Entrepreneurs' relief and dilution

Posted on 02 October 2018

Entrepreneur's relief and dilution

Following HMRC's consultation earlier this year (discussed in Issue 5), HMRC has announced that taxpayers who qualify for entrepreneurs' relief ("ER") can continue to do so even if their interest in the company is diluted by new shares being issued to raise funds for the company. 

The relief is optional.  If the taxpayer elects, the company concerned is assumed to be sold at its market value immediately before new funds are raised and the taxpayer treated as receiving the relevant proportion and so his or her gain calculated.  Then if later the taxpayer sells some or all of his shares the appropriate part of the previously calculated gain becomes taxable.  If the taxpayer meets all of the other conditions for ER (director or employee, trading company etc.) the previously calculated gain can benefit from ER.  The gain (or loss) accruing on the shares from the date of the fundraising to the disposal is taxable at normal CGT rates. 

You may wonder why the taxpayer has to elect.  The point is that if the company performed badly after the fundraising the previously calculated gain would still be taxable even if overall the taxpayer lost out on the shares.  Fortunately the taxpayer has a reasonable length of time in which to decide.

Another key point to appreciate is that this relief is intended only to assist a taxpayer who would have qualified for ER except for being diluted below the 5% threshold.  It won't help a taxpayer if the company ceases to qualify or the taxpayer ceases to be a director or employee before actually selling his shares. 

Companies planning to issue shares to raise funds before the legislation becomes effective (probably Spring 2019) that are concerned about diluting shareholders currently qualifying for ER may want to defer their plans, perhaps relying on borrowing in the meantime.

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