Entrepreneurs’ Relief (ER) is a valuable tax relief that allows a reduction in the capital gains tax (CGT) payable on the sale of shares in a ‘personal service’ company from 20% to 10%. The Finance Act 2019 introduced some significant changes to the eligibility criteria for individuals claiming ER and we discussed those changes in our previous blog.
The tax savings for those qualifying for the relief can be substantial and a recent judgement at the First Tier Tribunal (Warshaw v HMRC) highlights the importance of shareholders understanding whether their shares will qualify for ER prior to any sale.
Mr Warshaw submitted a claim for ER following a disposal of ordinary and preference shares in a company on the basis that, together, the shares constituted more than 5% of the ‘ordinary share capital’ of the company at the time of disposal and therefore qualified for the relief.
HMRC disagreed that the preference shares were ‘ordinary share capital’ which meant that Mr Warshaw did not satisfy the 5% test and was liable for additional CGT of over £1.1m. Mr Warshaw appealed.
Ordinary share capital is defined 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.”
The appeal therefore focussed solely on whether Mr Warshaw’s preference shares carried a right to a dividend at a fixed rate.
In this case, the company’s articles of association stated that the preference shares had a right to a fixed cumulative preferential dividend of 10% per annum on the aggregate of the subscription price and amount of preference dividend that has previously compounded and not yet paid.
HMRC claimed that the reference in the articles to 10% meant that the dividend was fixed. Mr Warshaw argued that because the amount to which the 10% is applied is compounded, the preference shares did not carry a right to a dividend at a fixed rate.
The Tribunal held that the preference shares were not fixed because the amount to which the percentage element applied varied. As such, the preference shares were classed as ordinary share capital and Mr Warshaw’s claim for ER was allowed.
HMRC has since updated its guidance in line with the decision and is unlikely to appeal the decision.
Although in this case the decision favoured the taxpayer, the same interpretation could also work against a taxpayer in circumstances where preference shares being classed as ordinary share capital of the company would dilute their respective shareholding below the 5% threshold.
The case demonstrates how important is for shareholders to seek early advice on the company’s share structure and rights attaching to their shares in order to avoid any unexpected tax liabilities on disposal.
This is especially true in light of the changes introduced by Finance Act 2019 and it is worth noting that under the new additional 5% tests the relief may not have been allowed.
If you would like to discuss any of the above in more detail, please contact a member of the corporate commercial team using the form below.