Entrepreneurs’ Relief has now been around for 10 years and it is easy to assume that there is nothing left to learn. In this article we consider a couple of recent cases which demonstrates that there are still lessons to be learned, or at least “bear traps” to avoid, and then goes on to consider the recent consultation to deal with one problem area.
5% of the shares
It is beyond the scope of this article to consider the relevant provisions, even in overview, however, it is necessary to refresh memories as to the meaning of the individual’s personal company. The definition is found in s169s (3) TCGA and requires:
- That the individual holds at least 5% of the ordinary share capital of the company; and
- The individual has control over at least 5% of the voting rights of the company, by virtue of his holding of the ordinary share capital.
The test is an absolute one and be aware of the dangers of assuming that rounding’s will apply. We had a recent case where an individual had been allotted 56 shares giving him 4.999% of the ordinary share capital (57 shares would have given him just over 5%). The problem was compounded as he acquired the majority of the shares in the company ten months before it was sold and lost ER on all of the shares (had he have held a qualifying 5% holding for a minimum period of 12 months the whole disposal would have qualified for ER).
Ordinary share capital
The 5% test relates to the company’s ordinary share capital. This is defined in S989 ITA 2007 as;
“ordinary share capital”, in relation to a company, 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 have no other right to share in the company’s profits.
This definition was introduced in 1938 and interestingly has not until recently been judicially reviewed, however, we now need to explore two recent cases.
Castledine v HMRC
In this case, C disposed of loan notes. These had been issued to him by the company in respect of shares he had previously held and he claimed ER on the held over gain. The company had a reasonably complicated share structure, having four classes of shares including redeemable shares. These only had a right to be redeemed at par on a capital realisation after at least £20b had been paid to the B ordinary shareholders.
The question was whether or not the redeemable shares formed part of the ordinary share capital. In essence C’s argument was that the deferred shares- “deliberately, did not entitle their holders to any rights normally associated with share ownership: no profit share, no voting rights and an entirely illusory right to the return of capital. They were shares only in name. By comparison, Preference shares did have rights to share in profits but were excluded from the definition in section 989 of the 2007 Act, no doubt because they had much the nature of loan capital and were comparatively risk-free. An entrepreneur, by contrast was someone who took risks with his own money and the conditions for relief in section 169S reflected that: a requirement for a 5% holding in the ordinary share capital and 5% of the voting rights in that capital”.
The tribunal rejected these arguments and accepted that a plain meaning to the words of the legislation should be adopted and held that the preference shares formed part of the ordinary share capital.
HMRC v McQuillan
This was an upper tribunal case. And again, the tribunal was asked to consider a case with a somewhat complicated share structure which included redeemable shares. Which to meet the requirements of a grant provider a loan to the company had been converted into redeemable shares with no change in economic substance or accounting treatment. Whilst the tribunal was sympathetic it took the view that they could not depart from the terms of the legislation and the redeemable shares formed part of the ordinary share capital.
The tribunal noted – “such a definition may enable those who are well advised to fall within its terms, whilst leaving a trap for the unwary”. This is the clear message from both cases and after 80 years it is interesting that two cases have come before the courts in the last two years.
The Castledine case involved loan notes and the loss of ER. In similar circumstances (an earlier sale containing an element of deferred consideration) ER can also be lost where the company issues new shares and as a result causes a personal stake to fall below 5%.
This potential problem is acknowledged, and it was announced in the Autumn Budget 2017 that the matter would be consulted upon. In outline, the proposal consulted upon allows an individual in this position to elect to be treated as if they had disposed of their shares and reacquired them at their market value just before the time the company issued new shares. The individual may claim ER on that gain either at the time of election, or on a future disposal of shares.
The consultation is now closed; however, the results have not been published. It is likely that any changes will be introduced in the 2019 Finance Bill.
What can be learned from the above?
In summary the government is prepared to change the legislation to deal with one perceived problem but not with others, each would seem to equally warrant change and not to be the intention behind the legislation. The suspicion must be that the Chancellor is more receptive to one lobbying group than the other!
Practitioners need to ensure, in the words of the tribunal chairman, that their clients are well advised.
This article was in published in our June 2018 enewsletter. To be added to our mailing list, click here and submit your contact details on our sign up form.