Warshaw – Cumulative preference shares constituted ordinary share capital and qualified for entrepreneurs' relief

In HMRC v Stephen Warshaw [2020] UKUT 366 (TCC), the Upper Tribunal (UT) has upheld the First-tier Tribunal's (FTT) decision that cumulative preference shares with rights to compound accrued but unpaid dividends constituted "ordinary share capital", for the purposes of section 989, Income Tax Act 2007 (ITA) and therefore qualified for entrepreneurs' relief (ER).

Background

Mr Stephen Warshaw (the Appellant), was chairman of Cambridge Education Group Limited (CEG), which is the holding company of the Cambridge Education Group (the Group). Prior to 12 March 2012, the Appellant held 44,183 ordinary shares and 396,000 preference shares in CEG.

The majority shareholder in CEG was a private equity firm, Palamon Capital Partners (Palamon). In March 2012, Palamon undertook a reorganisation of the Group as part of a recapitalisation. As a result of this reorganisation, two new holding companies were inserted into the Group’s structure: Cambridge Education Holdings 1 (Jersey) Limited (the Company) and Cambridge Education Holdings 2 (Jersey) Limited (Company 2).

On 12 March 2012, the Appellant exchanged all his ordinary and preference shares in CEG for new shares in Company 2. On 13 March 2012, he exchanged his ordinary and preference shares in Company 2 for new shares in the Company. 

As a result of these changes, the Appellant's shareholding in the Company replicated his original shareholding in CEG. He therefore held 44,183 ordinary shares and 396,000 preference shares in the Company. On 26 March 2012, the Appellant subscribed for 24,660 B ordinary shares in the Company.

On 4 December 2013, the Appellant disposed of his entire shareholding in the Company (the Shares) for cash and ceased to be a director and chairman of CEG.  

In January 2015, the Appellant submitted his 2013/14 self-assessment tax return to HMRC and included a capital gains computation for the disposal of the Shares, reporting a total gain of £6,438,419. The Appellant claimed ER in respect of this gain. 

In order for the Appellant to qualify for ER he had to demonstrate that for the relevant period prior to the disposal of the Shares, the Company was his "personal company", for the purpose of section 169I(6), Taxation of Chargeable Gains Act 1992 (TCGA). Section 169S(3), TCGA, defines "personal company" as a company where at least 5% of its ordinary share capital is held by the individual and at least 5% of the voting rights in it are exercisable by the individual by virtue of that holding. A personal company is therefore defined by reference to a specified percentage of both ordinary share capital and voting rights. 

If the preference shares were “ordinary share capital” (as defined in section 989, ITA) the Appellant held 5.777% of the ordinary share capital of the Company. However, if the preference shares were not ordinary share capital, he held only 3.5% of the Company’s ordinary share capital.

In October 2015, HMRC opened an enquiry into the Appellant's return and  issued a closure notice in August 2017, stating that the capital gains arising on the disposal of the Shares  did not qualify for ER because the preference shares were excluded from the definition of “ordinary share capital”. As a result the Company was not the Appellant's “personal company” and he was not entitled to ER. The Appellant appealed HMRC's decision to the FTT.

On appeal, the issue was whether the preference shares carried a "right to a dividend at a fixed rate". The FTT held that they did not, and that they therefore constituted ordinary share capital within the meaning of section 989, ITA, and therefore the Company was the Appellant's personal company and he was entitled to ER.  

HMRC appealed to the UT.

UT's decision 

HMRC's appeal was dismissed.

The UT agreed with the FTT. Under the Company's Articles of Association, the Appellant's preference shares carried a right to a fixed cumulative dividend at a rate of 10% a year on the amount subscribed. If, however, the preference dividend was not paid, for example, if there were insufficient funds to pay the dividend, the outstanding amount was to be compounded and future dividends were to be paid at 10% on the aggregate of the subscription price and the accrued but unpaid dividends. The UT agreed with the FTT that a fixed rate is a relationship between two variables, expressed as a ratio that requires, not only the rate of dividend to be expressed as a fixed percentage or amount per share, but also as to the amount to which the rate is applied. As the amount to which the 10% was to be applied could vary, the rate was not fixed and the preference shares met the definition of "ordinary share capital" for the purposes of section 989, ITA, and the Appellant was therefore entitled to ER. 

Comment 

This decision is one of several recent examples where HMRC has sought to disqualify a shareholder from ER (now called business asset disposal relief) on the basis that there was something unusual about the kind of shares held by the taxpayer. The decision provides helpful clarification on how the courts are likely to approach the meaning of "ordinary share capital", for the purposes of section 989, ITA.
In reaching its decision, the UT endorsed the view of the UT in HMRC v McQuillan [2017] UKUT 344 (TCC), that section 989 is simply intended to operate as a "bright dividing line" between shares that are ordinary share capital and shares that are not, and should not be given a purposive construction based on any particular tax regime in which it appeared.

A copy of the decision can be viewed here.