Entrepreneur’s relief is a very valuable relief, reducing chargeable gains from 20% to 10%.  It depends on the seller of shares holding not less than 5% of the ordinary share capital of a company (plus 5% of its voting rights).  It might be supposed that the expression ordinary share capital would not be the cause of any confusion.  The recent case of McQuillan -v- HMRC shows that this assumption is not correct!

Here the company that was sold had until a month before completion of the sale had in issue non‑voting redeemable ordinary shares in its share capital.  The question was whether these shares had the right to a “fixed rate of dividend”, namely zero, so that they could be ignored in calculating the 5%.  If they could not be ignored the taxpayer’s claim for entrepreneur’s relief would be scuppered.

Surprisingly the First Tier Tribunal found for the taxpayer.  This required the Tribunal to find that the shares in question had no right to dividends:  neither the Articles nor a Shareholders’ Agreement said this.  So the Tribunal were prepared to infer this agreement from the conduct of the shareholders (albeit no dividends were ever paid before the shares were redeemed!).  HMRC may well appeal.

Background

Corporate lawyers (if not tax lawyers) generally divide capital into three categories.  At one extreme is loan capital (that may or may not be secured) which carries the least risk because it is paid out first on a liquidation.  At the other extreme is ordinary share capital:  this carries the highest risk (as it pays out last) and in consequence carries the greatest return.

In the middle of the risk spectrum sits the third category of capital:  preference shares.  This may be thought of as quasi-debt.  It generally carries a fixed coupon (effectively a rate of interest) and pays out on liquidation before any payment to the holder of the ordinary shares.

The taxpayers here had originally borrowed £30,000 from their friends who also became the holders of 17% of the £100 issued ordinary share capital.  The loan was interest free.

In 2007 (a year before Entrepreneur’s relief was introduced) the company applied for a grant.  It was a pre-condition to the grant that the £30,000 was converted into share capital:  this to prevent the grant simply being applied to repay the loan.

An experienced corporate lawyer faced with this situation would almost certainly have decided to create a new class of preference share with an expressly stated zero coupon.  Here the draftsman chose to create a new class of ordinary share which was expressed to have no voting rights.  The 30,000 shares of £1 each were also redeemable and were indeed redeemed a month before the sale of the company.  If the redemption had taken place 12 months before the sale there would have been no problem.

Strangely nothing was said about dividend rights:  in the absence of any express exclusion the obvious conclusion was that the shares carried the right to dividends.

The redeemable ordinary shares were redeemed at par two weeks before a first dividend was paid to the holders of the 100 ordinary shares.  This fact seems to have allowed the Tribunal to find “an agreement” that the dividend entitlement was zero.  So far so good for the taxpayer.

HMRC’s Position

HMRC, relying on its Manual, argued that shares that had no dividend rights did not have a right to a fixed dividend.  They argued that shares with rights akin to loan capital (the preference share referred to above) would not be ordinary shares.  But that was not the case here.  Here the company had issued a class of share called ordinary shares that had ostensibly diluted the taxpayers down to a fraction of a percentage each.

So even if it was accepted that the redeemable shares had no dividend entitlement the rate was not fixed at zero.

Tribunal Finding

The Tribunal appears to have been strongly influenced by the fact that the capital had started off as debt.  In view of the ambiguity it would be harsh on the taxpayer (they concluded) to classify the shares as ordinary shares.

Drawing on VAT rates as an analogy they accepted that a right to no dividends was a right to a fixed rate of zero.

Unintended Consequences for the Future?

If this case stands it could lead to unintended consequences.  One example springs to mind.

Tax advisers with an eye to valuation will often suggest to their clients that EMI option shares are given no dividend rights and perhaps no voting rights.

Should this case law stand then can such shares still be characterised as ordinary shares?  It would seem wrong that they could.

Conclusions

Advisers to private companies will want to carefully review existing structures.  You will not want to be undertaking that review just before a sale of the company!