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Entrepreneur’s relief (ER) enables individuals to qualify for a lower rate of 10% for capital gains tax arising on a sale of shares, subject to certain requirements. One of the key requirement for shareholders to benefit from ER is that they have owned 5% of the ‘ordinary share capital of the company’ for two years.
Ordinary share capital is defined in the Income Tax Act 2007 as the company’s issued share capital, other than that which has a right to a dividend at a fixed rate. On the face of it, this should mean that any shares which have a right to a fixed dividend, fall outside of the ‘ordinary share capital’. Traditionally, preference shares hold a right to a fixed dividend and are therefore usually outside of the ordinary share capital, meaning that they do not benefit from ER. This is beneficial to ordinary shareholders as preference shares are often issued for much higher nominal amounts than ordinary shares, meaning that if they were to form part of the ordinary share capital for ER purposes the shareholders who do not hold preference shares would be ‘crowded out’, thus increasing their potential liability for tax.
The recent case between Stephen Warshaw and HMRC has added an extra dimension to this well-known problem. The taxpayer (Warshaw) held around £6.4 million worth of Ordinary shares, £158,036 of Ordinary B Shares and £77,747 worth of cumulative Preference Shares in a company, which he disposed of in 2013. His position was that he held 5.777% of the ‘ordinary share capital’ of the company, but if his preference shares were deemed not to form part of the ‘ordinary share capital’ he held only 3.5%.
HMRC sought to argue that his preference shares had a right to a fixed dividend of 10%, meaning that they did not form part of the ordinary share capital and accordingly Warshaw did not have an entitlement to entrepreneur’s relief. Warshaw sought to argue that the rate was not fixed as the dividend would not be paid if there were insufficient reserves to declare a dividend in any one year. In practice this meant that if a dividend could not be declared in any one year due to insufficient reserves the dividend was deferred until the next year, meaning that it could not be deemed to be at a ‘fixed rate’.
The case was decided in Warshaw’s favour. HMRC could appeal, but the recent updates to the HMRC Company Taxation Manual issued following the outcome of the case indicates that they have accepted the decision. The updated guidance makes clear that fixed rate shares that entitle the holder to a 10% cumulative dividend will not form part of the ordinary share capital, but fixed rate shares that entitle the holder to a 10% non-cumulative dividend will form part of the ordinary share capital because some years no dividend will be paid and so the shares are deemed to be ‘more like equity than debt’.
The key message of this case and the subsequent updated guidance is that care should be taken to ensure that the rights attaching to preference shares do not inadvertently cause them to fall within the definition of ordinary share capital. If they do it may have a knock-on effect on the ability of shareholders to benefit from ER.
If you wish to discuss any of the issues concerning the availability of ER, please contact our expert Corporate Commercial team.