Article, New Law Journal – March 2010
Insurance / Legal
Amanda Fyffe, of RGL's London office, advises practitioners to consider their options before applying entrepreneur’s relief as incorrectly applying entrepreneur’s relief in personal injury / fatal accident claims could materially impact the quantification of losses.
Many individuals with a personal trading company (PTC) will typically cease trading and crystallise the assets; or sell the business and its assets to a third party on retirement. Such disposals could potentially result in a sizeable capital gain liable to Capital Gains Tax (CGT). However, from April 2008, Entrepreneur’s Relief (ER) was introduced allowing relief for gains made:
- On the disposal of all/part of a business.
- On disposals of assets following cessation of a business.
- By certain individuals involved in running a business.
An individual is not always better off claiming ER on retirement and the specific circumstances need to be considered to determine if a claim for ER would be beneficial. ER is now often included in the calculation of lost earnings in personal injury or fatal accident claims, where a claimant (or deceased) had their own PTC which would have been disposed of on retirement. But should all claimants be deducting ER in such claims? This question is key because incorrectly applying ER in PI/FA claims could materially impact the quantification of losses.
Rules of relief
In calculating ER, the chargeable gain after the CGT annual exemption, is reduced by 4/9ths and CGT calculated at 18% on the gain; this equates to an effective rate of 10%.
To be eligible for ER individuals must, for at least one year before disposal, have owned at least 5% of the shares & voting rights and have been an officer/employee of the PTC. The PTC must be trading, or the holding company of a trading company, for the same period.
The value of ER?
There are three principle ways an individual can extract income from their PTC, namely:
- as a salary;
- as dividends;or
- on the crystallisation of assets following the sale/closure of the PTC
However, it is method (iii) where ER can potentially be utilised. Because of the effective 0% income tax on dividends up to the (HET) Higher Earnings Threshold, depending on the level of profits generated, there may actually be no benefit in retaining profits in the business to claim ER on retirement. In fact, in some circumstances, a higher tax liability may arise if ER is claimed on retirement.
- Scenario 1 If PTC profits do not exceed the sum of the PA+HET (currently £43,875 = PA: £6,475 + HET: £37,400) then retaining profits in the business and claiming ER on retirement would result in a higher tax liability than if the profits were extracted as dividends prior to retirement and caiming ER results in a lower net income received.
- Scenario 2 If PTC profits exceed the sum of the PA+HET (currently £43,875) then claiming ER will realise a tax benefit. However, to maximise the tax benefit only profits exceeding the PA+HET should be retained in the business. Profits up to PA+HET should be extracted from the PTC prior to retirement as dividendsThe use of ER in PI/FA claims. In this case, claiming ER results in a higher net income received.
The use of ER in PI/FA claims
In PI/FA claims, where individuals own a PTC, the claim typically includes an assessment of the loss of profits until their return to pre-incident capacity. However, in some claims the losses can continue until retirement. In these cases, the treatment of the PTC assets on retirement including retained profits), and whether ER would have been claimed in the “but for” scenario, need to be considered. To do this there are various factors which could indicate ER would have been claimed, such as:
- No provisions in place for retirement, e.g. pension funds or savings;
- PTC profits exceeding PA+HET;
- Low level of financial commitments;
- Historical retention of profits;
- Intention for the sale/cessation of the PTC on retirement.
Similarly, the inverse of the above factors could indicate that ER may not have been claimed in the “but for” circumstances. Incorrectly applying ER in PI/FA claims could materially impact the quantification of losses, resulting in either an overstatement or understatement of the claimed amounts. I refer to scenarios one and two above which demonstrate the differences in calculation on an annual basis. Consequently, in PI/FA claims including a lengthy future loss period to retirement, the misstatements could be significant. Therefore, careful consideration needs to be given in the application of ER.
As appeared in New Law Journal, March 2010.