A key requirement for shareholders to enjoy Entrepreneurs’ relief (ER) is that they have owned 5% of the ordinary share capital for two years. Whereas ‘normal’ shares may have a relatively low nominal value (sometimes as low as £100) preference shares are typically for much higher amounts and can run into millions. Therefore, if an individual invests in preference shares the other shareholders will be keen to avoid being ‘crowded out’ from ER.
A, B, C and D are individuals who own 25 £1 shares each in a trading company. There is a proposal for Mr E to subscribe for 1M £1 preference shares. If these preference shares represent ‘ordinary share capital’ for the purposes of ER then A, B, C and D would be denied ER in the future.
Fortunately, for the purposes of ER, ordinary share capital does not include ‘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’. On the face of it this should avoid the problem shown above for traditional preference shares with a fixed dividend. However it is not as simple as this because previous cases have decided that preference shares with no dividend rights do not fall within the exclusion (and therefore can crowd the other shareholders out). There has also been a recent case which has added an extra dimension to this well-known problem.
HMRC v Warshaw
In this case the tax payer wanted his preference shares to qualify as ordinary share capital because that was the only way that he would meet the 5% condition. Here, his ‘cumulative preference shares’ entitled him to a dividend of 10% of the capital but also 10% of any dividends that had not been paid in prior years. He argued that the dividends were not fixed because they could vary subject to the dividend payment pattern. Perhaps surprisingly he won the case, although as this was only a First Tier Tribunal decision HMRC could appeal.
The key message of this case was that it is not just the percentage which must be fixed but also the amount on which any percentage is applied.
This case should provide a good reason for companies to review their capital structures in an ER context. Although the tax payer in the above case will be pleased to have won, there will be many more shareholders who will be adversely affected by the ruling. In fact, for this reason, it will be interesting to see if HMRC decline to appeal the case. If the law is allowed to stand here then it could be quite a money-spinner for HMRC in cases which involve ‘funny’ preference shares.
Forbes Dawson are an independently owned, tax-only firm offering specialist tax consultancy services to private clients, businesses and professional advisers.