Entrepreneurs' relief (ER) is a prize worth fighting for, reducing as it does the rate of CGT to 10% on up to £10m of capital gain.
The recent First-tier Tribunal case of Potter [2019] UKFTT 554 (TC) raises two points of great practical interest on ER:
It’s a decision that is worth examining in some detail.
Mr and Mrs Potter were shareholders in a company called Gatebright Ltd which had traded as a broker on the London Metal Exchange. The ability to broke deals depended heavily on finance being available, and after the financial crash business pretty much dried up; Gatebright’s last invoice was issued in March 2009. Mr Potter kept trying, without success, for business but, after suffering some ill-health and other domestic misfortunes, the shareholders drew stumps and wound up the company in November 2015.
One of the requirements for the Potters to claim ER was for the company to have been a ‘trading company’ (or the holding company of a trading group) for a qualifying period of at least one year ending no more than three years before the disposal: that is, in the Potters’ case, for at least the year to November 2012. (The qualifying period has of course subsequently been increased to two years by Finance Act 2019.)
The first point raised by the case was whether the company was carrying on ‘trading activities’ throughout the required period. ‘Trading activities’ are defined to include activities carried on ‘in the course of, or the purposes of, a trade being carried on by [the company] or for the purposes of a trade that it is preparing to carry on’.
The tribunal concluded that, although it might be said that Gatebright was not actually carrying on any trade after it issued its last invoice in 2009, it could be considered to be ‘preparing to carry on its old trade once the economic environment permitted it’. It therefore passed the first leg of the ‘trading company’ requirement.
Pausing there, we think that that was the right answer for the wrong reason: we prefer the reasoning in the old case of Kirk & Randall v Dunn (1918-1924) 8 TC 663:
‘Because in the middle of a great career a company, or still more an individual professional man, might have a year when he was holding himself out for business, or the company was holding itself out for business, but nothing came, yet that would not effect a break in the life of the company for income tax purposes.’
No matter: however you look at it, the company was carrying on ‘trading activities’ of one sort or another.
But carrying on ‘trading activities’ is not of itself enough to render a company a ‘trading company’ for ER purposes. It’s also necessary that the company’s activities do not include ‘to a substantial extent’ activities that are not ‘trading activities’. HMRC guidance indicates that anything less than 20% may be treated as not ‘substantial’: but what the 20% is to be applied to is less than crystal-clear. It’s the part of the Potter decision that relates to this point that is particularly helpful.
Potter supports the view that a trading company may be able to make a substantial long-term passive investment without fear of losing its ER trading company status
By 2009, Gatebright had built up reserves of over £1m. To safeguard the reserves when the financial world crashed about its ears, the company had invested about £800,000 in two six-year investment bonds, maturing in November 2015.
HMRC naturally pointed to the fact that from 2009, most of the company’s assets were tied up in the investment in bonds and virtually all of the company’s income was derived from them. How could that be anything other than substantial?
The tribunal observed that the legislation focusses on ‘activities’. What did the company actually do?
‘Once the company had put its money into the bonds it did not, and indeed could not, do anything else in relation to them for six years until they matured. There were no investment activities. The company was locked into the bonds during their term and the directors did not do anything in relation to them.’ (para 80)
‘When one stands back and looks at the activities of the company as a whole and asks “what is this company actually doing?” the answer is that the activities of the company are entirely trading activities directed at reviving the company’s trade and putting it in a position to take advantage of the gradual improvement in global financial conditions.’ (para 84)
The question of the extent to which investments rob a company of its trading status is one that arises frequently. We think that the tribunal in Potter got it absolutely right: the legislation focuses on ‘activities’, not assets or income; and it is therefore the company’s ‘activities’ that must be examined.
Of course, some investments require more activity than others: keeping an investment portfolio under constant review and actively managing it may well amount to a substantial part of the ‘activities’ of a company that is also carrying on a trade. But the Potter case does give support to the view that a trading company may be able to make a substantial long-term passive investment without fear of losing its ER trading company status.
Entrepreneurs' relief (ER) is a prize worth fighting for, reducing as it does the rate of CGT to 10% on up to £10m of capital gain.
The recent First-tier Tribunal case of Potter [2019] UKFTT 554 (TC) raises two points of great practical interest on ER:
It’s a decision that is worth examining in some detail.
Mr and Mrs Potter were shareholders in a company called Gatebright Ltd which had traded as a broker on the London Metal Exchange. The ability to broke deals depended heavily on finance being available, and after the financial crash business pretty much dried up; Gatebright’s last invoice was issued in March 2009. Mr Potter kept trying, without success, for business but, after suffering some ill-health and other domestic misfortunes, the shareholders drew stumps and wound up the company in November 2015.
One of the requirements for the Potters to claim ER was for the company to have been a ‘trading company’ (or the holding company of a trading group) for a qualifying period of at least one year ending no more than three years before the disposal: that is, in the Potters’ case, for at least the year to November 2012. (The qualifying period has of course subsequently been increased to two years by Finance Act 2019.)
The first point raised by the case was whether the company was carrying on ‘trading activities’ throughout the required period. ‘Trading activities’ are defined to include activities carried on ‘in the course of, or the purposes of, a trade being carried on by [the company] or for the purposes of a trade that it is preparing to carry on’.
The tribunal concluded that, although it might be said that Gatebright was not actually carrying on any trade after it issued its last invoice in 2009, it could be considered to be ‘preparing to carry on its old trade once the economic environment permitted it’. It therefore passed the first leg of the ‘trading company’ requirement.
Pausing there, we think that that was the right answer for the wrong reason: we prefer the reasoning in the old case of Kirk & Randall v Dunn (1918-1924) 8 TC 663:
‘Because in the middle of a great career a company, or still more an individual professional man, might have a year when he was holding himself out for business, or the company was holding itself out for business, but nothing came, yet that would not effect a break in the life of the company for income tax purposes.’
No matter: however you look at it, the company was carrying on ‘trading activities’ of one sort or another.
But carrying on ‘trading activities’ is not of itself enough to render a company a ‘trading company’ for ER purposes. It’s also necessary that the company’s activities do not include ‘to a substantial extent’ activities that are not ‘trading activities’. HMRC guidance indicates that anything less than 20% may be treated as not ‘substantial’: but what the 20% is to be applied to is less than crystal-clear. It’s the part of the Potter decision that relates to this point that is particularly helpful.
Potter supports the view that a trading company may be able to make a substantial long-term passive investment without fear of losing its ER trading company status
By 2009, Gatebright had built up reserves of over £1m. To safeguard the reserves when the financial world crashed about its ears, the company had invested about £800,000 in two six-year investment bonds, maturing in November 2015.
HMRC naturally pointed to the fact that from 2009, most of the company’s assets were tied up in the investment in bonds and virtually all of the company’s income was derived from them. How could that be anything other than substantial?
The tribunal observed that the legislation focusses on ‘activities’. What did the company actually do?
‘Once the company had put its money into the bonds it did not, and indeed could not, do anything else in relation to them for six years until they matured. There were no investment activities. The company was locked into the bonds during their term and the directors did not do anything in relation to them.’ (para 80)
‘When one stands back and looks at the activities of the company as a whole and asks “what is this company actually doing?” the answer is that the activities of the company are entirely trading activities directed at reviving the company’s trade and putting it in a position to take advantage of the gradual improvement in global financial conditions.’ (para 84)
The question of the extent to which investments rob a company of its trading status is one that arises frequently. We think that the tribunal in Potter got it absolutely right: the legislation focuses on ‘activities’, not assets or income; and it is therefore the company’s ‘activities’ that must be examined.
Of course, some investments require more activity than others: keeping an investment portfolio under constant review and actively managing it may well amount to a substantial part of the ‘activities’ of a company that is also carrying on a trade. But the Potter case does give support to the view that a trading company may be able to make a substantial long-term passive investment without fear of losing its ER trading company status.
