CAN SELLERS STILL BENEFIT FROM ENTREPRENEURS RELIEF (ER) ON A SHARE FOR SHARE EXCHANGE?
It has become increasingly common for successful start-up companies or even personal service companies to be purchased by their clients. Usually, this is a way for larger companies to guarantee the services of a key partner business or individual.
The structure of those acquisitions often sees all or the majority of the shares in the smaller target company (SmallCo) purchased in return for the issuance of shares in the larger purchasing entity (BigCo). (Share for share exchange).
BigCo now has secured the services of SmallCo by making it a subsidiary, with its former owner having a shareholding in the overall business. From a tax perspective, the selling shareholder has made a capital gains tax disposal of his shares. However, a special tax roll-over relief applies to share for share exchanges (where all conditions of the legislation are met) which treats the original shares and the new shares as the same asset acquired at the time the original shares were acquired. Therefore, when the new shares are sold their ‘acquisition price’ for the purpose of calculating capital gains tax is deemed to be the value the original shares were obtained for.
However, this could have a detrimental effect on sellers who would otherwise benefit from Entrepreneur’s Relief (ER) of 10% on any capital gain (as opposed to standard rate of 20%). The reason for this is that one of the conditions for ER is that the seller’s shares must amount to 5% of the company.
So where someone sells 100% of SmallCo in return for 3% of BigCo, the sale of the shares in BigCo (although deemed to be the same asset) will not qualify for ER.
Thankfully this mismatch has been identified and a special tax rule enables the seller to make an election for the roll over treatment to be waived and the gain in the shares (up until the point of exchange) to crystallize and benefit from 10% ER.
In order to benefit from this, it is necessary that the election must be made on or before the second 31st January following the end of the tax year in which the share for share transaction takes place.
Corporate and tax lawyers should discuss this together with affected clients so they can consider the ER benefits against the requirement to fund the 10% tax charge without having received cash proceeds for the shares.