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When can you claim ER if you don’t own enough shares?

Adrian Mooy - Wednesday, March 11, 2020
 
ER conditions

 

While the conditions for capital gains tax (CGT) entrepreneurs’ relief (ER) were made tougher in April 2019, there was also good news for shareholders of companies who raise more capital by issuing more shares. Prior to the new rules the issue of new shares could result in an existing shareholder losing their entitlement to ER.

 

Example. Acom Ltd, a family company, has ten shareholders who own between 5% and 15% of the company’s shares. John owns 5% and has proportionate voting rights on company matters. Acom needs more working capital and intends to offer new shares to existing shareholders. John can’t afford to buy new shares. But if he doesn’t his stake in Acom will be diluted to less than 5% and he’ll lose his right to ER.

 

Individuals whose shareholding is diluted on or after 6 April 2019 to below the 5% qualifying threshold as a result of a new share issue can make an election to preserve their right to ER, but only for the period up to the date on which the new shares were issued. ER doesn’t apply to capital gains made after that date unless the individual acquires more shares so they again meet the 5% condition. If you make the election you might trigger a CGT bill.

 

Deemed sale

 

One of the terms of the election is that the shareholder is treated for CGT purposes as if they sold their shares. The amount they are deemed to receive for them is a proportion of the value of the whole company. For example, if Acom was worth £1 million, the value of John’s 5% stake would be £50,000. If the cost of John’s shares was, say, £5,000, he is deemed to have made a capital gain of £45,000 but because ER applies he’ll only pay tax at 10% of the gain after deducting any exemptions or reliefs he’s entitled to.

 

Timing

 

The time limit for making an election is twelve months from the 31 January that follows the tax year in which the new shares were issued. So if the shares were issued on 1 May 2019 the election must be made by 31 January 2022. Once the election has been made it is irrevocable.

 

Avoiding the CGT bill

 

Paying CGT, even at the ER rate of 10%, might not seem like an especially great deal as it means you’ll have to find the cash to pay the tax despite not actually having sold anything. However, a different election can be made to defer the gain from being taxed until you actually sell or transfer your shares. The time limit for this election is four years from the end of the tax year in which the new shares were issued, e.g. for shares issued in 2019/20 you have until 5 April 2024.

 

Under rules which took effect on 6 April 2019 you will lose ER if your shareholding falls to less than 5% of the company’s total share issue because of a new share issue. The good news is that by making two elections you can preserve your entitlement to ER and defer the tax bill that results until you sell your shares.

 

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