As you will be aware, changes were announced in the October 2018 Budget to the qualifying conditions for Entrepreneurs' Relief (ER) requiring that, as well as holding 5% of share capital (by nominal value) and 5% of voting rights, an ER shareholder should be entitled to 5% of dividends and proceeds on a winding-up at all times during the relevant holding period (one year until 5 April 2019, two years thereafter).

The way in which the tests were constructed was unhelpful in all but the most straightforward equity structures and had the effect of removing ER for many managers, even where there were circumstances in which they could potentially have a 5% economic interest in equity in a company on an exit event.

The Government has now proposed amendments to the new ER legislation which are designed to address various issues raised during consultation on the changes. The amended legislation creates a new, alternative qualifying test to the dividend/winding up test, which is that in the event of a disposal of the whole of the ordinary share capital of the company, the individual would be beneficially entitled to at least 5% of the proceeds.

Overall, this is a helpful change, which may allow some managers to qualify for ER if:

a)  They satisfy the existing ER tests, being that:

  • They hold at least 5% of the shares in the company by nominal value;
  • They hold at least 5% of the voting rights by virtue of those shares; and


b)  throughout the required holding period, the individual satisfies the 5% of dividends/proceeds on a winding-up test announced on Budget Day;


c)  when they sell their shares, they have held them for at least one (or, after 5 April 2019, two) year(s) and are entitled to at least 5% of the proceeds, assuming that the whole of the ordinary share capital of the company were sold for market value at that time, unless there is a reason to expect that they would not have received that percentage of proceeds at any time during the required holding period. (the new 5% economic test).



Overall, the new 5% economic test is beneficial and addresses some obvious shortcomings in the Budget Day changes, but it raises various practical issues:

  1. "Proceeds" for these purposes will be the proceeds of disposal of any "ordinary share capital" of the company. One important question is how far returns on preference shares will be counted into this calculation. This is a question on which there has been some recent case law and where HMRC's published view is not uniformly accepted, so careful consideration of any preference share rights will be essential where ER is in point. On the basis that "proceeds" does not include any amounts received in respect of debt instruments, investors who are able to structure their investments via loan notes rather than preference shares may find that this is helpful in allowing for ER planning in some circumstances.

  2. Preferred ordinary or priority shares are likely to be treated as ordinary share capital, so the returns on these shares will count for the purposes of the test and it is therefore likely that managers will need to hold at least 5% of these in order to qualify for ER.

  3. The test is beneficial for managers holding shares which are subject to a ratchet or hurdle, as it allows their economic entitlement to be calculated based on the market value of the ordinary share capital when the shares are ultimately disposed of. This means that some judgement may be required as to the level of proceeds that management shares are likely to receive on an exit when deciding whether to implement ER planning, it may be necessary to model future returns in order to determine how likely it is that the shares will deliver a 5% economic return to any of the managers.

  4. Whilst the test will generally help any manager who has a 5% economic interest at the time of an exit event, it is important to note that this depends upon it being reasonable to expect that the manager would have had that 5% interest at all times in the required holding period, assuming that the whole ordinary share capital of the company was sold for its market value at the end of that period. Care therefore needs to be taken where an individual's entitlement to proceeds varies over the holding period either because they acquire further shares or because steps are taken (such as a reorganisation of debt or equity) which have the effect of taking the individual's economic interest above the 5% threshold.

  5. Since the test looks at the proceeds that a manager would be entitled to receive if the company were sold at market value on the date when their shares are sold, valuation questions could arise if a manager disposes of shares in a transaction which is not a sale to a third party (for example, in a good leaver scenario).

  6. It is important to remember that the new 5% economic test is in addition to, not instead of, the old 5% ordinary share capital and voting tests and therefore these tests must also be satisfied in the usual way in order for ER to be available.

As a general point, it is important to remember that although these changes are intended to be helpful, the effect is still to limit ER to managers with a 5% economic shareholding and so whilst they may assist managers with a larger shareholding, they will not allow the planning that has previously been done for those with smaller holdings.

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