Entrepreneurs’ relief: What is “ordinary share capital”?
The Upper Tribunal (UT) has released its decision in Warshaw [2020] UKUT 0366 (TCC), upholding the decision of the First-tier Tribunal (FTT) on the statutory construction of the term “ordinary share capital” for the purposes of entrepreneurs’ relief (since renamed to the somewhat less catchy “business asset disposal relief”).
For entrepreneurs’ relief to apply on a disposal of shares, certain conditions must be met. The condition relevant in this case was whether the company in question was Mr Warshaw’s “personal company”.
Before the FTT, Mr Warshaw successfully appealed against HMRC’s decision to deny his claim for entrepreneurs’ relief on a disposal of shares held in a company. HMRC’s decision was on the basis that the company was not Mr Warshaw’s personal company, because certain preference shares which he held were not “ordinary share capital”, and he therefore did not hold the requisite percentage.
As the test applied at the time, a company was an individual’s personal company where at least 5% of the company’s ordinary share capital were held by the individual and at least 5% of the voting rights were exercisable by the individual by virtue of that holding. That test has since been changed significantly but the definition of ordinary share capital remains relevant in this and a number of other contexts.
The question for the UT was whether or not the preference shares carried only a “right to a dividend at a fixed rate” and no other right to share in the company’s profits. If so, the preference shares were not “ordinary share capital” and the taxpayer was not entitled to entrepreneurs’ relief. The percentage entitlement to dividends was fixed at 10% but the dividends were calculated by reference to both the nominal capital and any previous unpaid dividends (i.e. the dividends were cumulative and the 10% coupon compounded on unpaid, accrued dividends).
HMRC’s guidance states that they usually view a fixed rate preference share that is cumulative (i.e. where the right to dividends remains outstanding even where the company does not have profits in a particular year) as not being ordinary share capital. Conversely, if a fixed rate share is non-cumulative (so that the right to dividends in a particular year is lost if the company has insufficient profits to pay in that year) then HMRC see it as being ordinary share capital. Where the coupon compounds (as it did in this case), HMRC say this is “finely balanced”.
According to the judgment, the effect of the compounding right on the preference shares meant that there was not a fixed percentage on a “fixed amount”. If the shares in question had entitled Mr Warshaw to receive 10% of the nominal capital subscribed for the shares without compounding then the rate would be fixed and so too would the amount to which the rate applied. But as the dividends could compound, only the rate was in fact fixed; the amount to which the rate applied could vary and the shares were therefore ordinary share capital.
The UT thought it clear that a fixed rate dividend right does not cease to be fixed rate merely because it is cumulative. HMRC’s guidance therefore appears to be correct on that aspect – a fixed rate preference share that is cumulative is not generally ordinary share capital. In other respects the guidance currently reflects the arguments they put forward in this case and it seems likely that in due course these aspects will need to be amended, subject to any further appeals. In particular, the UT rejected HMRC’s submission (which is also referred to in their guidance on this matter) that the statutory distinction between a share which is ordinary share capital and one which is a fixed rate preference share should be informed by whether in economic terms the share is debt-like.
One final point of interest in the case is that HMRC accepted that a shareholding could satisfy the 5% voting limb of the personal company test even if it did not satisfy the 5% ordinary share capital limb of the test. As noted above, this definition is relevant in a number of different contexts, including business asset disposal relief, tax advantaged share schemes and corporate grouping. It is therefore potentially of wide application and joins a number of other decisions in recent years that consider this point in the context of entrepreneurs’ relief.
The test for business asset disposal relief has only become more complicated since Mr Warshaw disposed of his shares due to subsequent legislative changes. Individuals should take specialist advice if there is any doubt as to whether their shares meet any of the required conditions.
This article was written by Helen Coward and Tessa Newman at Charles Russell Speechlys. For more information, please contact Helen on +44 (0)20 7427 6766 or at helen.coward@crsblaw.com or Tessa on +44(0)20 7203 8843 or at tessa.newman@crsblaw.com.
