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Fixing the definition of ordinary shares for ER

Entrepreneurs' relief (ER) relies on an arcane definition of ordinary share capital that dates back to the 1890s. Chris Williams explains why the courts are still deliberating over it.   

19th Feb 2021
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The latest case to delve into the meaning of ordinary share capital for entrepreneurs’ relief is Warshaw (HMRC v Stephen Warshaw ([2020] UKUT 366).

It is packed with argument over the recurring theme of whether shares on which entrepreneurs’ relief was claimed met the criteria to make the company the claimant’s ‘personal company’.

In the Upper Tribunal, HMRC failed to overturn the decision of the FTT (TC 7107) which upheld Warshaw’s appeal against HMRC’s determination that his shares did not qualify for ER. In other words, his ER claim was upheld.

What is a personal company?

The criteria for a company to be a claimant’s personal company are that:

  • the claimant holds at least 5% of the ordinary share capital of the company; and
  • that holding gives the claimant at least 5% of the voting rights.

This apparently simple definition has been a frequent source of contention throughout the life of ER, mainly due to the efforts of taxpayers and their advisers to present small minority holdings as meeting both of these 5% tests.

HMRC did not dispute that Warshaw’s shares entitled him to at least 5% of the voting rights, which was the subject of the Holland-Bosworth case (see Entrepreneurs’ relief: Mem and Arts must make it personal).

What are ordinary shares?

The problem HMRC had was with the definition of ‘ordinary share capital’ which, like many a term in tax is defined differently in different contexts.

The entrepreneurs’ relief definition is borrowed from an income tax definition (ITA 2007 s 989). This 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 (my italics) but have no other right to share in the company’s profits”.

Fixed rate or not fixed rate?

HMRC asserted that Warshaw’s shares were only entitled to a dividend at a fixed rate and had no other rights to share in profits.

The shares in question carried a fixed dividend of 10% of their nominal value. If that had been their only entitlement there would have been no doubt that they were fixed-rate and so did not constitute ordinary share capital.

But there was a further entitlement. If the company failed to pay some or all of the dividend the shortfall was to be compounded and all future dividends would be 10% of the nominal value plus all previously unpaid dividends.

HMRC argued that the dividend rate was just the 10% fixed, and it was not necessary to look at the overall charging mechanism.

Digging in the detail

Warshaw’s legal team argued that the ‘10% fixed dividend’ view was too simplistic because the way the dividend was calculated created an element of variability.

Warshaw’s dividend was not only 10% of the nominal value of the shares but also had a compounding element that entitled holders of those shares to a dividend of 10% of the entire sum owed to them, ie the 10% nominal dividend for the year in question plus all outstanding unpaid dividend entitlements from earlier years. Therefore, in relation to the nominal value of the shares the amount of the dividend payable could vary (ie it was not fixed).

The UT’s judgment is firmly rooted in case law that dates back to the earliest days of corporate law in the 1890s. That does not mean that HMRC may not persist in taking this case further, but its prospects of succeeding if it does so do not look good.

Budget change?

The government could address the problem of the definition of ordinary share capital by amending the legislation.

However, they may well not see the need to do so following the reduction of the lifetime limit of ER (now called business asset disposal relief: BADR) to £1m from 11 March 2020.

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