Entrepreneurs’ relief (ER) has probably become the most well-known of all the capital gains tax (CGT) reliefs among practitioners and taxpayers alike. This is no doubt due to the generosity of the relief; ER offers a reduced CGT rate of 10%, as opposed to normal CGT rates (18% and/or 28% for 2015/16), where a claim for ER is made on gains from qualifying business disposals by individuals of up to £10 million in total.
Perhaps unsurprisingly for such a generous relief, ER is subject to a number of conditions, and HM Revenue and Customs (HMRC) often enquire into claims for relief to ensure that those conditions have been fully satisfied.
The fundamental requirement for ER is that there is a ‘qualifying business disposal’ (TCGA 1992, s 169H(1)). This includes a ‘material disposal of business assets’. An important category of business assets is shares or securities in a company (or an interest in them) (s 169I(2)(c)). There is a general condition that the company must be a trading company (or the holding company or a trading group) for a specified period of one year.
Is it a trading company?
A ‘trading company’ is defined as a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities (TCGA 1992, s 165A(3)). ‘Trading activities’ include activities carried on by the company in the course of, of for the purposes of, a trade being carried on by it. However, there is no statutory definition of ‘substantial’ for these purposes. So what is ‘substantial’ in this context?
HMRC’s non-statutory guidance in its Capital Gains manual (at CG64090) states that ‘substantial’ means more than 20%. It adds: “The question to ask is how should a company’s non-trading activities be measured to assess whether they are substantial?” HMRC points out that there is no simple formula, but that some or all of the following measures or indicators might be taken into account in reviewing a company’s trading status:
- Income from non-trading activities;
- The asset base of the company;
- Expenses incurred, or time spent, by officers and employees of the company in undertaking its activities;
- The company’s history;
- Balance of indicators.
A ‘trading group’ means a group of companies where one or more of its members carries on trading activities, and the activities of those members taken together do not include to a substantial extent activities other than trading activities (TCGA 1992, s 165A(8)). The meaning of ‘substantial’ is therefore also relevant to the determination of a group’s trading status. However, this article focuses on the trading status of single companies.
Is holding cash an ‘activity’?
Some companies are ‘cash rich’. They may have cash reserves from trading activities, which are surplus to trading requirements, and might not be inclined to distribute those funds to its shareholders. Could surplus cash make the company’s non-trading activities ‘substantial’?
The first point to note is that a trading company (or group) is defined according to its activities. Is holding surplus cash from profitable trading on deposit an ‘activity’, such as to make it a non-trading activity?
In Jowett (Inspector of Taxes) v O’Neill and Brennan Construction Ltd  STC 482 (a corporation tax case), a company discontinued its trade, and placed funds from trading in a bank deposit account, which generated interest. It was held that the company had not carried on any trade or business at any time in the relevant accounting period. The receipt of bank interest credited to a deposit account was not the “business of investment”.
If the receipt of bank interest does not represent a trade or business, does the retention of funds from trading activities constitute an ‘activity’ at all? The answer (as with many grey areas in tax) is probably “it depends” (i.e. it is subject the particular facts of the case), but HMRC certainly seems to consider that an activity could be involved. In its guidance in the Capital Gains manual (at CG64060), HMRC states:
“…the long term retention of significant earnings generated from trading activities may amount to an investment activity. The first point to consider is whether or not there is any identifiable activity distinct from the trading activity.” HMRC goes on to say:
“Factors to consider include…the nature of the underlying investments used as a lodgement for the funds, for instance if the funds are locked into long term investments or the investments themselves are high risk that may suggest that they are not available for the trading activity.”
The above HMRC guidance is in the slightly different context of whether a company is holding surplus cash “in the course of, or for the purposes of, a trade being carried on by it”, or “for the purposes of trade that it is preparing to carry on” (TCGA 1992, s 165A(4)(a), (b)).
Nevertheless, the inference seems to be that an ‘activity’ involves something more than merely holding undistributed cash from trading operations in a company’s bank account.
Is it surplus?
However, assuming that holding surplus cash does amount to an activity, the next point to consider is whether the cash is ‘surplus’ at all. The fact that a company’s bank account is in credit does not necessarily mean that those funds are surplus to its trading requirements.
For example, a retail company needs cash for working capital, such as to buy its trading stock. The level of working capital will depend on the type of trading activities undertaken by the company. In Barclays Bank Trust Co Ltd v IRC  STC (SCD) 125 (an inheritance tax case, concerning business property relief), the company’s trade was selling bathroom and kitchen fittings. The company’s turnover was around £600,000. It held £450,000 in cash. HMRC accepted in that case that £150,000 of that cash was required by the company at the relevant time (i.e. approximately 25% of its turnover).
A cashflow spreadsheet may be helpful in terms of establishing how much of a company's funds is required in its trade, and how much (if any) is actually surplus. This may be particularly useful if the company's trade is seasonal, such that cash may be surplus at certain times of the year, but possibly not at other times.
Is it ‘substantial’?
Assuming that there is surplus cash, and supposing that there is an ‘activity’ in respect of it (e.g. the cash is invested and reinvested on a regular basis), it is then necessary to consider (i.e. applying HMRC’s methodology in CG64090) whether the company's non-trading activities amount to more than 20% of its combined trading and non-trading activities.
The following points should be noted:
- The ‘asset base’ test should apply current (i.e. not historic) asset values. Furthermore (and as HMRC's guidance confirms) the test should also take into account goodwill and any other intangible fixed assets, which may not necessarily be shown on the company's balance sheet. In practice, I have seen cases where this approach has tipped the balance towards companies being trading companies.
- The ‘expenses incurred or time spent’ test will obviously depend on the circumstances of the case, and the type of investments being made. However, in many trading companies only minimal resources will be applied towards non-trading activities. For example, how much expense and time is generally involved in switching surplus cash from one investment to another on a periodic (e.g. monthly) basis, compared to running the company’s trading activities?
- HMRC's five indicators of a company’s status are not a checklist of individual tests. In other words, if one (or more) of the tests indicates non-trading activities, that does not necessarily mean that the company falls foul of the ‘substantial’ non-trading activities test for ER purposes. HMRC’s stated approach in CG64090 is to stand back and look at the company ‘in the round’, based on the approach in the inheritance tax case Giles (Farmer's Executors) v CIR, Sp C  SSCD 321 (Sp C 216).
Make it clear
In cases of genuine doubt as to trading status, the company may apply to HMRC for non-statutory clearance (CG64100), on behalf of its shareholders. HMRC has published a checklist of information to be included in such clearance applications:
Can individual shareholders apply for clearance, instead of the company? HMRC states in its Non Statutory Business Clearance Guidance (at NBCG2200) that its non-statutory business clearance service “…is not expected to include applications which clearly fall within the area of personal taxation for individuals.” However, HMRC has indicated (to the Chartered Institute of Taxation and certain other professional bodies) that clearance applications by shareholders may be accepted in cases of real doubt.
Take a view
It is understood that HMRC’s approach in terms of interpreting the activities of genuine trading companies has generally been helpful in the past. In ‘The Duck Test’ (Taxation, 7 November 2012), ER expert Kevin Slevin pointed out: “it is the author’s understanding that the shareholders in the company should expect it to be treated as a trading company where if it looks like a trading company, feels like a trading company, and there is no compelling reason why it should not be treated as a trading company.”
Nevertheless, prudent shareholders may not want to take any chances. HMRC's approach to determining a company's trading status (at CG64090) should therefore be studied carefully; and a non-statutory business clearance application to HMRC should be considered in appropriate cases.
Mark McLaughlin CTA (Fellow) ATT (Fellow) TEP is a consultant to professional firms with Mark McLaughlin Associates Ltd (www.markmclaughlin.co.uk). Mark is also Managing Editor of TaxationWeb (www.taxationweb.co.uk). He can also be contacted via Twitter https://twitter.com/charteredtax and LinkedIn http://www.linkedin.com/pub/mark-mclaughlin/11/811/12