Entrepreneurs’ Relief and Share Disposal
Can fixed rate, compounded, preference shares can count as ordinary shares for the purposes of Entrepreneurs’ Relief? Yes, the tax tribunal has ruled in a recent case - but such cases are probably fact-specific1.
Entrepreneurs’ relief is a vital tax break for businesses looking to reduce their capital gains tax liability. The relief is available if you are a sole trader or business partner; you have owned the business for at least two years; and you make a ‘material’ disposal of all or part of the business.
This includes a ‘material disposal’ of qualifying company shares if certain conditions are met. One condition is that the director or employer must hold at least five per cent of the ordinary shares and voting rights in their company.
Ordinary share capital means all the company's issued share capital, however described, other than capital the holders of which have a right to a dividend at a fixed rate but no other right to share in the company's profits.
So what does this mean in practical terms? A recent case sheds useful light on the court’s approach and on what basis it disagreed with HMRC.
What’s the background?
The company had a class of shares defined as 10 per cent cumulative preference shares of £0.01 each. The dividend was calculated by reference to:
“the aggregate of (i) the subscription price of such Preference Share and (ii) the aggregate amount of Preference Dividend that has previously compounded and not yet paid. The Preference Dividend accruing on each Preference Share shall be compounded on each anniversary of its dividend commencement date to the extent not previously paid.”
The taxpayer disposed of his entire shareholding in cash and claimed entrepreneur’s relief on the disposal. However, HMRC said these did not count as ordinary shares for the purposes of entrepreneur’s relief as the company was not his personal company.
The sole issue was whether the preference shares held by the taxpayer were “ordinary share capital”. If so, he was entitled to entrepreneurs’ relief on the disposal of his shares. However, it was accepted that the shares gave a right to a dividend and that there were no other rights to share in the profits, so it was necessary to consider whether the preference shares had a right to dividends at a fixed rate.
If HMRC’s argument that the shares did not qualify as ordinary shares stood, the taxpayer held just 3.5 per cent of the company’s ordinary shares and would not qualify for relief.
The Tribunal agreed with the taxpayer: it was not enough to look only at the percentage element of the calculation applied to determine the dividend – but also the compounded amount to which it is applied, therefore, the rate was not fixed.
What does this mean for businesses?
Businesses and directors should now review their shareholdings to check whether they would be entitled to claim entrepreneur’s relief on a disposal. Where the shares carry the right to a fixed rate, cumulative dividend where the fixed rate may vary, it may turn on whether or not those shares actually count as ordinary shares as to whether they qualify for this relief.
It is also worth noting that HMRC’s internal manual (Company Taxation Manual) has recently been updated in light of this ruling. Notably, the guidance says this case is of persuasive rather than precedent authority. The manual sets out the general principles in the case of “preference shares where coupon compounds over time or a preference share where a rate of interest is added if dividend is unpaid”, as follows:
If the rate is fixed and cumulative arguably the shares are not ordinary share capital as there is in the end nothing beyond a right to a return at a fixed rate, albeit that the coupon compounds. Where a further rate of interest is added if the dividend is unpaid, the issue is whether the additional interest is seen as a return on the original investment, which would support fixed rate. But if seen as a separate return on amounts outstanding there would be a right to two differing fixed rates, and the tiered dividends analysis would apply.
However, HMRC says whether these shares amount to ordinary share capital are “borderline – this is finely balanced and may depend on facts of case”.
1Warshaw v HMRC TC/2017/08674
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