An overhaul of the test for Entrepreneurs’ Relief, which allows qualifying shareholders to pay capital gains tax at a reduced rate of 10% on the disposal of shares in personal companies, will reduce the number of shareholders entitled to claim the relief.

Changes introduced following the 2018 Autumn Budget aim to ensure that only those individuals with a genuine 5% or more “economic interest” in a company will qualify for the relief. Also, the qualifying holding period, during which both the old and the new tests must be satisfied, has been increased from one to two years for disposals made on or after 6 April 2019.

The original test requires that, in addition to being an officer or employee of the company, an individual holds at least 5% of the ordinary share capital and voting rights in the company. Now, one of two new tests must also be met.

The less onerous “proceeds” test requires that the individual would be entitled to receive at least 5% of the sale proceeds that would be payable to all ordinary shareholders if the company was sold on the day of the disposal.

The taxpayer must have held that entitlement throughout the qualifying holding period.  However, the value of the company at the date of disposal is assumed to apply for the entire holding period, making the test relatively user friendly and potentially available for growth shares even where the hurdle would not have been met for the full two previous years.

It is not all plain sailing and some “preference shares” which do not have a fixed entitlement to a dividend but, instead, have an entitlement which will vary depending, for example, upon profitability, will be regarded as ordinary shares rather than preference shares for the purpose of assessing the 5% entitlement.

The much more demanding alternative requires the individual to have at least a 5% interest in the company’s distributable profits and assets available on a winding up to the equity holders generally. Its application is both extremely complex and burdensome, requiring detailed consideration of rights available to the company’s loan creditors in addition to any preference shares, and share valuations over the entire holding period. It is not well suited to complex share structures and is likely to fail where, for example, so-called alphabet shares are involved.

The new tests create uncertainty and make determination of eligibility more complex. Advice should therefore be sought well in advance if a disposal of shares is being considered.

EMI shares will not be affected by the 5% “economic interest” requirement, in the same way that the 5% nominal value and voting rights tests do not apply, but will be subject to the extended 2 year qualifying period, although this includes any period where the shares were held under option.

On the positive side, to protect an individual’s entitlement to the relief where a minority shareholding is diluted below the 5% threshold as a result of new equity investment, the shareholder may elect to claim a notional gain accrued up to the point of dilution thereby locking in the relief. Payment of tax due on the notional gain may be postponed until the shares are sold with any subsequent gain being taxed at full rates.