In a previous edition of Tax Matters Digest, we included a brief article on recent cases where Entrepreneurs’ Relief was denied due to issues with the companies’ share capital that could be resolved fairly easily. Following this, another case, similar in nature, has been heard by the Upper Tribunal (UT). Unlike the previous cases, this one relates to Enterprise Investment Scheme (EIS). EIS is designed to help smaller higher-risk trading companies to raise finance by offering a range of tax reliefs to investors who purchase new shares in those companies. In order for the investors to be able to claim the tax benefits on their tax returns, the issuing company must satisfy HMRC that it, the company, meets the necessary conditions. One of those conditions is that the shares must be ordinary shares and must not contain any preferential rights, including no present or future preferential right to the company's assets on its winding up.
In Flix Innovations v HMRC, a reorganisation which generated tiny preferential rights was found to disqualify the shares from EIS, meaning the investors did not receive the anticipated tax reliefs. This was so despite the UT acknowledging that the reorganisation was carried out solely for commercial reasons.
Originally the company had A and B share classes. The A shares were owned by the founders and the B shares were owned by outside investors. The A shares carried rights allowing the holders to control the company. Additional capital was required but the B shares proved to be unattractive as the ability to control the company rested in the A shares. The A shares could not be cancelled for Company law reasons.
It was decided that a similar result could be achieved if some of the A shares were converted to Deferred shares and the balance of the A shares and the B shares converted to a single class of ordinary shares (Ords).
Post reorganisation the rights on a winding up were allocated between the Ordinary and Deferred share classes as follows:
After the reorganisation of the share capital, new Ords were issued to investors. HMRC however refused to issue the EIS certificate on the basis that the Ords had preferential rights, being the preferential right on a winding up as against the deferred shares.
The taxpayer argued that the preferential rights were so small that they should be ignored. The UT however agreed with HMRC saying that the legislation is highly prescriptive and so it is not possible to import a de minimis into the legislation where one is not explicitly stated.
The taxpayer’s appeal was dismissed.
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