Clarifying 'Ordinary Share Capital' in Entrepreneurs' Relief: Revenue and Customs v. McQuillan

Introduction

The case of Revenue and Customs v. McQuillan (CAPITAL GAINS TAX) ([2017] UKUT 344 (TCC)) revolves around the interpretation of the term "ordinary share capital" within the context of entrepreneurs' relief under the Taxation of Chargeable Gains Act 1992 (TCGA). The appellants, The Commissioners for Her Majesty's Revenue and Customs (HMRC), contested the First-tier Tribunal's decision which had favored the respondents, Michael and Elizabeth McQuillan. The crux of the dispute pertained to whether redeemable shares with no right to dividends should be classified as part of "ordinary share capital," thereby affecting the eligibility for entrepreneurs' relief.

Summary of the Judgment

The McQuillans established a business and, to facilitate expansion and franchising, incorporated The Streat Franchising Limited (“Streat”) with a combination of ordinary shares and redeemable shares. The redeemable shares, issued to the McQuillans' relatives, were structured to carry no dividends and were intended to function as interest-free loans. Upon selling their ordinary shares, the McQuillans sought entrepreneurs' relief, which offers a reduced capital gains tax rate. HMRC denied this relief, arguing that the redeemable shares should be included in the calculation of ordinary share capital, thereby reducing the McQuillans' ownership below the requisite 5% threshold.

The First-tier Tribunal (FTT) initially sided with the McQuillans, interpreting redeemable shares with a 0% dividend rate as not constituting "ordinary share capital." However, upon HMRC's appeal, the Upper Tribunal overturned the FTT's decision, affirming that such redeemable shares do indeed form part of ordinary share capital. This interpretation upholds HMRC's position that the inclusion of these shares negates the McQuillans' eligibility for entrepreneurs' relief.

Analysis

Precedents Cited

The judgment references several key cases to solidify its stance:

Castledine v Revenue and Customs Commissioners [2016] SFTD 484: Confirmed that deferred shares with no dividend rights are part of ordinary share capital.
Flix Innovations Limited v Revenue and Customs Commissioners [2016] STC 2206: Reinforced that purposive construction cannot override the clear statutory definitions, especially concerning share classifications.
Revenue and Customs Commissioners v. Trigg [2016] STC 1310: Highlighted the importance of adhering to the literal meaning of statutory terms without overstepping into purposive interpretations.
Birtch v Cropper (1889) 14 App Cas 525: Established that, by default, all shares in a company rank equally unless stated otherwise.

Legal Reasoning

The Upper Tribunal meticulously analyzed the statutory definition of "ordinary share capital" as articulated in Section 989 of the Income Tax Act 2007 (ITA). The key points in their reasoning include:

Literal Interpretation: The term "ordinary share capital" encompasses all issued share capital, except that which has a fixed dividend rate and no other profit-sharing rights.
Dividend Rights: For shares to be excluded from "ordinary share capital," they must carry a definitive right to dividends. Redeemable shares with a 0% dividend do not confer such rights and hence remain part of ordinary share capital.
Ambiguity Rejection: The Tribunal dismissed the notion of ambiguity in the statute, asserting that a 0% dividend rate does not equate to "a dividend at a fixed rate."
Purposive Construction Limits: Emphasized that purposive construction should not override clear legislative language, maintaining that statutory definitions are not to be stretched based on the economic substance or intended outcomes.

Impact

This judgment has significant implications for future cases involving entrepreneurs' relief and the classification of share capital. Specifically:

Strict Adherence to Statutory Definitions: Companies must carefully structure their share capital, ensuring that any non-ordinary shares are explicitly defined to avoid unintended tax consequences.
Clarification on Dividend Rights: Even nominal or 0% dividend rights are insufficient to exclude shares from "ordinary share capital," thereby affecting ownership calculations.
Limitation on Purposive Interpretation: Reinforces the principle that statutory terms are to be interpreted based on their literal meaning, limiting the scope for broader purposive interpretations that could lead to varied tax treatments.

Complex Concepts Simplified

Ordinary Share Capital

Refers to all the issued shares in a company that typically carry voting rights and an entitlement to dividends. These shares represent ownership and carry the risks and rewards associated with the company's performance.

Redeemable Shares

These are shares that can be bought back by the issuing company at a future date. In this case, the redeemable shares were structured to carry no dividend rights, effectively functioning as loans rather than equity participation.

Entrepreneurs' Relief

A tax relief intended to reduce the capital gains tax rate to 10% on qualifying business disposals, subject to certain conditions, including holding a minimum percentage of ordinary share capital.

Capital Gains Tax

A tax on the profit realized from the sale of non-inventory assets, such as shares in a company.

Purposive Construction

An approach to statutory interpretation where the court seeks to understand the purpose behind the legislation, rather than just its literal wording.

Conclusion

The Upper Tribunal's decision in Revenue and Customs v. McQuillan serves as a pivotal clarification on the definition of "ordinary share capital" within the realm of entrepreneurs' relief. By affirming that redeemable shares with no dividend rights are indeed part of ordinary share capital, the judgment underscores the necessity for precise statutory interpretation over broader purposive approaches. This outcome not only solidifies the stance that dividend rights are essential in classifying share capital but also precludes entrepreneurs from circumventing ownership thresholds through nominal share structures. Consequently, business owners and tax practitioners must exercise meticulous attention in share capital configurations to ensure compliance and eligibility for beneficial tax reliefs.