Entrepreneurs' Relief - a few considerations
The recent case of HMRC v M and E McQuillan  UKUT344 highlights a current trap for entrepreneurs and small business owners who issue further shares in their company, with the consequence that their own shareholding is diluted, and the effect this has on the availability of entrepreneurs' relief. However, a recently published HMRC consultation seeks to remove what may be considered an unfair application of this relief and widen its availability in certain circumstances.
The facts of the McQuillan case
Mr and Mrs McQuillan set up a company to run a sandwich shop business. They each held shares in the company together with two other family members, who also made a loan of £30,000 to the company.
The company expanded and Mr and Mrs McQuillan approached a regional business agency for a grant. Grants were offered but on the condition that the loan to the company should be converted into redeemable shares. As a result, the issued shares of the company consisted of 100 voting shares (the McQuillans held 66 and the family members held 34) and 30,000 redeemable shares, held by the family members, which had no voting rights and no rights to dividends.
Mr and Mrs McQuillan sold their shares in the company in 2009. In their tax returns they claimed entrepreneurs' relief in relation to the disposal of their shares.
What is Entrepreneurs' Relief?
Entrepreneurs' relief applies to certain qualifying business disposals. It operates so as to apply a 10% capital gains tax rate to qualifying gains up to a lifetime limit (currently £10 million). One of the conditions for the relief to be available is that the taxpayer must have held at least 5% of the company's ordinary share capital for at least a year before the disposal.
HMRC refused the claim on the basis that the McQuillans had not throughout the period of one year prior to the disposal held at least 5% of the ordinary share capital in the company. HMRC argued that the 30,000 redeemable shares were part of the company's 'ordinary share capital' and so on that basis the shares held by the McQuillans did not meet the 5% threshold needed.
Did the McQuillans qualify for Entrepreneurs Relief?
The case revolved around the definition of ordinary share capital. The definition is set out in Section 989 Income Tax Act 2007 and states that ordinary share capital means '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 the company's profits.'
The upper tax tribunal said that from a literal reading of the section the definition of what constitutes ordinary share capital is very clear. The only exception is in respect of capital, where the holders have a right to a dividend at a fixed rate and no other rights to share profits.
In the McQuillan's case, it was made clear that the shares issued in exchange for the loan carried no rights to a dividend. The tribunal therefore held that the redeemable shares clearly fell within the definition of ordinary share capital and accordingly the McQuillans didn’t have 5% of the share capital needed to qualify for entrepreneurs' relief.
The McQuillan case and Entrepreneurs' Relief - our comments
The upper tax tribunal sympathised with Mr and Mrs McQuillan's circumstances and recognised that entrepreneurs' relief was in fact designed for entrepreneurs such as themselves. However the law in this particular situation was against them. The tribunal recognised that there is a case for the legislation to be reviewed to address what may be perceived as unfairness.
This review is now taking place as it has been proposed to allow the relief where the entrepreneurs' personal stake falls below the normal 5% qualifying level as a result of raising funds for commercial purposes by means of issues of new shares. Individuals in this position may be able to elect to be treated as if they had disposed of their shares and reacquired them at market value just before the time the company issued new shares. Entrepreneurs' relief may be claimed on that gain either at the time of election or on a future disposal of shares. HMRC are consulting on this until 15 May 2018 and it is expected that this new relief will apply to dilutions taking place occurring as a result of fundraising issues on or after 6 April 2019.
In any event, entrepreneurs should be wary about capitalising loans in exchange for shares and assess the tax and legal impact these, and any other, arrangements may have. Entrepreneurs' relief should always be one of the considerations taken into account and, whilst the consultation may widen its availability, tax and legal advice should nevertheless be obtained.
For more information please get in touch with James Frampton.