In an article published on 7 September 2016 and found here we looked at qualifying for Entrepreneurs’ Relief ("ER") and recent cases that had generally been decided against taxpayers. A case involving Mr & Mrs McQuillan was the exception at the time. The Upper Tax Tribunal (“UTT”) has now reversed the decision of the First-tier Tax Tribunal (“FTT”) in the McQuillan case and found that there was no entitlement to ER.
Why is ER important ?
ER ensures a capital gains tax rate of 10% on the sale of shares in trading companies compared to the standard rate of CGT of 20% for higher rate taxpayers.
ER applies to the first £10 million of lifetime gains (measured from 6 April 2008) and the full entitlement to the relief will result in a tax saving of £1 million. Therefore, there is a huge financial incentive to qualify for ER.
ER requires the satisfaction of certain conditions. The shares must be ordinary shares in a trading company and represent at least 5% of the ordinary shares and be entitled to at least 5% of the voting rights in relation to the company. In addition, the shareholder must be an employee or a director of the company (or a member of a corporate group including the employer company) with the directorship or employment and the shareholding having been held for a 12 month period ending with the sale of the shares.
The McQuillan case
The McQuillan case concerned the definition of ordinary shares included in a sale in January 2010. The statutory definition of an ordinary share for these purposes is “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 McQuillan case involved 30,000 £1 redeemable shares created to capitalise a loan made by other shareholders to the company at the request of a local government funding organisation. The company also had 100 ordinary shares in existence of which the McQuillan’s owned 66 and 34 owned by the other shareholders (who also owned the redeemable shares). The redeemable shares had no voting rights and no right to share in the growth of the company. The UTT case report mentions that the articles of association setting out the share rights was silent regarding dividend rights.
The redeemable shares were redeemed at par value a couple of weeks before a sale of the ordinary shares in the company. HMRC rejected a claim for ER on the sale of the McQuillan’s ordinary shares on the basis that the redeemable shares were ordinary shares for ER tax purposes and swamped the remaining 100 ordinary shares, and so the McQuillan’s had not satisfied the 5% shareholding test for the 12 months prior to the sale of the company.
The UTT found for HMRC and held that it could not be construed that shares with no right to a dividend can be regarded as having a right to a dividend at a fixed rate of 0% and so have a right to a dividend. This meant that the redeemable shares did meet the statutory definition of an ordinary share. The UTT also held that the statutory definition of ordinary shares created dividing lines for a reason and that “the nature of dividing lines was that they had to be clear and predictable and, necessarily, they would create hard cases close to the line”.
The UTT decision is consistent with the decision made in the Castledine case which was heard in 2016.
The key point from the UTT decision in McQuillan (and the Castledine case) is that small differences in drafting can have a dramatic and sometimes unexpected tax effect. The failure to qualify for ER in the McQuillan case could result in an extra £80,000 tax per shareholder being paid assuming an otherwise full entitlement to ER. On the same basis today, the extra tax would be £1 million per shareholder due to the increase in the maximum entitlement to ER.
Further information and legal support
If you would like more information on Entrepreneurs’ Relief or would like to carry out a review of your company’s share capital to check your entitlement to Entrepreneurs’ Relief or any other form of tax relief please do not hesitate to contact any member of our Tax Team.