Entrepreneurs’ relief on company shares - the definition of “ordinary share capital”
Entrepreneurs’ relief, where the conditions are met, ensures a tax rate of just 10% applies to a capital gain. For individuals, it is available where a “material disposal of business assets” is made.
Included within the definition of “a disposal of business assets” is a disposal of shares in or securities of a company. Broadly for it to be a “material” disposal the following conditions must be met for the entirety of the one year period ending with the date of disposal:
- The company was the individual’s “personal company”;
- The company was a trading company or the holding company of a trading group; and
- The individual was an officer (director) or employee of the company or of one or more companies that are members of the group.
This article focuses on the first requirement noted above. A company will be an individual’s “personal company” if the individual:
- Holds at least 5% of the ordinary share capital of the company, and
- That holding gives them at least 5% of the voting rights in the company.
In the recent case of HMRC v McQuillan the upper tribunal found that redeemable shares were part of the ordinary share capital of a company, so that it was not the “personal company” of its two directors.
Mr and Mrs McQuillan had set up a company to run a sandwich shop business. They each held shares in the company, together with two family members who also jointly made a £30,000 loan to the company. When the McQuillans approached a business development agency for a grant, they were asked to convert the loan into redeemable shares. As a result, the issued share capital of the company comprised 100 voting shares (of which the McQuillans held 66) and 30,000 non-voting redeemable shares held by the two family members.
Later on, Mr and Mrs McQuillan claimed entrepreneurs’ relief on the disposal of the company (the redeemable shares were redeemed immediately before the disposal). HMRC denied the claim on the grounds that the redeemable shares were part of the ordinary share capital, so that the McQuillans’ shareholdings had represented less than 5% of the ordinary share capital of the company at some point during the 12 months prior to disposal. The issue was, therefore, the interpretation of ‘ordinary share capital’.
For the purposes of entrepreneurs’ relief, “ordinary share capital” has the meaning given by the Income Tax Acts where it means all of a 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.
In this case the redeemable shares did not provide a right to a dividend and, thus, could not fall within the exclusion from being ordinary share capital which is afforded to certain shares which offer a fixed rate of dividend.
The upper tribunal observed that the definition of ‘ordinary share capital’ was not susceptible to analysis by reference to economic risk and reward. It added that the classification of the shares as debt, as opposed to equity, in the accounts did not prevent them from being ordinary shares.
The upper tribunal ‘sympathised with the circumstances’ of Mr and Mrs McQuillan, recognising that they were the kind of entrepreneurs for whom the relief was devised. It also noted that the definition of ordinary share capital ‘may enable those who are well advised to fall within its terms, whilst leaving a trap for the unwary’; and it suggested that this was a case for the legislation to be reviewed to address this perceived ‘unfairness’.
In the meantime, entrepreneurs should be warned of the potential implications of converting loan capital into redeemable shares.
This is intended as a summary and overview of the tax situation and does not constitute financial advice and no action should be taken without first seeking professional advice specific to your circumstances.