Entrepreneurs Relief Denied: Zero Coupon Shares

On 6 September 2017 the Upper Tribunal (“UT”) handed down its judgment in HMRC’s appeal against the First Tier Tribunal’s judgment in HMRC v McQuillan [2017] UKUT 344 (TCC), a case concerning the conditions that must be met for a taxpayer to claim entrepreneurs’ relief.

The facts

The company, Streats, was originally formed with 100 shares, 33 held by each of Mr and Mrs McQuillan, and 17 each held by Mr and Mrs Pannick. Mr and Mrs Pannick leant the company £30,000, which was initially shown as a creditor in the Company’s books.

The Company was successful and the directors approached Invest Northern Ireland (“Invest NI”) for funding to take the business to the next level.

As a condition for its investment, Invest NI insisted that the Company’s indebtedness to the Pannicks should be converted into share capital and that the Pannicks should not receive any repayment for a period of years.

In order to meet this condition, the Pannick’s loans were converted into zero dividend, non-voting redeemable shares, so that the final issued share capital of the Company was £30,100 divided into 100 ordinary shares and 30,000 redeemable shares.

The Company was sold and the shareholders sought to claim Entrepreneurs’ Relief on the disposal.

Entrepreneurs’ Relief (“ER”)

In order to qualify for ER the shareholders had to be employees or office holders and the Company had to be their “personal company”. This term is defined in TCGA 1992, s 169S as being a company in which the shareholder holds at least 5% of each of the voting rights and the ordinary share capital.

Both the McQuillans and the Pannicks met the first test: their ordinary shares had all of the voting rights in the Company. The second test is less straightforward: ordinary share capital is defined in ITA 2007, s 989 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,”

The McQuillans argued that the zero coupon on the redeemable shares held by the Pannicks constituted a fixed dividend right and that the redeemable shares did not constitute ordinary share capital for the purposes of the legislation and that, in consequence, they were entitled to claim ER on their gains.

Unsurprisingly, HMRC took the opposite view: a share that did not carry a dividend right could not be treated as having a fixed coupon and that the McQuillans were not entitled to claim ER.

As was reported in our article on <insert date and hyperlink to Sean’s article>, the First Tier Tribunal found in favour of the McQuillans – a zero coupon could be treated as a fixed dividend for the purposes of ITA 2007, s 989.

The Upper Tribunal (“UT”) took as the basis of the FTT’s decision the suggestion that there was ambiguity in the ITA 2007, s 989 definition of ordinary share capital.

However, where the FTT had seen ambiguity, the UT saw clarity, in order for the redeemable shares to be treated as falling outside of the definition of ordinary share capital in s989 there had to be some form of coupon attaching to the shares; shares that had no right to any kind of a dividend could not be said to have a fixed entitlement to share in the profits of the company.

The UT went on to criticise the FTT’s literalistic approach to interpreting the statute, pointing out the purposive approach favoured in recent cases, including Castledine v HMRC [2016] SFTD 484, which was a very similar case that had been decided at the same time as the FTT decision in McQuillan, but which had been decided on the opposite basis: that shares without a dividend right could not be said to carry a fixed coupon.

Wider impact

McQuillan is of interest to practitioners, because it highlights again the courts’ approach to statutory interpretation, but also because it underlines a significant risk where shares have been redesignated or converted into deferred shares: shareholders may spend years ignoring the existence of such shares only to be quite firmly bitten by them when they come to sell their companies and seek to claim Entrepreneurs’ Relief.

Because of the long qualification lead-time for Entrepreneurs’ Relief, clients should be encouraged to positively address the remnants of previous share-ownership structures and review share classes which don’t carry dividend rights.

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