Meaning of ordinary share capital

The FTT has held that cumulative preference shares qualify as “ordinary share capital” when determining the level of a person’s shareholding for entrepreneurs’ relief purposes.

The FTT has held that cumulative preference shares qualify as “ordinary share capital” for the purposes of entrepreneurs’ relief: Warshaw v HMRC [2019] UKFTT 268. The fact that the shares carried a right to dividends which required compounding, if insufficient profits were available in a particular year, meant that the shares were not simply shares which gave a right to a dividend at a fixed rate.

The decision is, however, contrary to HMRC’s stated position on cumulative preference shares and should be treated with a degree of caution. It seems highly likely that HMRC will appeal the decision.

Background

The taxpayer held both ordinary and preference shares in a company of which he was a director. On disposal of those shares, he claimed entrepreneurs’ relief pursuant to the provisions of TCGA 1992 s.169H. HMRC rejected the claim on the basis that he did not have the necessary 5% holding of ordinary share capital for it to qualify as a disposal of share in his personal company.

It was common ground that if both the ordinary and preference shares were taken into account, then the 5% threshold would be met. However, HMRC contended that the preference shares did not qualify as “ordinary share capital” as defined in ITA 2007 s.989. This defines ordinary share capital as all the company’s issued share capital “other than capital of 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 terms of the preference shares held by the taxpayer were determined by the Articles of Association. The Articles provided that the preferences shares only had a right to a “Preference Dividend” defined as follows: “In priority to any other class of shares, each Preference Share shall have the right to a fixed cumulative preferential dividend (“the Preference Dividend”) which shall accrue on a daily basis from the dividend commencement date at the rate of 10 per cent per annum on the aggregate of (i) the subscription price of such Preference Share and (ii) the aggregate amount of Preference Dividend that has previously compounded and not yet paid. The Preference Dividend accruing on each Preference Share shall be compounded on each anniversary of its dividend commencement date to the extent not previously paid.”

Decision of the FTT

HMRC argued that, because the rate of the dividend remained fixed, the shares fell within the exception in s.989 and could not be ordinary share capital. It was not necessary that both the rate of the dividend and the amount on which the dividend was to be calculated should be fixed (as argued by the taxpayer). In particular, s.989 was not concerned with the timing of the dividend, as otherwise (based on the taxpayer’s argument) it would not be possible to ascertain whether shares were ordinary share capital when they were first issued, but rather only at the time when any dividend was paid (when it would be known if compounding was necessary).

The taxpayer countered that its approach did not require the status of the shares to be determined when the dividend was paid. The question was whether it was possible that dividends would accrue other than at a fixed rate and in the present case it was. Relying on ‘compounding’ arising from limb (ii) of the dividend calculation in the Articles of Association, the taxpayer argued that, because the rate of dividend was identified by looking at the entire dividend as a proportion of the share capital, ie both the percentage element and the compounded amount to which it was applied, the rate was not fixed. It was not enough just to look at the percentage element of the calculation applied to determine the dividend.

Although “initially attracted by the argument advanced by” HMRC, on balance, the FTT found in favour of the taxpayer. It was necessary to take into account both the percentage element and the amount on which it is applied to identify the rate of dividend for the purposes of s.989. Accordingly, since in this case the Articles only provided for one of those elements to be fixed (the percentage) and not the other (the amount to which it was applied, which could vary), the shares were not excluded from being “ordinary share capital”.

The FTT was bolstered in its conclusion by the fact that it considered that HMRC’s preferred approach would have produced anomalous results. For example, under HMRC’s approach, neither shares that paid a dividend equal to 0.1% of taxable profits nor ones that paid a dividend of 50% of those on a company’s A shares would have qualified as ordinary share capital.

Comment

The definition of “ordinary share capital” in s.989 is important in a number of areas of the tax code, not simply entrepreneurs’ relief. As such, the decision is potentially of very wide importance.

However, it should be noted that the decision is contrary to HMRC’s guidance, as recently agreed with the CIOT, where HMRC specifically stated that cumulative preference shares would not be ordinary share capital. As such, it seems likely that HMRC will appeal the decision.

Indeed, as the FTT indicated, the decision may be a finely balanced one. The mere fact that the amount on which the dividend is calculated may vary due to necessary accumulation of unpaid dividends seems to be qualatively different to the other examples quoted by the FTT. The amounts are fixed in advance for the cumulative fixed rate preference shares (even if they have to be accumulated) in a way that they are not where a dividend is dependent on an external figure such as the taxable profits or dividends declared on A shares.

Moreover, as pointed out by HMRC in their guidance, cumulative fixed rate preference shares are “more like debt than equity”. It is perhaps surprising that the FTT did not seek to attempt a purposive construction of the definition, which may have given greater weight to this aspect.

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