Investment or trading? It matters when you want to sell.
In our last article we considered the practical aspects of preparing a business for sale. Here we look at the tax reliefs available on sale and how property developers can inadvertently lose out.
Entrepreneurs’ Relief is a Capital Gains Tax relief potentially allowing up to £10m of gains to be taxed at a rate of 10%.
When looking at the disposal of shares in a company, one of the requirements of the relief is that the shares being disposed of are in a ‘personal’ trading company. This generally rules out listed companies, although not those listed on AIM.
Entrepreneurs’ Relief is a Capital Gains Tax relief potentially allowing up to £10m of gains during your lifetime to be taxed at a rate of 10%, instead of the standard rate of 20%. Qualifying for Entrepreneurs’ Relief can therefore save up to £1m per person.
When looking at the disposal of shares in a company, one of the requirements of the relief is that the shares being disposed of are in a ‘personal’ trading company. This means holding at least 5% of the company’s ordinary share capital, having 5% of the voting rights and in broad terms having 5% of the economic value of the company for 24 months leading up to a disposal.
Entrepreneurs’ Relief considers a trading company to be one that does not have ‘substantial’ non-trading activities, and in this context HMRC consider substantial to be 20%. When considering the non-trading activities of the company we have to look at asset value, turnover, profitability and management time.
Property investment companies are not trading for Entrepreneurs’ Relief purposes as the receipt of rental income is considered a non-trading activity. Property development companies, however, are regarded as trading, but this position can easily become blurred where unsold properties are retained for letting.
If you retain properties for rental within your development company, documenting why will be vitally important. HMRC will assess the intention of the directors, taking account of market conditions. Shorter term lets, during a period when it is not possible, or commercially unattractive to sell, will help demonstrate that the investment activities are incidental to the main trade, although HMRC may not agree the company has retained its trading status.
Another issue facing property companies is that they may, over time, have built up substantial cash reserves representing more than 20% of the balance sheet value of the company.
It is recognised that certain companies will need significant working capital because of the nature of their business, or have retained profits from trading activities, and this may not prevent Entrepreneurs’ Relief being claimed. However, HMRC will view each case on its particular facts.
It is worth noting that, generally, the company must have been a trading company throughout the 24 months leading up to the disposal: simply distributing cash shortly before a sale, or stopping letting properties, will not be a solution if the company is susceptible to being challenged on its trading status.
If the conditions for Entrepreneurs’ Relief are not met, none of the gain on the shares will qualify for relief, and will be taxed at the standard rate of 20%.
In addition to thinking about the availability of Entrepreneurs’ Relief on a sale of a company, we need to consider Business Property Relief.
Business Property Relief (BPR) is another valuable relief that can reduce the Inheritance Tax due on a chargeable transaction, whether a lifetime gift or on death. Shares in unquoted trading companies that have been owned for at least 2 years can qualify for 100% relief from Inheritance Tax.
The test of whether a company is a trading company is different to that for Entrepreneurs’ Relief. For BPR purposes, the company must not be engaged wholly or mainly in the making of investments or dealing in land and buildings. The test for BPR is therefore a 50% test.
Factors taken into account when considering Entrepreneurs’ Relief (asset value, turnover, profit and management time) also apply to BPR.
As with Entrepreneurs’ Relief, if the company is not a trading company BPR is not available at all.
Deciding whether a company is trading, and therefore qualifies for Entrepreneurs’ Relief and/or Business Property Relief can be complex, and we would recommend that you seek advice before taking decisions that could affect your ability to claim these very valuable reliefs.
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