03 August 2016

The issue

Many companies use deferred shares as a means of converting potentially valuable ordinary shares into worthless shares, for example in connection with incentive arrangements or restructurings.

Two cases have cast doubt over whether or not the resulting deferred shares should be taken into account as part of the company's ordinary share capital when assessing the availability of entrepreneurs' relief.

The cases

Recently, the First-tier Tribunal considered two cases on the meaning of ordinary share capital with markedly different outcomes. In both Castledine v HMRC and McQuillan v HMRC, the shares in question had no rights other than to redemption at par value. In both cases the different interpretation the Tribunal applied ultimately decided whether or not entrepreneurs' relief was available. In one case it was held to be available, in the other it was not.

Section 989 of the Income Tax Act 2007 defines ordinary share capital as "all the company's issued share capital (howsoever described), 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 company's profits".

In circumstances where the availability of entrepreneurs' relief, and potentially other tax relief, is important, it is crucial to understand how each class of shares in the company is treated in this context. Getting this wrong could mean that individuals seeking entrepreneurs' relief do not hold 5 per cent or more of the ordinary shares in the company, which is one of the requirements to qualify for the relief.

In Castledine, the Tribunal held that deferred redeemable shares with no voting rights, no dividend entitlement and no realistic expectation of a distribution on a winding up formed part of the ordinary share capital of the company. The taxpayer in this case argued that the deferred shares had none of the characteristics of ordinary shares and that Parliament could not have intended such shares, with no economic value, to rank equally with participating shares. The Tribunal accepted HMRC's argument that the legislation was straightforward and unambiguous and held that it was not for them to deconstruct it and go beyond the literal words of the provision. As a result, the deferred shares were included in the aggregate numbers for ordinary share capital and the taxpayer, as a consequence, did not hold the required 5 per cent of the ordinary shares to be eligible for the relief.

In McQuillan, the Tribunal held that redeemable shares with no voting rights and no dividend entitlement did not form part of the ordinary share capital of the company. HMRC argued that as the redeemable shares had no rights to a dividend they could not satisfy the requirement in section 989 to have a right to a dividend at a fixed rate. The Tribunal, however, allowed the taxpayers' appeal, in this case holding that there was ambiguity in the way section 989 was drafted and that a right to no dividend could be interpreted as a right to a dividend at a fixed rate of zero, satisfying the requirement in the provision. As a result, the redeemable shares were excluded from the ordinary share capital and the taxpayers, each holding more than 5 per cent of the ordinary shares, were entitled to claim entrepreneurs' relief.


The uncertainty generated by these conflicting decisions will, hopefully, be resolved in the longer term. Until then it would be prudent to try to minimise the risks. We suggest:

  • clear drafting of share rights for new arrangements - introducing a nominal fixed rate dividend to shares which are not intended to be classed as ordinary shares could help although care (and advice) should be taken when structuring rights merely to avoid a particular tax consequence, especially given the revised DOTAS regime
  • adjusting proposed holdings – in some cases it may be possible to make immaterial adjustments to the numbers of shares being issued to ensure that any deferred/redeemable shares which fall into the uncertain category do not affect the availability of relief even if they are later held to be part of the ordinary share capital
  • review existing arrangements – existing arrangements should also be reviewed to identify and address potential problems. This should be done as soon as possible, especially where a potential exit is on the horizon, given the requirement to satisfy the relevant criteria for at least one year prior to sale.

For further information please contact Mark Shepherd.

Key contact

Mark Shepherd

Mark Shepherd Partner

  • Head of Private Equity
  • Corporate
  • Healthcare

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