It was announced in the Autumn Budget on 22 November 2017 that the government will consult on how Entrepreneurs’ Relief could be provided to those shareholders who, as a result of their company issuing new shares in order to raise funds for commercial purposes, have had their shareholding reduced to below the 5% qualifying level.
The rationale is that the change would give entrepreneurs an incentive to continue to be involved in their businesses following external investment.
Perhaps the government shares the sympathy expressed by the Upper Tribunal in the recent 2017 case of The Commissioners for HM Revenue and Customs v Michael and Elizabeth McQuillan, discussed below.
Entrepreneurs’ Relief is a valuable capital gains tax relief that permits the taxing of qualifying gains at a fixed rate of 10% – a significantly lower figure than the maximum rate of 20% on gains made from the disposal of business assets.
A gain on the disposal of shares in a company is an example of a chargeable asset for which Entrepreneurs’ Relief could be sought. The key conditions that must be fulfilled in order to qualify for this relief is that, in the 12 months preceding the relevant disposal, the seller was an officer or employee of the company holding at least 5% of the “ordinary share capital”, which allowed him/her to exercise at least 5% of the voting rights.
Section 989 of the Income Tax Act 2007 defines “ordinary share capital” 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”. On appeal of the McQuillan case, the Upper Tribunal of the Tax and Chancery Chamber scrutinised this definition.
The Commissioners for HM Revenue and Customs v Michael and Elizabeth McQuillan  UKUT 344 Case
Mr and Mrs McQuillan held 33% each of the shares in a sandwich shop company, which they had started back in 1999. The remaining 34% of the shares were owned by Mr and Mrs Pennick in equal proportions.
At some point after incorporation, the Pennicks made an interest-free loan to the company of £30,000 and, in order for the company to secure certain grants, the loan was converted into 30,000 redeemable shares of £1 each. Such shares were expressed in a shareholders’ agreement between the parties as being non-voting with no right to a dividend, which were also “redeemable at par at a future date decided by the Directors at their sole discretion”.
As a result of the arrangements, the company had 30,100 shares in issue which meant that, if the 30,000 redeemable shares were treated as ordinary share capital, Mr and Mrs McQuillan’s shareholdings would have decreased to less than 1% each.
In December 2009, in the lead up to a sale of the company to a third party, the redeemable shares were redeemed. Following the sale in January 2010, Mr and Mrs McQuillan each attempted to claim Entrepreneurs’ Relief on the disposal of their ordinary shares with the rationale that they owned 5% or more of the company’s ordinary share capital in the 12 months preceding the sale. HMRC, however, refused to grant them the relief on the basis that, as a result of the redeemable shares being issued, both Mr and Mrs McQuillan’s shareholdings were below the requisite 5% threshold to qualify for Entrepreneurs’ Relief.
In 2016, the First Tier Tribunal found in favour of Mr and Mrs McQuillan by deciding that shares with no right to a dividend were equivalent to shares that had a right to a fixed dividend of 0% – essentially, that the redeemable shares did not constitute ordinary shares for the purpose of Entrepreneurs’ Relief. HMRC appealed before the Upper Tribunal.
The pivotal question for the Upper Tribunal was the statutory definition of “ordinary share capital” – are redeemable shares that have no right to a dividend included in the definition of shares that have a “right to a dividend at a fixed rate” (that rate being 0%)?
In September 2017, the Upper Tribunal released a literal interpretation of the legislation and overturned the First Tier Tribunal’s decision. The Upper Tribunal held that shares that have no dividend rights constitute ordinary shares in respect of Entrepreneurs’ Relief and did not fall under the excluded shares within the statutory definition of “ordinary share capital”.
The Upper Tribunal rejected the First Tier Tribunal’s decision that shares with no dividend rights were equivalent to shares that had a right to a fixed dividend at a rate of 0% by making reference to the 2016 case, HMRC v Apollo Fuels Limited, which concluded that “nil is not a number or an amount, but the absence of a number or an amount”.
As a result, it was found that Mr and Mrs McQuillan did hold less than 5% of the company’s ordinary share capital for much of the 12 months preceding the sale and, consequently, did not qualify for Entrepreneurs’ Relief.
Although the Upper Tribunal sympathised with Mr and Mrs McQuillan by recognising that the couple were the type of entrepreneurs for whom the relief was devised, it asserted that the definition in section 989 of the Income Tax Act 2007 “… is apt to produce results which appear unfair”.
The judgment went on to add that there “… will be deserving cases that fail to qualify for relief, and non-deserving ones that do qualify. Such a definition may enable those who are well-advised to fall within its terms, whilst leaving a trap for the unwary.”
If the proposals in the Autumn 2017 Budget come into force, shareholders like Mr and Mrs McQuillan are more likely to qualify for Entrepreneurs’ Relief. Until then, it is recommended that shareholders review their company share capital structure to ensure that, if there are multiple classes of shares, those hoping to seek Entrepreneurs’ Relief on an exit from the company do actually own at least 5% of the company’s ordinary share capital.