Preference shares and entrepreneur’s relief following the Warshaw decision

The position of individual members of management teams of private equity backed businesses looking to qualify for entrepreneurs’ relief has been further complicated by a recent judgment at the First Tier Tribunal (Warshaw v HMRC (TC07107) (“Warshaw”)). This is in addition to the legislative changes in Finance Act 2019 summarised here.

Warshaw will potentially be relevant for any individuals who hold shares in a portfolio company group where the private equity fund has financed at least part of their investment with preference shares.

There has long been uncertainty about whether particular types of preference shares were included, or excluded, from the definition of ‘ordinary share capital’. This is important in determining the calculation of the 5% tests for entrepreneurs’ relief. After much discussion, HMRC sought to clarify the position by confirming its view of several types of preference shares in a document circulated by the Chartered Institute of Taxation last year, and to be included in HMRC’s manuals in due course. This included a view on preference shares that had a coupon which was cumulative and (to the extent unpaid) compounding.

The judgement in Warshaw disagreed with HMRC’s view. In brief, the judge held that where preference shares carry a right to dividends that is cumulative and compounding if preference dividends are not paid on time, this does not constitute a right to dividend that was ‘fixed’. As such, the shares counted as ordinary share capital for purposes of the 5% tests.

In this particular case, the judgement was in favour of the taxpayer. However, in other situations it would be overwhelmingly more common for this interpretation to work against the taxpayer. In particular, where recent rules on interest deductibility have led investors to introduce leverage in the form of preference shares, the effect is likely to be that management shareholders would be heavily diluted in respect of calculating their proportion of the ‘ordinary share capital’ and so could fail to qualify for entrepreneurs’ relief. In many cases, this will be contrary to the expectations and advice received at the time the investments were made.

The First Tier Tribunal decision is not binding and it seems likely to be appealed by HMRC. That said, it creates a very uncertain position for existing management shareholders. Those structuring transactions now will also need to take this case into consideration.

Please contact us if you would like to talk through the impact of this decision for particular cases.

Chris Chapple


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