Definition of “ordinary share capital” when considering entrepreneurs’ relief

Mr & Mrs McQuillan (“the appellants”) were directors and shareholders in a company that they had incorporated in 2004. The issued share capital of the company at incorporation consisted of 100 £1 ordinary shares of which the appellants each held 33 of those shares and another couple, Mr & Mrs Pennick, each held 17.

Mr & Mrs Pennick has also lent £30,000 to the company which was showing as a directors’ loan in the company accounts.

When the company began to grow, it approached Invest Northern Ireland (“Invest NI”) in 2006 for a grant. The grant was approved but on the basis that Mr & Mrs Pennicks’ loan was converted into shares to satisfy Invest NI that the grant would not be used to repay the original loan from Mr & Mrs Pennick.

It was subsequently agreed to convert the loan into £30,000 redeemable, non-voting shares, for which Mr & Mrs Pennick held 15,000 each. The shareholder agreement provided that “any Redeemable Share Capital from time to time in issue shall not bear any voting rights and will be redeemable at par at a future date decided by the Directors at their sole discretion”. The shareholder agreement provided that dividends would be paid to the shareholders but was silent on the proportion in which they would be paid.

In 2009, an offer to purchase the company was made and subsequently accepted by the directors. It was resolved that the 30,000 non-voting redeemable shares be redeemed at par before the sale took place, with the purchasers acquiring all of the 100 ordinary shares shortly afterwards on 1 January 2010.

The appellants disclosed the sale of their shares on their 2009/10 tax returns and claimed entrepreneurs’ relief (ER) on the capital gains tax payable.

HMRC subsequently opened an enquiry into those returns and concluded that the disposals did not qualify for ER. Following a statutory review which upheld HMRC’s decision, the matter was brought to the first-tier tribunal (FTT).

The argument

The FTT had to decide whether the disposal of the shares by the appellants constituted a disposal of shares in their personal company. In order to decide this, the FTT had to determine what constituted ordinary share capital within the definition of a personal company.

Ordinary share capital is defined in s989, ITA 2007 as “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”.

HMRC held that the 30,000 redeemable, non-voting shares formed part of the ordinary share capital of the company, which when included with the existing 100 ordinary voting shares, effectively gave each of the appellants a 0.001% stake in the company.

HMRC argued that the shares disposed of by the appellants could therefore not be shares in a personal company as in the 1 year ending with the date of sale, neither of the appellants owned at least 5% of the ordinary share capital in the company.

The appellants argued that the redeemable, non-voting shares did not form part of the ordinary share capital of the company as not only did the shares have no voting rights or any other right to share in the company’s profits, but they in addition had no right to dividends which in their opinion equated to a right to a fixed dividend at 0%.

The appellants also argued that at the time of the loan conversion in 2006, entrepreneurs’ relief had yet to be introduced into the legislation and neither party to the loan conversion could have realised that this may have implications for entrepreneurs’ relief. To then deny entrepreneurs’ relief would be inconsistent with the spirit and intention of the legislation.

The FTT listened to both arguments and then had to consider whether “a dividend at a fixed rate” included shares which have no right to any dividend.

The FTT acknowledged that the statutory provision defining ordinary share capital was ambiguous and that where such provisions are not plain, a common sense approach may be adopted under ordinary principles of statutory interpretation.

The FTT decided that due to the limited information presented before it, a right to no dividend is a right to a dividend at a fixed rate for the purposes of that definition. The appellants’ appeal was therefore allowed.

The importance of this case

The ruling is in contrast to the recent decision reached in Castledine v HMRC (TC049330) where it was held that deferred shares with no right to dividends and voting which could only be redeemed at par are within the definition of ordinary share capital as per s989, ITA 2007. This resulted in Mr Castledine owning a total stake in the company of 4.99% and it therefore meant that he was not eligible for entrepreneurs’ relief.

The decision reached by the tribunal was therefore somewhat surprising as it would appear that it was borne more out of sympathy to the appellants than on any judicial interpretation or precedent.

This case therefore adds yet another layer of complexity to the entrepreneurs’ relief, with advisors and their clients being no clearer on what would constitute ordinary share capital for these purposes.

It remains to be seen whether HMRC will appeal the decision.

If you require any further information in relation to this case or CGT matters, please ring the TaxDesk on 0845 4900 509 and ask for Sean Eastwood.