11 Nov Can you avoid the entrepreneurs relief cash trap?
Sheltering profit in a company is fine, but keeping it in cash or investments can jeopardise entrepreneurs relief (ER) when you come to sell or wind up the business. Why and what steps can you take to avoid this happening?
With tax on dividends rising on 6 April 2016 and corporation tax (CT) set to fall to 18% by 2020, keeping profits in your company rather than paying them out looks increasingly attractive. When the time comes to sell or wind up your company and take the accumulated profit you can usually expect to pay tax at the entrepreneurs’ relief (ER) rate of just 10%. Well, that’s the theory. The trouble is that accumulating profits in the form of cash can put ER at risk.
A main condition of ER is that a company must not carry on activities which are to a “substantial extent activities other than trading” . If your company has accumulated cash, HMRC might argue that this is a substantial non-trading activity and so refuse ER. That means the money you receive on sale or wind up of your company will be liable to capital gains tax of up to 28%.
Is cash a non-business activity?
There’s been much debate on whether simply holding cash in a bank account is an activity at all. If not, it can’t be a non-trading activity and so can’t affect your entitlement to ER. HMRC goes along with this view to some extent, but isn’t prepared to entirely ignore cash. However, it says that as long as cash and other non-trading activities aren’t worth more than 20% of the company’s value and don’t use more than 20% of its resources, ER won’t be jeopardised.
Tip 1. When working out the proportion of cash compared to your company’s overall value you can ignore amounts needed for working capital or earmarked for trading purposes, e.g. money to buy new equipment etc. Plus you can take account of off-balance sheet assets, e.g. goodwill. These increase the value of trade-related assets and so the amount against which the 20% is measured.
Ways to avoid the cash trap
The excess cash problem is usually more acute in small companies, but whatever the business there are steps you can take to reduce the risk of HMRC challenging ER even where the amount of cash exceeds its 20% test.
Tip 2. Have a fair remuneration and dividend policy. By all means accumulate profit in your company, but pay a fair proportion each year to director shareholders in salary and dividends.
Tip 3. Don’t use cash to invest in the stockmarket or similar arrangements during the twelve months (this is the test period for ER) prior to selling or winding up your company. Also don’t place cash on long term deposit – for more than a year – unless it is earmarked (see Tip 1. above).
New company tactic
If, despite following our tips, you have excess cash in your company there’s one alternative arrangement that can almost guarantee you ER.
Tip 4. Before too much cash accumulates wind up the company and take the cash as a capital distribution. This will qualify for ER. Set up a new company to which the business can be transferred. Because of admin and costs this is best suited to small companies with few assets and employees.
If cash exceeds 20% of a company’s value and resources HMRC may challenge a claim to ER. Regularly paying reasonable dividends and salary to director shareholders will help counter this. Also avoid actively investing the cash. If all else fails wind up the company (and start afresh) before too much cash accumulates.