As a result of conflicting decisions in two recent tax cases, there is uncertainty as to the impact of deferred shares (and other shares with no dividend rights) on shareholder tax reliefs, in particular entrepreneurs’ relief for individuals and group reliefs for corporate shareholders. The issue is whether these shares are “ordinary share capital” for tax purposes.
It is important to be clear which shares are part of a company’s ordinary share capital because several tax reliefs are dependent on the shareholder holding more than a specified percentage of it. If deferred shares are ordinary share capital they may dilute the ordinary shares. Consequences could include the following:
- A parent company with all the ordinary shares, all the voting rights and entitlement to all the profits of the company might lose group reliefs if there were a large number of deferred shares held by another shareholder. Most group reliefs require the parent to hold at least 75% of the ordinary share capital of the subsidiary.
- An employee seeking entrepreneurs’ relief and holding over 5% of the participating ordinary shares might fail to qualify for entrepreneurs’ relief if deferred shares held by other shareholders diluted his holding of ordinary share capital below 5%.
- Conversely, holding deferred shares can help an employee qualify for entrepreneurs’ relief if they are ordinary share capital. It is necessary for the employee to hold at least 5% of the voting rights and 5% of the ordinary share capital but not necessarily an entitlement to 5% of profits.
As a general rule therefore, if the deferred shares are held by the shareholder seeking tax reliefs it is better if they are ordinary share capital. If they are held by other shareholders, it is better if they are not ordinary share capital.
For tax purposes, ordinary share capital is all of a company’s issued share capital other than capital the holders of which have a right to a dividend at a fixed rate but no other right to share in the profits of the company. This carve out is designed to exclude preference shares with returns similar to a loan at fixed rate interest. This means that shares carrying a fluctuating dividend constitute ordinary share capital even if the dividend is very small and payable only after other classes of shares have received large dividends.
In the case of Castledine v HMRC  UKFTT 145 (TC), the First Tier Tribunal held that shares with no dividend rights were ordinary share capital and diluted the taxpayer’s percentage of ordinary share capital below the 5% qualifying threshold for entrepreneurs’ relief, despite his ordinary shares carrying an entitlement to 5% of the profits of the company.
HMRC’s Employee Share Schemes User Guide supported this interpretation, stating that HMRC would treat them as such and will not contend that they carry the right to a fixed dividend of 0%.
In the case of McQuillan v HMRC  UKFTT 0305 (TC) heard two days after Castledine, a different First Tier Tribunal judge reached the opposite conclusion, also in the context of entrepreneurs’ relief, holding that a right to no dividend was a right to a dividend at a fixed rate of 0%. Therefore the shares, which had been issued on conversion of an interest-free loan, were not ordinary share capital and the taxpayer who held 33% of the ordinary shares qualified for entrepreneurs’ relief. The judge considered HMRC’s published views but did not consider himself bound by them.
The McQuillan case may well be appealed as it is inconsistent with HMRC’s published views and the practice of advisers. The law will remain unclear until a higher court rules on the issue. In the meantime shares with no dividend rights should be avoided and care should be taken to ensure that shares with minimal dividend rights fall on the right side of the line:
(a) if the intention is that deferred shares should be not be ordinary share capital, the shares should have the right to a very small fixed dividend; but
(b) if they are intended to be ordinary share capital, the shares should have a right to a very small fluctuating dividend, possibly payable only after other share classes have received a substantial dividend.
It may also be appropriate to review existing share rights where reliance has been placed on deferred shares being, or not being, ordinary share capital and considering whether the Articles of Association should be amended.