Entrepreneurs’ Relief reduces the amount of Capital Gains Tax (CGT) on a disposal of qualifying business assets on or after 6 April 2008, as long as you’ve met the qualifying conditions throughout a two-year qualifying period either up to the date of disposal or the date the business ceased.
To claim Entrepreneurs’ Relief you have to meet the relevant qualifying conditions throughout a period of 2 years. You must have owned the business directly or it must have been owned by a partnership in which you were a member.
If you’re entitled to Entrepreneurs’ Relief, qualifying gains up to the lifetime limit (see below) applying at the time you make your disposal, will be charged to CGT at the rate of 10%.
The lifetime limit for a disposal is:
- 6 April 2008 to 5 April 2010, £1 million
- 6 April 2010 to 22 June 2010, £2 million
- 23 June 2010 to 5 April 2011, £5 million
- 6 April 2011 onward, £10 million
Tightening the Qualifying Conditions for ER
The qualifying conditions have been tightened at the beginning of this year, with the qualifying period being increased from 1 year to 2 years, and the requirement for entrepreneurs to own 5% of voting share capital being changed to entrepreneurs who own shares entitling them to 5% of distributable profits and net assets of the company. This change catches those businesses giving non-voting preference shares to individuals as a way to achieve better tax treatment on income through dividends.
Whilst this tightening may defeat some claims to ER if the existence of preference shares were to reduce an ordinary shareholder’s entitlement to under 5% of distributable profits, the change can also mean that preference shares are more likely to be considered as ordinary for the purpose of gaining the relief.
The treatment of Preference Shares for the purpose of ER
In Steven Warshaw v HMRC [2019] UKFTT 268 (TCC), the FTT has confirmed that as the relevant preference shares did not attract a fixed dividend, they could amount to ordinary share capital, for the purpose of entrepreneurs’ relief (ER).
Background:
Mr Warshaw was chairman of Cambridge Education Group Limited (CEG), a holding company, in which he held ordinary and preference shares.
On 12 March 2012, Mr Warshaw exchanged all of his shares in CEG for shares in Cambridge Education Holdings 2 (Jersey) Limited (CEH2). On 13 March 2012, Mr Warshaw exchanged all his shares in CEH2 for shares in Cambridge Education Holdings 1 (Jersey) Limited (CEH1).
Following these exchanges of shares, if Mr Warshaw’s preference shares were ‘ordinary share capital’, as defined in section 989, Income Tax Act 2007 (ITA 2007), he would hold 5.777% of CEH1. If they were not, he would hold 3.5% of CEH1 and not satisfy the 5% threshold required in order for the company to be classified as Mr Warshaw’s ‘personal company’, which would enable him to claim ER.
In December 2013, Mr Warshaw sold his shares in CEH1 and ceased to be a director. In 2015, he claimed ER on this disposal.
HMRC opened an enquiry into Mr Warshaw’s tax return and issued a closure notice confirming that the capital gains arising on the disposal of the shares in CEH1 did not qualify for ER because CEH1 was not Mr Warshaw’s ‘personal company’, for the purposes of section 169S(3), Taxation of Chargeable Gains Act 1992 (TCGA 1992) on the basis that the preference shares were not to be counted towards the shareholding qualifying limit.
The decision was successfully appealed.
The sole issue before the FTT was whether the preference shares amounted to ‘ordinary share capital’, as defined in section 989, ITA 2007. If they did, CEH1 would qualify as Mr Warshaw’s ‘personal company’, for the purposes of section 169S(3), TCGA 1992, and he would be entitled to ER on the disposal of his shares.
The FTT firstly considered the nature of the shares. The preference shares were cumulative and attracted a right to a fixed dividend at 10% per year, but if there were insufficient reserves to pay the dividend in one year, payment was deferred to the next year and the dividend would be paid at 10% on the aggregate of the subscription price and the amount compounded.
If, as was the case here, when the preference shares were issued, the articles of association of the company provided only that the percentage element of a dividend was fixed, then the shares did not have a right to a fixed rate dividend (i.e. the dividend could go up and down as a percentage of distributable profits). As such, the shares fell within the definition of ‘ordinary share capital’, provided by section 989, ITA 2007, and CEH1 was Mr Warshaw’s personal company. He was therefore entitled to ER on the disposal of his shares.
Summary:
Entrepreneurs should be aware that preference shares giving rise to dividends can be classed as a qualifying ownership % for the purpose of ER. This arguably can be a double edged sword. On the one hand it is further incentive for owners of preference shares without voting rights, knowing that they are able to claim the relief if entitled to more than 5% of distributable profits. On the other hand, it could result in an ordinary shareholder being found to hold less than 5%.
Taxpayers should consider the wording of a company’s articles of association and the rights attached to any shares disposed of when claiming ER.
Selling your company or reviewing your articles of association – Ai Law
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Source: Steven Warshaw v HMRC [2019] UKFTT 268 (TCC) ; https://www.ft.com/content/a8ac64aa-dba3-11e8-9f04-38d397e6661c; HMRC Guidance HS275 Entrepreneurs’ Relief (2019).
