Last year, the Government made some changes to the rules on entrepreneurs’ relief, aimed at individuals who use a corporate vehicle to conduct their business. Before the changes, it was possible for the individual’s personal company to trade through a joint venture or partnership and apply “look-through” rules to qualify for trading status. This was stopped, but now, following Budget 2016, the position is being restored in cases where the individual holds a 5% interest in the relevant joint venture or partnership.
However, there are quirks in the new rules. As we shall see, the position has not been restored exactly in the way that one might expect. We shall concentrate on the rules for joint ventures, but the rules for partnerships are similar and give rise to the same issues.
(This article can be downloaded in pdf format at Academia.edu)
In this article, the statutory references are to draft legislation which has not yet been passed. This legislation is being introduced by the Finance Bill 2016 Clause 75 Schedule 13.
But before we discuss the detail, we need a short recap on entrepreneurs’ relief.
What is entrepreneurs’ relief?
Entrepreneurs’ relief is a tax incentive for individuals who wish to set up their own business and become millionaires. If the relevant conditions are satisfied, capital gains arising on the sale of the business are taxed at a rate of 10%.
Where the individual uses a corporate vehicle, the following conditions must apply1:
- The company must be a trading company or holding company of a trading group (the trading test);
- The individual must own at least 5% of the ordinary share capital, together with 5% of the company’s voting rights. A company which satisfies this condition is the individual’s personal company; and
- He must be an employee or officer of the company, or of a group member if the company is part of a group.
All three conditions must be satisfied for a one year period until he sells his shares. If the trading test fails, all is not completely lost. Provided that he satisfied the above three conditions for a one year period till the trading test failed, he has a further three years in which to sell his shares and benefit from the relief2.
What was the position on joint ventures before Budget 2015?
Before 18 March 2015, it was possible to look through a holding in a joint venture company and appropriate the relevant portion of the latter’s trading activities. Furthermore, one disregarded the holding of the shares as a separate activity – this ensured that the latter could not constitute a non-trading activity, thereby affecting the company’s trading status3.
For example, it was possible for a person to hold a 5% stake in his personal company which in turn, had a 10% holding in a joint venture company (10% being the minimum holding for the look-through rule to apply4). Even though the personal company had no other assets apart from its joint venture shares, it would have been regarded as a trading company in its own right.
As a consequence, entrepreneurs’ relief was available on selling the personal company shares after the statutory one year holding period had expired. But in economic terms, the individual’s share in the trade only amounted to 5% of 10% or 0.5% – a miniscule amount, and far less than the required 5% holding required by the personal company test. This test is there to ensure that only those who have a significant amount of capital at risk in the business are rewarded for their efforts. That doesn’t seem to be the case in this example.
What is the position after Budget 2015?
Following Budget 2015, it was decided to simply abolish the rule permitting the attribution of a joint venture company’s trade to its corporate shareholders5. Two consequences follow from this measure:
- Firstly, it is obvious that the company cannot appropriate the relevant part of the joint venture’s trade. If the individual wants to claim entrepreneurs’ relief, his company needs to find a trade of its own;
- Secondly, the company’s shareholding in the joint venture must now be taken into account for the purpose of determining its trading status. In most cases, the shareholding will be regarded as a non-trading activity. This could disqualify the company even if it did have its own trade.
It is clear however, that on both counts, a company with no assets at all except for the joint venture holding fails the trading test. If the individual shareholder disposes of his stake, the standard CGT rates apply.
All well and good. But now consider the position of an individual who is the sole shareholder of his own personal company. In the previous example, his stake in the underlying business is effectively 10%. Entrepreneurs’ relief would have been available had he personally held the shares in the joint venture company. But because his stake is held indirectly, he is disqualified from the 10% rate.
This doesn’t sound right. And so, to address this situation the rules are to be changed yet again.
What is the position after 18 March 2015 following Budget 2016?
First note that the changes are being backdated to 18 March 2015 when the amendments were originally made (the “old rules”)6. The draft legislation itself goes about it in a roundabout way, by rearranging the existing definitions and adding a new Schedule for defining terms such as “trading company” and “trading activities”7. What fun.
In a nutshell – the general rule that joint venture holdings cannot be appropriated as part of the company’s trading activities still applies. However, the joint venture rules are restored if the individual holds at least 5% of the shares and voting rights of the joint venture company for at least a one year period8. This one year period coincides with the same one year period which applies on a successful claim for entrepreneurs’ relief, ending on the date of disposal or, on the date that the individual’s personal company fails the trading test9.
In calculating the individual’s interest in the joint venture company, one takes into account the following10:
- Direct holdings, where the individual holds shares directly in the joint venture company;
- Indirect holdings though a corporate vehicle. This isn’t restricted to the individual’s holding in the personal company whose shares are to benefit from the 10% rate. It can be any company in which the individual has an interest, no matter how large or small the stake (apart from the personal company in which he has to own more than 5% to qualify for the relief). All that matters is that this company owns some part of the joint venture company’s share capital, whether directly or indirectly11.
The simplest example is that of an individual P, who holds his interest purely through his own personal company. Taking the previous example, we see that if P is simply holding the minimum 5% in this company, which in turn holds the minimum 10% in the joint venture, P still doesn’t qualify, as his stake is too small at 0.5%. Which was the intention when the joint venture rules were originally passed last year.
But now let us suppose that P is the sole shareholder of his personal company. Under the old rules, P would have been disqualified, but under the new rules he has a 10% stake in the joint venture company. P’s company is deemed to be carrying out a portion of the joint venture company’s trade, and as long as the latter continues to be a trading company for at least one year, entrepreneurs’ relief will be available.
One point to note. As a consequence of these new rules, whenever a joint venture is involved, the question whether a company is trading depends on the identity of the shareholder.
In the following example, we have a company Tradeco whose only asset consists of a shareholding in joint venture company JVC, a trading company. Tradeco has two shareholders, P, who holds 10% and Q who holds 90%. Their interests in the underlying business of JVC are as follows:
- P owns 10% of 10% which amounts to 1% – so for P, the attribution cannot be made;
- Q owns 90% of 10% which amounts to 9% – so for Q, the attribution can be made.
The result is that for Q, Tradeco is a trading company, but for P, it is not.
What is “wrong” with the new rules?
There’s always something wrong isn’t there?
The new rules work very well when P is investing purely though his personal company and there is no change in the activities of this company. But consider the following example.
- P has just established his new company Tradeco. Tradeco is a pure trading company, and so P should qualify for entrepreneurs’ relief if he sells the company after one year;
- However, “halfway through” – 6 months later – Tradeco contributes its trading assets to a joint venture company JVC in return for a 50% holding (we shall assume there are minimal tax charges). Tradeco’s only asset is its shares in JVC
What’s the tax position now? Can P still sell claim entrepreneurs’ relief if he sells his Tradeco shares at the end of the first year?
First, consider the old “old rules” – the position before Budget 2015 when joint ventures were permitted. The entry into the scene of the JVC would have made no difference. Because one was allowed to attribute the JVC’s activities to the joint venture member, Tradeco would have retained its trading status in spite of divesting itself of its trade.
Now consider the “old rules” – the rules that came about because of the Budget 2015 changes. We now have to disregard the JVC’s trading activities so that Tradeco’s only activity is that of holding shares in another company. Tradeco stops being a trading company and entrepeneurs’ relief can no longer apply.
Suppose instead that Tradeco were to wait till its first anniversary before transferring its trade to JVC. This time, entrepreneur’s relief is available. It is still the case that the trading condition does not hold for the year till the date of disposal – but we don’t need to rely on this condition. Because Tradeco was trading for a full year before becoming a joint venture member, we can rely on the condition that permits P to sell his shares within three years of failing the trading test.
Now consider the new rules. On the face of it, this restores the position to what it was before Budget 2015. Tradeco continues to be a trading company in spite of the introduction of the JVC because P has an indirect interest in the latter amounting to more than 5%. So if P waits for another 6 months, he should be able to claim the 10% rate. Shouldn’t he?
As we shall see, it’s not that simple.
Example 1 – What happens when an existing trading company joins a joint venture?
It isn’t enough for P to hold a 5% interest in the joint venture company. The attribution can only be made if P holds this interest for “the relevant period” which, as we have seen depends on the route by which P is to claim entrepreneurs’ relief. In particular12:
- If P is to sell the shares while Tradeco is still trading, P needs to have held his joint venture stake for at least a one year period until the date of the Tradeco disposal;
- Alternatively if P is taking advantage of the three year grace period that applies when a company stops trading, he must have held the joint venture stake for at least one year until the time that Tradeco ceases to be a trading, company13.
Applying these conditions to the situation where Tradeco becomes a joint venturer 6 months into its lifetime, we see that there is a problem:
When Tradeco transfers its trade to the JVC, it stops being a trading company. This is because of the general rule that prohibits the attribution of the JVC’s activities to its corporate shareholders.
At the one year stage, Tradeco is still not a trading company. It is still not permitted to look through to the JVC because P has held his interest through Tradeco for only 6 months. So at this stage, we are in the position that for the previous 6 months, Tradeco has failed the trading test.
It is only by waiting for a further 6 months that the look-through rule begins to take effect. So one and a half years after Tradeco was established, P can sell and claim the 10% rate. Tradeco satisfies the trading test, not because of its initial status as a trading company, but by virtue of holding on to its stake in the JVC for a full year.
Example 2 – A trading company joins a joint venture (variation)
Now consider the situation where Tradeco joined the joint venture a full year after incorporation instead of 6 months. As with the previous example, the very act of transferring its trade to the JVC causes Tradeco to lose its trading status. But once again, P can rely on the condition that permits him to sell his shares within three years of Tradeco ceasing to trade, when it became a joint venture member. This is possible because Tradeco had previously been trading for a full year rather than 6 months.
Perversely, if he waits for a further 6 months, Tradeco becomes a trading company again. Furthermore, its trading status is effectively backdated to the time that it became a joint venture member, so it is regarded as never having ceased trading. But this doesn’t matter – at this stage P can still claim the 10% rate simply relying on the joint venture rules which ensure that the trading conditions have been fulfilled for a whole year until the date of disposal.
Example 3 – Tradeco leaves the joint venture company and acquires a trade
Now suppose instead that Tradeco has been a joint venture member for a full year during which P has held the requisite 5%+ interest. Suppose also that Tradeco sells its JVC stake and acquires its own trade, to be a trading company in its own right. Can P sell Tradeco after 6 months?
Surely he can. Tradeco has never stopped trading. The joint venture condition was satisfied for the full year, enabling the trading attribution to be made, and then Tradeco had its own trade for 6 months.
The answer is not very straightforward at all.
By rights, P should be able to claim because he has held a stake in a trading company for the required one year period prior to the date of sale. But this is not actually the case here. Although P has held a stake in the JVC through Tradeco for the required one year period, he hasn’t held this stake for the one year period to the date of the sale. As a consequence, the attribution of the JVC’s activities to Tradeco cannot be made. Tradeco is only a trading company for 6 months. P needs to wait another 6 months, by which time, Tradeco will have been trading “on its own” for a full year.
P cannot even rely on the three year grace period which applies when a company fails the trading test. For Tradeco cannot said to have ceased to be trading on leaving the joint venture – how can this be the case when it subsequently starts trading on its own account?
One more example, and then you can all go home.
Example 4 – Tradeco leaves the joint venture company and invests its surplus cash
Suppose that Tradeco leaves the joint venture, but instead of starting a trade, it uses its joint venture profits to make investments in other companies. Tradeco would have been a trading company had P sold his shares at the point of departure. But now it is not – on leaving the joint venture Tradeco has changed its status.
Can we rely on the fact that if a company fails the trading test, entrepreneurs’ relief can still be claimed in the following three years? The new joint venture rules cater for this possibility – the attribution of the JVC’s activities can be made because P holds a 5% interest for the one year period till Tradeco stops trading as a result of leaving the joint venture.
But is this really the solution? Are we not using some circular reasoning here? This is what our argument amounts to:
- If Tradeco fails the trading conditions for entrepreneurs’ relief, P can still claim the 10% rate if he sells his Tradeco shares within the following three years;
- In order to qualify, Tradeco must have satisfied the trading conditions for at least one year up to the date that the trading conditions failed;
- Tradeco satisfied the trading conditions by virtue of being a member of a joint venture. The joint venture’s trading activities are attributed to Tradeco;
- The attribution can be made on the basis that P held a stake in the JVC throughout a one year period ending on the date that Tradeco failed the trading conditions;
- To have failed the trading conditions, Tradeco must have satisfied them at some stage. How did it satisfy those conditions?
- It satisfied the trading conditions by virtue of being a member of a joint venture. The joint venture’s trading activities are attributed to Tradeco – which takes us back to point 4.
So perhaps not.
Why are these examples so odd?
As we have seen, it all works very well on the assumption that a joint venture structure is adopted from the outset. Provided that the requisite 5% interest is held in this way for a continuous period lasting more than a year, entrepreneurs’ relief should be available.
But these new rules don’t take into account the situation where a company rearranges its business structure. We saw some bizarre examples of how a company is regarded as trading as long as is a joint venture member, but once it makes an exit, its trading status is withdrawn for the whole of this period – the cancellation being retrospective.
The key to why the above examples yield such odd results is the fact that the joint venture attribution depends on timing issues and when individual shareholders are intending to make an exit. In some scenarios, if the individual decides not to sell during the joint venture period, the attribution is no longer valid.
This issue is not so pressing if the company has a trade in its own right. But even in these cases, one needs to be wary, as the company’s shareholding in the joint venture can still impact its trading status.
Summing up – it’s not that simple!
The partial restoration of the joint venture rules serves the purpose of allowing individuals to hold an interest in a joint venture company indirectly through a personal company. As long as the stake in the underlying business is large enough, and is held for a one year period, entrepreneurs’ relief ought to be available on exit.
However, the requirement to hold the joint venture interest right up till the date of disposal can create havoc in certain circumstances, and leads to some very bizarre results. It would be a lot simpler if this requirement were dropped altogether before the final passing of the Finance Bill. Let’s hope that someone in the corridors of power spots this and sees some sense!
- TCGA 1992 ss 169I(6), 169S(3). ↩
- TCGA 1992 s 169I(7). ↩
- TCGA 1992 s 169S(4A), referring to the definition of trading company in TCGA 1992 ss 165, 165A. The attribution of the activities of a joint venture company was permitted by virtue of TCGA 1992 ss 165A(7), (12). ↩
- TCGA 1992 s 165A(14). ↩
- TCGA 1992 s 169S(4A)(a), FA 2015 s 43. ↩
- FB 2016 Schedule 13, paragraph 6. ↩
- FB 2016 Cl 75 Schedule 13 – adding a new definition section TCGA 1992 s 169SA, repealing TCGA 1992 s 169S(4A) effectively shifting the joint venture rules to a new Schedule 7ZA. ↩
- TCGA 1992 Schedule 7ZA paragraphs 3-12. ↩
- TCGA 1992 Schedule 7ZA paragraph 25. ↩
- TCGA 1992 Schedule 7ZA paragraphs 5-6, 9-10. ↩
- TCGA 1992 Schedule 7ZA paragraph 4. ↩
- TCGA 1992 Schedule 7ZA paragraphs 5, 9, 25. ↩
- TCGA 1992 s 169I(7). ↩
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