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Entrepreneurs' relief and loan notes

03 September 2010

In the Finance (No.2) Act 2010 there is an important change to the way entrepreneurs' relief works where an individual sells shares and receives QCB loan notes in return. This change is retrospective and applies to all disposals on or after 23 June 2010.

Since the introduction of entrepreneurs’ relief (ER), which allows the first £5m of lifetime gains made by an individual to be taxed at 10%, QCB (rather than non-QCB) loan notes have been more attractive to an individual seller as the conditions for ER only had to be met when his shares are exchanged for loan notes and not when the loan notes were ultimately redeemed.

This was important because, whilst an individual may satisfy the conditions for ER when he disposes of his shares, he is very unlikely to satisfy the conditions when the QCB loan notes are redeemed, given the requirement to hold 5% of the shares in the target company. This, up until the Emergency Budget, outweighed the disadvantage of QCB loan notes which was that the held-over gain was still payable even if the issuer of the loan notes defaulted on repayment.

Previous position

Prior to the Emergency Budget in June, if an individual satisfied the conditions for ER at the time of the exchange then the gain including ER was calculated at that time and then held-over until the QCB loan notes were redeemed. This meant that an individual could both benefit from ER and not have to pay the tax until he had money to do so; hence their attractiveness.

New position

However, for any disposal on or after 23 June 2010, an individual now has to make an election in order for a gain to be treated as arising at the time of the exchange and so benefit from ER (on the assumption that ER will not be available when the loan notes are redeemed).

However, the hold-over rules no longer apply and so any gain becomes taxable at 10% in the year of the disposal.

This could create difficulties where the individual does not receive any up-front consideration or the loan notes are to be redeemed after the date the tax has to be paid (31 January after the end of the relevant tax year). Such an individual is now faced with the choice of whether he should elect and try to find the money to pay the tax at 10% up-front or pay CGT at the main rate (now likely to be 28%) on the full amount of the gain when the loan notes are redeemed.

This puts QCB loan notes on the same footing as non-QCB loan notes so, given the risk of having to pay tax even upon default, non-QCBs are likely to become more attractive.

Gains already held-over into QCBs

In addition, because of the introduction of a higher rate of CGT of 28% and the way in which the legislation is drafted, any individual who held over a gain arising between 5 April 2008 and 22 June 2010 by receiving QCB loan notes will now be taxed at a rate of 15.56% (assuming that they are a higher rate taxpayer) when the loan notes are redeemed.

This may come as a shock to those who think that they had locked in a 10% rate. It remains to be seen whether this is an unintended change which will be rectified at a later date or just another way in which the Government is raising money.

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Tom Wilde

Associate
T: 03700 86 8713
I: +44 (0)118 965 8713
E: tom.wilde@shoosmiths.co.uk