Entrepreneurs' Relief: Clarification on the definition of ordinary share capital
An individual selling shares in a qualifying trading company will be eligible for Entrepreneurs’ Relief if he meets the following conditions throughout the specified qualifying period prior to the sale:
- He holds at least 5% of the ordinary share capital;
- That shareholding entitles him to at least 5% of the voting rights;
- That shareholding also entitles him to at least 5% of the company’s distributable profits and at least 5% of the assets available for distribution on a winding up (these new conditions are for sales taking place on or after 29 October 2018 only); and
- He was an officer or employee of the company.
For disposals occurring on or before 5 April 2019 the qualifying period is the 12 months ending with the date of sale. For disposals taking place after that date, the qualifying period is 2 years ending with the date of sale – so the various conditions have to be satisfied for a longer period of time.
It will be obvious that to qualify for the relief it is essential that the shareholder owns at least 5% of the “ordinary share capital”. Therefore, defining which shares constitute “ordinary share capital” and which ones do not is very important. There are a number of cases where shareholders created a new class of shares – which they believed to be something other than ordinary share capital (eg deferred shares or variable rate preference shares) – but which turned out to be “ordinary share capital” as defined for tax purposes. The effect was to dilute their own shareholding below the minimum 5% qualifying threshold which, in turn, led to the loss of Entrepreneurs’ Relief, disappointment and a tax liability that was several hundred thousand pounds higher than expected.
The Chartered Institute of Taxation, with HMRC’s permission, recently published a document setting out HMRC’s initial views on whether particular rights attaching to different types of shares would mean that those shares would be classified as “ordinary share capital” for tax purposes. There are some interesting views. For example, preference shares carrying a fixed entitlement to a dividend which is cumulative will not be regarded as ordinary share capital whereas preference shares carrying the same fixed entitlement to a dividend which is not cumulative will be regarded as ordinary share capital. This fine distinction may seem minor in an economic sense but it is of major significance for tax purposes.
Any shareholder or director who is thinking about creating a new class of shares should pay particular attention to the rights attaching to those shares, whether they will form part of the company’s ordinary share capital for tax purposes and the impact this will have on different shareholders’ entitlement to Entrepreneurs’ Relief. Failure to do so could result in an unwelcome and unexpectedly large tax liability on a future share sale.
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