Reform needed for 5% shareholding req for Entrepreneur’s Relief

Current tax rules require shareholders to be officers or employees of a company and hold 5% of the ordinary shares (and voting rights) for a 12 month period prior to sale to qualify for the holy grail of entrepreneur’s relief (ER) – ER results in a 10% personal capital gains tax rate (CGT) as opposed to a top rate of 28% CGT which is worth a potential £1.8m in tax savings.

I am currently encountering 3 common problems related to this condition in advising fast growth tech companies:

  1. Founders are seeing their equity being diluted as they approach much needed successive investment rounds and may therefore find themselves sinking below the 5% threshold – what adverse impact might this have on the funding decisions of business founders?
  2. You need to hold the 5% minimum requirement for 12 months prior to sale – what about employee shareholders who exercise share options just prior to sale (because that’s all the share option scheme permits)?
  3. What if a Founder is willing to share equity with a number of key employees (and reach the 5% threshold in each case) but is unwilling to relinquish voting rights? Especially if say 5 or more shareholders are given 5% each thereby breaching the 75% ownership limit necessary for passing special resolutions? Although this can often be managed via a shareholder agreement, some founders may be unwilling to enforce their (perceived) rights by suing for breach of contract.

Clearly, any tax incentive worth a potential £1.8m requires conditions and safeguards but it is disappointing when these conditions lead to skewed and sometimes uncommercial decisionmaking.

What changes or improvements would you like to see made to entrepreneurs relief?

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