Entrepreneurs’ Relief: When is zero not a number?

To qualify for Entrepreneurs’ Relief (ER) on a share disposal, you must hold at least 5% of the company’s ordinary share capital. But what exactly is the “ordinary share capital” of the company?

This is a subject that thousands of small company directors and shareholders need certainty on when they dispose of their shares on retirement.

When you dispose of shares in a trading company, ER should apply to that gain if you have been an officer or employee of the company for a year prior to the disposal. Additionally, you must have held at least 5% of the ordinary share capital and voting rights during that period. The ER will reduce your rate of CGT on the gain to 10% if the gain lies within your lifetime limit for ER of £10m.

A company was set up in 1999 by Mr and Mrs McQuillan, who each owned 33% of the shares, and their in-laws Mr and Mrs Pennick, who each owned 17%. The Pennicks made a £30,000 interest-free loan to the company which was still outstanding in 2006 when Invest NI (a regional development agency) was approached for grant funding. As a condition of offering the grants, Invest NI insisted that the loan be converted to redeemable shares, which should not be redeemed for three years.
As a result, the company’s share capital became:

In keeping with the obvious intention to preserve the flavour of the original loan, the redeemable shares had no voting rights. No dividends had been paid by the company up to the date the shares were redeemed.

In 2009, an offer was made to purchase the company’s shares: the redeemable shares were redeemed and the remaining 100 ordinary shares were then sold. Mr and Mrs McQuillan, who were in their early sixties decided to retire and claimed ER, but HMRC refused their claim.

As far as the McQuillans were concerned, the 30,000 redeemable shares were not ordinary shares and they argued that the only ordinary shares were the original 100. As a consequence, they each had owned at least 5% of the ordinary share capital for the last decade.

However HMRC contended that the 30,000 redeemable shares should be considered as ordinary shares, which meant that for most of the year running up to the sale each of the McQuillans had only owned 33/30,100 or around 0.1%.

For the purposes of ER, a company’s 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”.

Everyone accepted that the redeemable shares had no right to share in the company’s profits. The only point of disagreement was their entitlement to a dividend.

The Tribunal decided that the redeemable shares had no right to a dividend, and so could not be ignored in the context of calculating the shareholding for ER. The McQuillans lost their right to claim ER, as they did not own 5% of the ordinary share capital.

When zero is not a number

The Tribunal referenced a judgement in the Court of Appeal (Apollo Fuels Limited):

“nil is not a number or an amount, but the absence of a number or an amount.”

But what about VAT, where there is a zero rate of tax? Wasn’t this a useful analogy in support of the argument for a zero rate of dividends? Unfortunately EU law states that the so-called “zero rate” of VAT is not in fact a rate of tax, but merely the UK’s manner of applying the “exemption with refund” system.

What about applying a purposive approach? Counsel for the McQuillans suggested that “to deny entrepreneurs’ relief in the circumstances… would be inconsistent with the spirit and intention of the legislation”. The difficulty is that their problem is not with the Entrepreneur’s Relief rules themselves, but rather with the general definition of ordinary share capital given in ITA 2007, and the spirit and intention of that Act has nothing to do with anyone’s entitlement to ER!

If Parliament had wished the definition to work in a subtly different way for ER purposes, they would have made it so by adding extra bells and whistles – which, for example, is what they did in CTA 2010 for group relief and consortium relief.

Certainly, it is harsh that the McQuillans failed to obtain ER. The Tribunal was very sympathetic to them, as the chair pointed out: “they are the kind of entrepreneurs for whom the relief was devised”. However, there will always be cases where deserving taxpayers lose out, just as there are cases where the undeserving benefit. The statutory definition of ordinary share capital is there to “establish a bright dividing line between those shares which will be reckoned with… and shares which are not”.

Tax Accountant’s Conclusions

The definition of ordinary share capital includes more than just the shares which we routinely think of as ordinary shares. Sometimes, for all sorts of commercial reasons, there are other shares lurking around within a company which might sabotage a claim to Entrepreneurs’ Relief. An early review and, if needed, some cleaning-up activity might make the year running up to the eventual sale a bit safer.

If you would like more detailed information on some aspect of UK Tax, send me an e-mail and I’ll be pleased to advise further.

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