In Flix Innovations Ltd v HMRC [2015] TC04710, EIS relief was denied as a company's ordinary shares carried preferential rights on winding up.
In order for shares to qualify for tax relief under the Enterprise Investment Scheme (EIS) they must meet a set of qualifying conditions. They must be unredeemable ordinary shares and, depending on the date of issue under section 173 ITA 2007, must not contain any preferential rights, including no present or future preferential right to the company's assets on its winding up.
The taxpayer company had issued B ordinary shares under an EIS scheme and it wanted to raise further funds by making a further issue of shares.
- The company's founders held A ordinary shares and its EIS investors B ordinary shares. The A shares contained special economic rights that increased their voting power and allowed them to control the board.
- The B shareholders were uninterested in increasing their investment in the company because increasing their shares effectively gave more rights to the A shareholders.
- Cancellation of A shares was impossible as the company had insufficient reserves.
It was decided to change the Articles and vary the rights of some of the A shares into non-voting deferred shares. At the same time, the rights to the remaining ordinary shares were altered so that their nominal value (£933) was repaid in preference to that of the deferred shares (£150). Only the ordinary shareholders could participate in any remaining surplus on a winding-up.
- The company submitted form EIS1 to HMRC stating that “the shares listed… are ordinary shares which, at no time since they were issued, have carried any preferential rights to the company’s assets on a winding-up…”
HMRC read the new Articles and they refused to issue an EIS certificate on the basis that the ordinary shares now carried preferential rights on a winding-up.
The company appealed HMRC's decision claiming that the preferential right attaching to the ordinary shares can be ignored provided it is small. It cited HMRC’s published guidance set out in paragraph VCM12020 of their published manuals which stated as follows:
"The rights carried by ordinary shares may in some cases be preferential as compared with the rights of deferred shares, but this is not necessarily so. In particular, where deferred shares carry a purely theoretical right to a residue of assets in a winding-up (for example where, in the case of a very small company, after the first £20 million has been distributed to ordinary shareholders the deferred shareholders are entitled to 1p per share), we do not regard the ordinary shares as carrying a preferential right."
The FTT examined the changes made to the ordinary shares and found that they indeed contained preferential rights over the deferred shares, although, purely in economic terms these rights were small.
- It then examined the EIS rules in ITA 2007 and decided that the rules were prescriptive: there is a statutory procedure which must be followed in order to enable an investor to claim relief.
- The EIS rules contain no de minimus rule.
- HMRC was right to deny EIS relief.
The taxpayer appealed and the decision was confirmed by the Upper Tribunal which held that:
- The words "carry any present or future preferential rights" in the legislation indicate that all such rights are excluded: there is no de minimis.
- Although the general policy of the EIS legislation is to limit relief to ordinary shares which carry the risk and reward of ownership, this has been implemented by specifically limiting relief to shares which do not carry any preferential rights.
- In the context of the highly detailed legislation and the use of the word 'any', it is impossible to ignore the preferential rights carried by the ordinary shares.
- This can be contrasted with the exemption from the withdrawal of relief where an investor receives only ‘insignificant value’ from the issuing company. This indicates that where Parliament intended inconsequential matters to be disregarded, it said so expressly.
The taxpayer’s appeal was therefore dismissed.
Comment
The EIS rules have taken yet another scalp: the devil of the EIS legislation is in the detail and there is a lot of detail to consider when you draft a set of Articles. The above example in HMRC's manual requires attention and we would not be surprised if the taxpayer contemplates judicial review.
The problems faced in this case by shareholders are very common. Those who found companies generally want to both have their cake and eat it: staying in control of the company whilst preserving their rights to profits.
External Links
Flix Innovations Ltd v HMRC [2015] TC04710 (FTT)
Flix Innovations Limited v HMRC [2016] UKUT 0301 (UT)