In a decision published on 6 November 2015, the First Tier Tribunal (“FTT”) in the case of Flix Innovations Ltd v HMRC  UKFTT 0558 (TC) held that shares in the appellant company, Flix Innovations Limited (“Flix”), were not qualifying shares for EIS purposes.
In its preparations for a further investment in Flix, the shareholders agreed that a number of shares held by the directors would be converted into worthless deferred shares, so that they did not benefit from the additional investment into the company by its other shareholders.
Following this reorganisation of Flix’s share capital, the rights of the share classes were such that, on a sale or return of capital, the holders of the Ordinary shares in the capital of the Company would receive a payment equal to their shares’ nominal value, then the holders of the deferred shares would receive a payment equal to the deferred shares’ nominal value, after which the holders of the Ordinary shares would receive the balance of the proceeds; the deferred shares would not receive anything more than their nominal value.
ITA 2007, s 237(2)(aa) provides that shares which benefit from preferential rights cannot qualify for EIS relief.
The parties agreed that the Ordinary shares did have a preferential right – to the return of their nominal value, ahead of the deferred shares’ right to receive the return of their nominal value. However, the appellant argued that the preferential right was not material (in practice, it amounted to a preferential right to receive £933 ahead of the deferred shares, when Flix was valued in excess of £2.4m).
The judgment accepted that it is possible to take a de minimis approach to construing legislation: where a matter is too trivial for the law to be concerned with it, it can be ignored. However, the wording of the statute in question must be considered to see whether it permits this approach to be taken.
In the case of ITA 2007, s 173(2) (aa) the relevant part of the legislation reads:
“2) Shares meet the requirements of this subsection if they are ordinary shares which do not, at any time during period B carry…
“(aa) any present or future preferential right to a company’s assets on its winding up.” [added emphasis]
The FTT held that the wording of s 173(2)(aa) does not to allow any judicial room for manoeuvre in its interpretation and the word “any” means that the de minimis approach is not permissible.
For these reasons, the court held that the legislation is not focussed on the relative magnitude of the capital rights that different classes of shares enjoy, instead it looks at the priority of those rights: if the deferred shares had been able to receive their nominal value back at the same time and in the same priority as the Ordinary shares, there would not have been an issue, notwithstanding that the deferred shares had no other capital rights over and above the return of their nominal value.
While the case’s focus is on a question of statutory interpretation, it also serves to highlight the care that needs to be taken when companies are considering the structure of their share-rights. Deferred shares in particular can prove to create difficulties for various tax reasons:
- There is their potential impact on EIS, as was demonstrated in Flix;
- Deferred shares form part of a company’s ordinary share capital – large numbers of deferred shares can have a detrimental effect on shareholders’ ability to claim Entrepreneurs’ Relief; and
- Because the shares have limited rights, their value will be very low, which will mean that employment taxes charges can arise if employee shareholders dispose of them and receive more than the deferred shares’ market value.
This last point is very relevant in situations where shareholder directors fall out and one agrees to buy-out the other; often we see situations where the leaver’s shares will be converted into deferred shares immediately before the buy-out process begins, especially where a buy-out is phased. While it is unlikely that HM Revenue & Customs would necessarily take the point that a charge under ITEPA 2003, pt 7, ch 3D arises, it is something that a future purchaser of the business may wish to make an issue of.
As Flix demonstrates, having good commercial reasons for undertaking a transaction in shares is not sufficient to prevent adverse tax consequences arising if the structuring does not adequately take into account the relevant legislation.
For further information please contact the TaxDesk on 0845 4900 509 and ask for Thomas Dalby.