During a divorce tax planning continues to be an area of focus and concern for both the Courts and our instructing solicitors
In a recent case the husband and wife were both directors and shareholders in a company. The wife operated the company and was keen to achieve a clean break, pushing for the husband’s resignation as a director as part of a settlement agreement and for his shares to be transferred to her.
However, the method and timing of events could have had a significant impact on the amount of tax payable by the couple and consequently the value of the matrimonial assets.
It’s often beneficial if a share sale or transfer qualifies for capital treatment rather than being treated as income. Providing certain conditions are met capital treatment can be achieved via a share buy-back by the company or the use of a holding company to purchase the husband’s shares. An expensive alternative is for one party to extract funds from the company via salary or a dividend to allow them to purchase the shares.
Capital Gains Tax (CGT) applies on gains arising on the disposal of shares. Entrepreneurs’ Relief reduces CGT to 10%, rather than the normal 28% or 18% rates that apply, depending on whether the gain falls into the individual’s higher rate or basic rate band.
The key (but not only) conditions to qualify for Entrepreneurs’ Relief are:
- the individual must have held at least 5% of the equity and voting rights for the 12 months preceding disposal;
- they must have been an employee, director or office holder in that period; and
- the company must meet the trading requirements. Broadly 80% of the company’s activities must relate to trading rather than investment activities.
In this situation the wife wanted the husband to resign as a director with the share transfer being sorted out afterwards. Agreeing to this seemingly unimportant administrative exercise would have removed the husband’s eligibility for Entrepreneurs’ Relief, causing him to pay CGT at 28% rather than 10%.
It is therefore important for an individual meeting the above criteria to ensure they remain a director up until the moment of the share disposal or transfer in order to qualify for Entrepreneurs’ Relief.
As the conditions for Entrepreneurs’ Relief need to be met at the time of sale difficulties can arise where deferred consideration or loan notes are involved. In this situation the company was unable to raise the capital to buy the husband’s shareholding outright so the wife proposed making payment over a 10 year period under a loan note arrangement.
Assuming the husband was a director at the time of the share transfer he may only be entitled to Entrepreneurs’ Relief on the first portion of the 10 year deferred consideration. We advised on the wording of the settlement agreement to ensure that the husband’s gain on disposal of his shares was taxable in the year of disposal thereby qualifying for Entrepreneurs’ Relief rather than over the period in which the consideration was received.
Whilst this approach minimises the total tax payable it does have a negative cash flow impact. We worked this through with the parties to ensure the husband’s CGT liability could be paid on time.
The difference in the tax that could have been payable by the parties in this situation was substantial and depended on the structure of the settlement agreement. The husband’s shares were valued at £2 million. We were able to advise on a settlement agreement resulting in total tax payable of £200k (10%). We calculated that total tax payable could have been as much as £1.4million (72%) if the wife had paid for the husband’s shares from her post tax income after he had resigned as a director, forfeiting his right to Entrepreneurs’ Relief.