Take care with percentages, says expert, as tribunal interprets entrepreneurs' relief strictly

Earlier this month, a first-tier tax tribunal judge held that certain deferred shares in a company fell within the definition of 'ordinary share capital' set out in the tax legislation (16-page / 151KB PDF), which brought the proportion held by taxpayer Alan Castledine down to 4.99%. Castledine had tried to argue that the deferred shares should not be counted in the calculation on the basis that they had no economic value, which would have resulted in him holding 5% of the qualifying shares.

As part of the 2016 Budget last week, the UK chancellor extended ER to encourage new investment in unlisted companies, provided that certain conditions are met. However, the 5% requirement would remain vital for employees and officeholders of listed companies seeking to qualify for traditional ER, particularly after the first-tier tribunal's decision in this case, said tax expert Catherine Robins of Pinsent Masons, the law firm behind Out-Law.com.

"The first-tier tribunal said the wording of the definition of ordinary share capital in the tax legislation was clear," she said. "This effectively cost Mr Castledine nearly £200,000 in tax, as without ER he had to pay CGT at 28% rather than 10%."

"The moral of the story is to always check percentages very carefully and be careful that spreadsheets do not round up the percentages: 4.99% is not the same as 5% for tax purposes. Taxpayers and their advisers should ensure that they take into account all the shares in issue, as well as the effect that subsequent share issues or transfers could have on the percentages – only very limited share classes, for example some preference shares, can safely be ignored," she said.

ER was previously only available to business owners, defined in the legislation as individuals who had worked for and owned at least 5% of the ordinary shares in a company for at least a year before their shares are sold. The government plans to extend this to external investors who purchase newly issued shares in an unlisted trading company or unlisted holding company of a trading group, provided that the shares are held for a continuous period of at least three years before sale.

The new form of ER will be available in respect of shares issued or on after 17 March and held for at least three years from 6 April 2016, subject to a lifetime cap of £10 million. ER reduces the rate of CGT payable on the disposal of qualifying shares to 10% which is a significant saving, despite the cut in CGT rates from 28% to 20% as part of the 2016 Budget.

Castledine had been the commercial director of Park Resorts Ltd until his retirement in September 2007, just after the company had been acquired by Dome Holdings Ltd (DHL). In December 2008, with the company in significant financial difficulty, Castledine was re-employed to save it from bankruptcy. As part of a successful restructuring, he was allocated 5% of the ordinary shares in DHL, which he later disposed of and attempted to claim ER on.

The situation was complicated by the fact that DHL had issued additional deferred shares, which had no voting rights and no rights to dividends attached. The share class had been created as a means of removing ordinary shares from the DHL senior management team that had been awarded to them while they were working when they left the company. Taking these shares into consideration reduced Castledine's shareholding in the company below the 5% threshold.

In his ruling, tribunal judge Malachy Cornwall-Kelly said that the legislation was sufficiently clear in that "there are to be no fine distinctions or special exceptions in the matter; that a simple, broad brush, easily workable approach is mandated".

"The creation of the class of deferred shares was openly commercial, and perfectly genuine," he said. "It has all the appearance of being a carefully devised means of ensuring the wellbeing of the company in the case of share-incentivised employees ceasing to play a part in it, or indeed becoming its rivals after they have left. Why should such a proper and lawful measure be found at odds with a presumed intention of parliament?"

"In the present case, it could be argued that parliament's definition of a person entitled to [ER] envisages someone who has, as it were, a fullbodied risk stake in the company in question: 5% of the ordinary share capital and 5% of the voting rights relating to it ... As we have noted, however, there has been no specific evidence before the tribunal to support the suggestion that parliament intended more than the legislation states, and to place weight on these speculations means introducing to the statutory definition a layer of meaning which is not apparent at first reading; it also risks producing an unwelcome degree of uncertainty, with all the administrative problems which could follow," he said.