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When can preference shares qualify as ordinary shares for tax relief purposes?

By RJP LLP on 22 May, 2019

The focus on entrepreneurs’ relief (ER) is increasing again, as questions are being asked about whether it is fair to have such generous tax breaks for business owners. According to research, the relief doesn’t necessarily act as an incentive to individuals to start a business, but it is certainly a reward for the financial and personal risks involved. The rules concerning eligibility for ER have tightened up recently and bearing this in mind, it is worth highlighting a number of cases where for one reason or another, access to the relief and hence the lower rate of capital gains tax was denied.

Is a zero dividend a fixed dividend?

For a capital gain on a disposal of shares to qualify for ER, the shares being disposed of must be held in the shareholder’s own personal company; the test applied is that at least 5% of ‘ordinary share capital’ (OSC) is owned by the shareholder. The Chartered Institute of Taxation (CIOT) defines this 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".

This is open to misinterpretation and problems have arisen in specific cases. For instance, what happens if the shareholder has a right to no dividend? In HMRC v McQuillan [2017], the Upper Tribunal held that a right to a dividend of zero was not a right to anything at all. Such shares therefore do not have a right to a dividend at a "fixed rate", they are shares with no dividend rights and for the purposes of claiming ER, will qualify.

 

What about preference shares?

More interestingly, there has recently been some clarification over whether preference shares can in some circumstances also qualify as OSC when claiming entrepreneurs’ relief. This is worth knowing because holders of preference shares have the advantage of a higher priority claim to the assets of a company in the event of insolvency. As clarified by the CIOT, the following are all situations where shares that are technically preference shares would actually qualify as OSC for ER purposes.

 

  • A fixed rate preference share with a zero coupon;
  • A preference share with a right to "tiered" dividends (as the rate of dividend is not fixed);
  • A fixed rate preference share, but the holders receive a payment above the par issue price based on the figure for reserves when redeemed, or when the company is sold, or placed in liquidation (although the holder is entitled to a fixed rate of return, the entitlement to a payment above par is an "other right to share in the company's profits"). Note that HMRC flag this as being particularly "finely balanced", and therefore subject to further review;
  • A fixed rate preference share, but the holders are entitled to receive a further dividend payment should certain events occur (usually unlikely except in exceptional circumstances e.g. breach of banking covenants). Again, although the holder is entitled to a fixed rate of return, there exists an "other right to share in the company's profits’’;
  • A preference share with 2 alternate fixed rates, the rate used depending upon certain events during the year (e.g. level of profits).

 

What is important to be aware of  is that issuing shares and altering existing shares can have a very significant impact on whether a shareholder can qualify for entrepreneurs’ relief. Given that this relief is currently an opportunity to reduce capital gains tax by up to £1m over a lifetime, that’s well worth watching.

Always take expert advice on issues relating to company shares. Individuals who own ordinary shares in companies that have also issued preference shares should seek advice on their personal position.

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