Will the evolving BADR/ Entrepreneur’s Relief landscape discourage risk-taking in the private sector?

Let’s look at a higher-rate paying founder with a full Lifetime Limit and no other gains/ losses, who invested £1 million in a new company, subsequently sold the shares for £5m,  with disposal dates in 2018/19 or later tax years (including 2027/28 using the lower LL announced at last month’s Budget).

A £1 million investment producing £5 million proceeds gives a £4 million gain, but the Capital Gains Tax (CGT) bill rises from about £399,000 in 2018/19 to about £929,000 in 2027/28.

Worked comparison

I’ve assumed the individual is already a higher-rate taxpayer, so any gain not covered by ER/BADR is taxed at the applicable higher CGT rate. Higher-rate share gains were taxed at 20 per cent through most of this period, increasing to 24 per cent from 30 October 2024.

“Net ROI” is expressed in nominal terms and means:

(sale proceeds − original £1 million investment − CGT) ÷ £1 million original investment.

So, for example, 310 per cent means the individual gets their £1 million capital back plus £3.10 million net profit.

* the ER lifetime limit was reduced from £10 million to £1 million on 11 March 2020, rather than at the start of 2020/21. The 2019/20 figure assumes disposal before 11 March 2020. A disposal between 11 March and 5 April 2020 would instead be restricted to the £1 million limit.

** For 2024/25 the 24 per cent rate only applies from 30 October 2024. Before that date the higher rate on an ordinary share gain was 20 per cent. So, the figure shown assumes a disposal from 30 October 2024 onwards.

2027/28 following the recent Budget

This gets slightly worse because, based on the announced 2027/28 rules, the BADR lifetime limit falls from £1 million to £500,000 from 6 April 2027, although the BADR rate stays at 18 per cent. The ordinary higher CGT rate remains 24 per cent and the AEA is expected to remain £3,000.

So:

£4,000,000 gain
less £3,000 AEA
= £3,997,000

BADR:

£500,000 × 18 per cent = £90,000

Remaining gain:

£3,497,000 × 24 per cent = £839,280

Total:

CGT = £929,280

Net proceeds:

£4,070,720

Net profit versus the £1 million invested:

£3,070,720

Net ROI:

307.07 per cent

Three distinct tax deteriorations

There are three distinct tax deteriorations:

1. March 2020: cutting the ER lifetime allowance from £10 million to £1 million costs this investor almost £300,000.
2. 2024 to 2026: the rise in the general CGT rate to 24 per cent, followed by BADR moving from 10 per cent → 14 per cent → 18 per cent, takes the liability from about £699,000 to £899,000.
3. April 2027: reducing the BADR lifetime limit to £500,000 adds another £30,000.

So, the same economic investment, £1 million becoming £5 million, has moved from roughly:

£399,000 tax / £3.60 million net profit / 360 per cent ROI

to:

£929,000 tax / £3.07 million net profit / 307 per cent ROI

That is an increase of about £530,000 in CGT, reducing the entrepreneur’s after-tax gain by about 14.7 per cent compared with the 2018/19 result.

Does this matter?

Would a founder investing £1 million in 2018/19 have acted differently, had they known that a disposal in 2027/28 would have yielded a £530,000 increase in the tax cost (compared to what they might have hoped for at the time they invested)?

That’s the 64 million dollar question really.

One should not lose sight of the fact that investing £1 million in illiquid shares in a private limited company is generally a risky business, and our hypothetical investor could not have know, at the point of investment, that he/ she stood to make a decent return.

The return could have been £nil. There is an inherent asymmetry here; the founder bears the risk, whilst the government enjoys the upside.

For illustration’s sake, had they assumed a 60 per cent probability of losing all their investment; and a 40 per cent chance of exiting at £5 million; then the expected gain (ignoring the time value of money) becomes:

• Under the ‘2018/19 regime’: (40 per cent x £3,601,170) – (60 per cent x £1 million) = £840,468
• Under the ‘2027/28 regime’: (40 per cent x £3,070,720) – (60 per cent x £1 million) = £628,288

Which represents a 25 per cent reduction in profit.

Yes, there will sometimes be scope for loss relief that might reduce the economic impacts of an unsuccessful investment, but this is not guaranteed and depends on the circumstances.

Had the eventual tax treatment been known when the investment was made, it would have reduced the expected after-tax return available to compensate the founder for putting their capital at risk. For some investments that would not have changed the decision; but for marginal investments it rationally could have done.

Businesses and investors want certainty

Businesses and their founders value a tax environment that is stable and predictable; unfortunately the ER/ BADR landscape has been anything but predictable in recent years, as highlighted above.

Whilst there are legitimate arguments that BADR is not well targeted, or that it had become too expensive to maintain, it’s hard not to conclude that successive changes to the regime have weakened confidence in the government’s willingness to back private enterprise.

The behavioural response could be significant. The majority of founders (who, it must be said, have no hope of attracting the new Founder’s Relief as currently drafted) could, in response to increasing CGT costs:

• invest lower sums in startups;
• require more outside capital rather than risking more personal wealth;
• prefer lower-risk investments;
• seek higher valuations on exit;
• move entrepreneurial activity elsewhere;
• or simply decide that another five to ten years of stress and illiquidity isn’t adequately rewarded.

None of which would be terribly helpful to UK PLC.

For more information or to speak to an expert, please get in touch.