The entrepreneurs’ relief update (Part 4)

Peter Rayney concludes his series on the latest entrepreneurs’ relief changes.

The following is a fully-worked example explaining the mechanics of the new entrepreneurs’ relief (ER) ‘shareholder dilution’ election.

Example: ER and issue of shares to private equity provider

BoRhap Ltd was incorporated in July 1985. Since then its issued share capital has always been held by its management team, as shown below:

Shareholders £1 Ordinary shares Ordinary shares

Nominal value/voting

rights/capital rights

Mr Scaramouch 24,000 48%

Mr Galileo 10,000 20%

Mrs Figaro 8,000 16%

Miss Bismillah 8,000 16%

50,000 100%

All the shareholders, therefore, currently qualify for ER.

However, in May 2019, the BoRhap Ltd directors reached a broad agreement for £5 million worth of debt and equity funding, which was required to finance a major capital expenditure programme. The proposal was that the private equity fund, Rhapsody Equity LLP, would inject £5 million into the company by way of:

500,000 £1 A ordinary shares;
3,500,000 £1 preference shares; and
£1,000,000 loan notes.

Following the private equity funding, all the classes of issued shares in BoRhap Ltd would carry a right to a variable dividend. All these shares would, therefore, constitute ordinary share capital under the wide definition in ITA 2007, s 989.

For the purposes of the funding exercise, BoRhap Ltd has been valued at around £10.2 million.

Under the proposed shareholder’s agreement, all the voting rights would vest in the existing ordinary shares (51%) and the A ordinary shares (49%). The capital rights (including a surplus on a winding-up) would be based on the same proportions as the voting rights but would be ‘paid-out’ only after the £3,500,000 of preference shares had been fully repaid.

Consequently, following the injection of the equity finance, the company’s share capital structure would be as summarised below.

Shareholders	£1 Ordinary shares 51% voting	£1 A Ordinary shares 49% voting	£1 Preference shares Non-voting	Ordinary shares Nominal %
Management shareholders
Mr Scaramouch	24,000			0.6%
Mr Galileo	10,000			0.3%
Mrs Figaro	8,000			0.2%
Miss Bismillah	8,000			0.2%

Rhapsody Equity LLP		500,000	3,500,000	98.7%
	50,000	500,000	3,500,000	100.0%

After BoRhap Ltd issues shares to the private equity provider, all the original ‘management’ shareholders will be diluted below the 5% issued ‘ordinary share capital’ threshold for ER purposes. That is sufficient to cause BoRhap Ltd to cease being their ‘personal company’ (within TCGA 1992, s 169S(3)).

However, the original ‘management shareholders’ could capture the (unrealised) ER-eligible gains on their separate shareholdings immediately before the new share issue. By making an election under TCGA 1992, s 169SC, each management shareholder would be deemed to sell and immediately re-acquire their shares prior to the new share issues to Rhapsody Equity LLP.

For these purposes, each shareholder’s deemed disposal consideration would be a pro-rata share of the value of the company at that date. The legislation specifically requires this valuation treatment, which is very beneficial as this avoids any normal minority valuation discounts.

Thus, assuming the market value of the entire company is £10.2 million, the shareholders’ ER-protected capital gains would be as calculated below:

	Mr Scaramouch	Mr Galileo	Mrs Figaro	Miss Bismillah
Proportion of £10.2m deemed sale value	48%	20%	16%	16%

	£’000	£’000	£’000	£’000
Deemed disposal proceeds	4,896	2,040	1,632	1,632
Less: Base cost (assume negligible)	(-)	(-)	(-)	(-)
Gain qualifying for ER	4,896	2,040	1,632	1,632

The shareholders’ base costs for future CGT purposes would be the same as their deemed disposal proceeds.

Practical Tip:

In the vast majority of cases, shareholders will wish to elect to defer the CGT on their ‘dilution election’ ER-eligible gains until a subsequent actual disposal of their shares takes place. This is done by making a separate ‘supplementary’ election under TCGA 1992, s 169SD.