Mark McLaughlin points out that company shares with little or no rights can cause unexpected problems for shareholders for capital gains tax entrepreneurs’ relief purposes.
Entrepreneurs’ relief (ER) offers individual taxpayers an attractive capital gains tax (CGT) rate of only 10% on total net chargeable gains from qualifying disposals of up to £10 million, if certain requirements are met.
For trading company shareholders, ER is subject to four alternative main conditions (i.e. A, B, C or D in the ER legislation). The most common of these is condition A. This broadly requires that throughout the period of one year ending with the date of disposal: firstly, the company is the individual’s personal company and is either a trading company or the holding company of a trading group; and secondly, the individual is an officer or employee of the company (or, if the company is a member of a trading group, of a trading group member) (TCGA 1992, s 169I(6)).
Are they ‘ordinary’?
A ‘personal company’ is defined in terms of the individual holding at least 5% of the ordinary share capital, and being able to exercise at least 5% of the voting rights by virtue of that holding (s 169S(3)).
So what is ‘ordinary share capital’? This is defined for ER purposes as all the company’s issued share capital, other than capital which gives the shareholder the right to a dividend at a fixed rate, but no other rights to share in the company's profits (s 169S(5); ITA 2007, s 989). Thus, although a fixed rate dividend share does not form part of the company’s ordinary share capital for ER purposes, any other type of share is taken into account.
The meaning of ‘ordinary share capital’ therefore represents a potential trap. It means that an individual’s shareholding in the company could be diluted (i.e. possibly to less than the 5% requirement for ER purposes in condition A above) by shares that possess few or none of the rights that normally attach to shares.
Diluted shareholding
For example, in Castledine v Revenue & Customs [2016] UKFTT 145 (TC), the taxpayer owned a number of ‘A’, ‘B’ and preference shares in a company, together with loan notes. He disposed of loan notes in 2011/12 and 2012/13, and claimed ER in respect of the disposals.
The company’s share capital included ‘deferred shares’, which had no voting rights and no right to dividends (i.e. their sole value was in the right to be redeemed at par on a capital realisation after at least £1 million had been distributed in respect of each ‘B’ ordinary share).
If the deferred shares counted as ‘ordinary shares’ the taxpayer held 4.99% of the company’s ordinary share capital. However, if the deferred shares were not taken into account, the taxpayer held exactly 5% of the company’s share capital, which would have been sufficient for his ER claim. HM Revenue and Customs (HMRC) considered that ER was not due because the deferred shares must be taken into account, resulting in the taxpayer holding less than 5% of the company’s ordinary share capital.
Unfortunately for the taxpayer, the First-tier Tribunal agreed with HMRC. The tribunal noted that the ‘long and unchallenged existence’ of the meaning of ‘ordinary share capital’ could be traced back to Finance Act 1938, and concluded that the company’s deferred shares fell within that meaning as it applied to ER. The taxpayer’s ER claim therefore failed.
Practical Tip:
Shares with little or no rights are sometimes nicknamed ‘funny’ shares. However, their existence can be anything but funny for some minority shareholders wishing to avail themselves of ER. The wide definition of ‘ordinary share capital’ has the potential to cause problems. I have seen instances where a company's share capital included shares with little or no rights (i.e. no dividend or voting rights), and yet the existence of those shares diluted the shareholdings of some individuals below the minimum percentage required for ER purposes. Therefore, do not assume that just because shares have little or no rights they can be ignored when counting a company's share capital.
