.

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