Investors’ Relief (IR) was introduced in the Finance Act 2016 Schedule 14, which received Royal Assent on 15 September 2016. On Budget day it was billed as the ‘little brother’ of Entrepreneurs’ Relief (ER), and headlined as an extension of this popular capital gains tax (CGT) relief. However, a review of the qualifying conditions suggests it has been built from both the ER and Enterprise Investment Scheme (EIS) legislation. The tax break is essentially the same as ER, a 10% CGT rate on the disposal of qualifying shares up to a lifetime limit of £10m of gains. It is important to note that this is an additional £10m limit to ER’s limit, so a taxpayer could avail of both reliefs, in the right circumstances.

Qualifying shares

Like the other two CGT reliefs mentioned above, certain conditions must be met by both the investee company and the investor in order for the disposal of shares to qualify for IR. These qualifying conditions include:

• A new issue of ordinary shares made after 16 March 2016 in an unquoted trading company; and
• Paid for wholly in cash and fully paid up when issued; and
• Shares need to be held for a minimum period of three years from the date of issue (known as the ‘holding period’); and
• Subscribed for and issued by way of a bargain at arm’s length; and
• Subscribed for genuine commercial reasons and not for tax avoidance.

The main difference between IR and ER is that the shares must be subscribed for. This makes family succession planning and transaction planning at investor level much more difficult where IR is sought. One of the requirements for the investor is that they are detached to some extent from the company – for example they generally cannot be an employee (though see later) – meaning company level planning may also be impractical in many circumstances.

The trading test for IR is the same test as in s165A TCGA 1992 for ER, stating that the company must be substantially trading. Although the legislation doesn’t define ‘substantially’, HMRC’s guidance defines it as trading activities greater than 80% of a company’s overall activities. Typically areas such as turnover, asset base and management time would be reviewed to establish whether a company is trading, but there may also be other differentials to take into consideration in establishing a trading identity.

Unlike ER, which requires a look back period of 12 months in the first instance, the company must remain a trading company during the entire period of ownership of the shares in order for IR to be available.

IR does not include the same restrictions as EIS, such as being required to have less than 250 employees and less than £15 million in gross assets. This opens up the availability of IR to a wider group of investees. The rules also have an anti-avoidance motive test, which continues with HMRC’s theme of widening the net on those seeking to exploit “tax advantaged” reliefs. Although listed companies are generally excluded, AIM companies are not, by virtue of AIM not being a recognised stock exchange. This may be where IR is seen to be the most desired option, as AIM companies are less likely to be able to avail of EIS, leaving IR as a possible solution to attract tax efficient investment.

The Q/T formula

It is possible for an investor to own a mixture of qualifying shares, shares that do not meet the qualifying conditions (excluded shares) and qualifying shares that are still within the three year holding period (potentially qualifying shares) in the same company. In this case, the amount of any gain made on a disposal of their shareholding, which will qualify for IR, will be determined by the Q/T fraction where:

• Q is the lower of the number of qualifying shares held immediately before the disposal and the number of shares disposed; and
• T is the total number of shares disposed of in the disposal concerned.

This effectively means that the qualifying shares are treated as disposed of first for IR purposes, meaning those with mixed holdings are not disadvantaged.

Qualifying investors

The conditions that must be met by the individual subscribing for the shares are contained in s169VB TCGA 1992 and can be summarised as follows:

• The taxpayer cannot be a remunerated officer or director of the company during the share-holding period;
• Generally the taxpayer cannot be an employee of the company during the shareholding period. One exception is where employment commences 180 days after the subscription of the shares and there was no prospect of the employment at the date of subscription;
• There is no minimum or maximum shareholding limit in any one company;
• An individual lifetime limit of £10 million gains applies.

The original draft of Finance Act 2016 denied the investor from being an officer, director or employee of the company at all. However the rules were changed following an amendment to the Bill, which allows for business angels to become an officer or director of the company provided they are not remunerated for their services. The amendment also included an allowance for unforeseen employment, which in practice may be difficult to prove. These connection tests also extend to individuals connected with the investor by definition of s286, which includes business partners, and this will need particular attention when targeting IR.

Another amendment made in June 2016 was the extension of a qualifying investor to include trustees and shares jointly subscribed for by two or more individuals. In the former case the beneficiaries must have had an interest in possession in respect of the shares during the three years prior to the disposal, and must have passed the employee connection test to qualify as an ‘eligible beneficiary’. Note that this condition must only be met in the three years prior to disposal and not the entire share-holding period, unlike many of the other conditions.

A potential pitfall here is that the beneficiaries must make an election, by any means, to the trustees before the date of disposal in order to be treated as an eligible beneficiary and for a claim for IR by the trustees to be successful. Although the term ‘by any means’ casts the net wide, it would be advisable that beneficiaries of interest in possession trusts make such an election in writing to cement their position. It is important to note that trustees do not receive their own £10 million lifetime limit. Instead it is the beneficiaries’ own individual lifetime limit that is used up.

New shares subscribed for after the Budget on 16 March 2016 can qualify for IR. However, a special rule in this case has been introduced for shares subscribed for after this date but before 6 April 2016. In this case, the minimum holding period is extended to the 5 April 2019. The effect of this rule means that we will not see claims for IR until the 2019/20 tax year at the earliest. However, much like EIS, disqualifying events during the three year holding period can deny the relief – such as the company ceasing to be a trading company or the shares themselves meeting certain disqualifying conditions.

Disqualification of shares

The shares will become disqualified should the investor receive value from the investee company within the period of one year prior to the subscription of the shares, to the third anniversary of the issue date. Although an aggregated receipt of value less than £1,000 during this period would be ‘insignificant’ and not disqualify the shares. A receipt of value includes:

• Repayment or redemption of share capital;
• Repayment of a debt;
• Transfer of an asset to the investor at less than market value;
• Benefit payments which are not at arm’s length.

Special care should be taken where assets are transferred at market value and where benefits are made at arm’s length during the share ownership period. Although this would not be a receipt of value and would not disqualify the shares, it could trigger a benefit in kind, which would be classed as director’s remuneration and disqualify the investor through the connection test.

The payment of dividends and interest on loans would not be a receipt of value for this purpose, provided the payment does not exceed a commercial rate of return.

Reorganisations

It is potentially possible for qualifying shares received under a reorganisation of share capital, by the meaning of s126, or a s135 share for share exchange, to continue the shareholding period of the previously owned qualifying shares and therefore qualify immediately for IR.

This is only possible when no new consideration is given by the investor to the company for the new shares. Should consideration be given for the new shares, the three year holding period would restart and the new shares would not qualify for IR until the shares have been owned for at least three years.

However, similar to ER, an election is available to disapply s127 and crystalise a gain in order to secure IR at the time of the disposal of the original shares. This of course would likely be a dry tax charge, where no cash proceeds exist. The rules around reorganisations and preserving IR are complex and it is imperative they are treated with care.

Inheritance tax efficient

The ‘substantial’ trading test for IR – the 80/20 test – is a more stringent test than the test for Business Property Relief (BPR) in the inheritance tax regime which includes a ‘mainly’ trading test, which generally means more than 50% of trading activities. Therefore in most instances where shares qualify for IR they are likely to also qualify for 100% BPR.

Given the large lifetime limit of £10 million, the absence of an annual limit, and the fact that there is no maximum limit on shareholdings in one company, IR qualifying investments could be an efficient way to protect up to £10 million of inheritance tax exposed cash from BPR following a two year share ownership period, while also benefiting from the reduced 10% CGT rate.

Conclusion

If IR is to be called the little brother of ER, then it is definitely the more sensitive child within the CGT relief family and will take a lot more care and attention to nurture it through to maturity. However, with a lifetime tax savings of up to £1 million, it may well be worth the effort. IR is more akin to EIS and likely to appeal to the passive investor who is looking to invest larger sums of money in more mature companies. In truth, where ER and EIS are a possibility, in most cases they are likely to remain the priority relief for taxpayers, but IR is a welcome filler between the two. Perhaps a half-brother of both ER and EIS is a more suitable family title for this new arrival.

Sherena Deveney is a Senior Tax Manager in EY specialising in Private Client Services.

Email: sdeveney@uk.ey.com