Family businesses could see three key areas impacted by changes to capital gains tax proposed by the Office for Tax Simplification last month:
- Succession planning
- Cash extraction
- Share options for retaining key employees
The key changes
In their report released on 11 November 2020, the Office for Tax Simplification (OTS) made the following recommendations:
- Align capital gains tax (CGT) rates with those of income tax.
- Replacing entrepreneurs’ relief with retirement relief
- Slashing of the CGT annual exemption
- Removal of CGT uplift on death
Succession planning with a family business usually involves getting company shares into the hands family members or managers. This can be done during the lifetime of the owner, upon their death, or a mix of the two. However succession is approached, there will be CGT and inheritance tax (IHT) consequences:
- If shares are gifted during lifetime, CGT can be deferred if the company is trading and there shouldn’t be IHT to pay due to business property relief (BPR).
- If shares are sold, then CGT will be payable but potentially only at 10% if entrepreneurs’ relief is available.
- If shares are gifted on death via a Will, then there is a CGT-free uplift to market value, and again IHT should be nil due to BPR.
The OTS report could make the latter two options more expensive. They have proposed changing business asset disposal relief (aka entrepreneurs’ relief) to retirement relief, which would restrict the 10% tax rate to those at retirement age, whilst increasing the 5% shareholding test to 25% and the holding period from 2 years to 10 years. For certain shareholders selling their shares, this would mean 20% tax, or up 45% if CGT rates are aligned with income tax.
The OTS also suggest removing the CGT uplift on death, so that the base cost of inherited shares is no longer their value at the date of death, but instead the value that the deceased acquired them for. For family businesses this is often a negligible amount, so this proposal would greatly the future CGT liability if the shares were subsequently sold.
It is possible to pass on shares to the next generation without incurring CGT by spreading gifts out over many years, utilising annual exemptions. This has been generally used by owners of non-trading companies who cannot use hold-over relief to defer capital gains. However, this practice would be curtailed by proposals to reduce the annual exemption from £12,300 per year to between £2,000 and £4,000.
Companies often accumulate excess profits over the years, which the owners haven’t needed to draw on as salary or dividends. If the business comes to the end of its life, the company can be liquidated and this excess cash extracted at capital gains tax rates of 20% (or sometimes 10% with entrepreneurs’ relief), rather than treated as income.
If CGT rates are aligned with income tax rates then extracting these rolled-up profits will get much more expensive. Even if the Government decide to keep CGT rates as they are, the OTS has recommended that distributions of rolled-up profits are treated as dividends and tax at rates of up to 38.1%.
Share options for retaining key employees
The EMI scheme, which allows selected employees to enjoy CGT rates on gains on share options, is a very tax efficient way to reward key employees and to retain them by giving them a stake in the company. However, the scheme is at risk of being scrapped due to the ability to target certain employees.
Rishi Sunak prepared the ground for future tax rises in his recent spending review, so these proposals could be implemented in the Budget expected next spring. It would seem prudent to accelerate existing plans for company liquidations ahead of this, or to put in place an EMI scheme in case these are scrapped going forward.