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How to maximise BADR when establishing a personal company
Since 6 April 2008, Business Asset Disposal Relief (formerly known as Entrepreneurs’ Relief) is a valuable relief from capital gains tax for individuals and certain trustees disposing of qualifying business assets. HMRC guidance is available in its capital gains tax manuals at CG63951P onwards.
Key features of Business Asset Disposal Relief (BADR) when selling shares are:
1. To qualify, both of the following must apply for at least two years up to the date you sell your shares:
- you’re an employee or office holder of the company (or one in the same group)
- you must hold 5% of share capital and voting rights throughout the relevant period.
- the company’s main activities are in trading (rather than non-trading activities like investment) – or it’s the holding company of a trading group (If the company stops being a trading company, you can still qualify for relief if you sell your shares within three years).
2. There are also other rules depending on whether or not the shares are from an Enterprise Management Incentive (EMI)
3. You will pay 10% tax on qualifying gain where the total qualifying gain is no more than £1m over lifetime
4. Deadline to claim BADR is 12 months following the filing tax return deadline of the tax year when you sold or closed your business, ie if you sold your shares/business in 2021 to 2022, you have until 31 January 2024 to claim the relief.
Here are some of the ways the gain can be maximised when working through the company:
Split business ownership to benefit from increased lifetime limits
Consider sharing the ownership with a spouse or family member to extend the benefit of all individuals’ lifetime limits to cover more of the gain when there is a chance of the company growing and generating high value gains in excess of £1m.
Ensure the type, class and percentage of shares you hold qualifies you for BADR
When allocating shares, consider if the shareholder is beneficially entitled to at least 5% of the profits available for distribution to equity holders and, on a winding up, you would be beneficially entitled to at least 5% of assets available or in the event of a disposal of the whole of the ordinary share capital of the company, the individual would be beneficially entitled to at least 5% of the proceeds.
Alphabet shares may qualify
Since December 2018 Bill Amendment, alphabet shares may continue to qualify for BADR, as long as they entitle the holder to at least 5% of sale proceeds in the event the business is sold.
Ordinary and preference shares assessed based on the same rights criteria
Whether you hold ordinary shares or preference equity shares is less relevant. It is the rights those shares give that will determine your BADR entitlement. There have recently been several cases where the definition of a personal company was challenged by HMRC. The lessons from tribunal hearings were that judges try and adhere to the literal meaning of the terms of the law when ruling on cases, although we are yet to see a case involving growth shares.
Relaxed conditions for EMI shares
Shares granted via an EMI scheme always qualify for BADR as there are no personal company tests to be met. The test of the qualifying period of 24 months does apply, but the holding period includes the period when you held the options.
Nominal value of share capital matters, not number of shares
When you assess whether or not you hold the required 5% of share capital, you need to establish whether the value of nominal capital you hold amounts to at least 5% of the total value of nominal capital issued. The number of shares you hold is not the correct reference point.
Indirect shareholdings via a personal company
Your personal company may be a member of a JV or partnership. The disposal of your shares in your company is likely to qualify for BADR, if it had at least 5% interest in the trading JV or 5% interest in the income, capital and voting rights of the trading partnership for the relevant period.
Optimise business structure from the start
Consider the ownership structure in the context of a potential business disposal right from incorporation, if you can plan this far. Any subsequent share transfers between individuals may trigger stamp duty and capital gains tax (unless business assets relief is claimed which will defer the gain) and unless occurring between spouses.
Each shareholder will need to qualify for BADR in their own right. The required 5% stake must be held outright directly for the relevant individual to qualify. Shares held by associates do not ‘increase’ ownership stake of a director wishing to claim BADR.
Take care when altering the rights attached to shares
Any changes to the rights of the shares may affect entitlement to BADR. If, as a result of the recent changes in legislation, the rights need to be changed, for example by amending articles, the 24-month period during which the conditions to qualify for BADR must be met will commence from the date of change.
Do not lose out when considering the 24-month qualifying period
All three qualifying conditions – (1) personal company, (2) trading company or holding in a trading group, and (3) you must be officer or employee – must be met for the relevant 24-month period.
However, once you meet the personal company condition yourself and qualify for BADR, any new shares you acquire will also qualify for BADR (even if those newly acquired shares are not held by you for the relevant 24-month period). For example, if the shareholding in your personal trading company is split between you and your spouse, who due to the type of shares does not qualify for BADR (for example they are non-voting shares), those shares could be transferred to you. You would qualify for BADR on those newly transferred shares, as long as you already qualify for BADR on your original shareholding.
Manage the impact of dilution
If a new share issue results in a dilution of your holding below the required 5%, and so at the point of a subsequent disposal your company is not your personal company, not all the benefit of BADR is lost.
The gain on disposal is apportioned between the period up to dilution which is taxed at the BADR rate of 10%, and the remainder period from dilution to disposal, which is charged at normal CGT rates. You can also elect to defer payment of BADR CGT arising on dilution until the shares are actually sold and you receive the proceeds.
Align the ownership of an associated asset and the company for at least three years before you dispose of your shares
Where an asset held outside the company but used in its business is held jointly but only one of the asset owners qualifies for BADR on the sale of company shares, BADR on the associated disposal of the asset will be restricted. The asset could be transferred to the director-shareholder but must then be owned and used in the business for at least three years from the date of transfer, otherwise the part transferred later will not qualify for BADR. This causes complications if the sale of the shares cannot be sufficiently deferred to allow for the associated asset to meet the three-year condition. The rules on BADR on associated disposals are complex.
Manage cash carefully
Factor in the impact of any activities that may be considered non-trading. A company with substantial non-trading activities (usually meaning that the business generates 20% of its turnover or assets (depending on type of business) from those activities) is likely to have BADR restricted or denied. Non-trading activities may mean activities such as accumulating excessive cash reserves, actively managing deposits to generate investment returns and making loans. However, this is a grey area, and your case will be considered on its individual merits. Obtaining BADR non-statutory clearance may clarify your specific circumstances.
Ensure your status as an officer or employee is not challenged
You should ensure your director or secretary status is reflected on the public record held at Companies House and any resignation aligns with the disposal date of the shares. If you are an employee, your employment status must be evidenced by facts. HMRC may seek witness statements to confirm them.
Watch out for ‘anti-phoenix’ rule
Importantly, there are ‘anti-phoenix’ rules in place to avoid the exploitation of this generous relief. You need to be incredibly careful if you claim BADR and then within a two-year period you set up a new same or similar company or business ‘vehicle’; then the beneficial capital gains tax treatment of a capital distribution may be denied. This ‘anti-phoenix’ rule was brought in to stop company dissolutions that are driven mainly by the avoidance of income tax.
If this occurs, HMRC will normally seek to tax what you think is a capital distribution as an ‘income’ dividend at higher income tax rates. More information on anti-avoidance rule can be found within HMRC manual CTM36305 onwards with examples.