HMRC changes guidance on preference shares and Ordinary Share Capital

Preference shares are a type of share that typically provides dividends at a fixed rate before any dividends are paid to ordinary shareholders. Typically, there are two main types of preference shares: cumulative and non-cumulative (although preference shares can be designed in pretty flexible terms):

• Cumulative preference shares: If the company does not pay a dividend in any given year, the unpaid dividend carries forward to future years (accumulates)
• Non-cumulative preference shares: If the company does not pay a dividend in any given year, say because the company did not have distributable reserves, then the right to that dividend for that year is lost. It does not accumulate.

Until recently, HMRC’s guidance stated that they considered non-cumulative, fixed rate preference shares as part of OSC. This was based on the general principle that in some years the dividend would be paid, in others it would not (and would never be paid), and that this had the hallmarks of equity rather than debt.

The recent update to HMRC’s guidance has introduced a critical change to HMRC’s view. HMRC now states that both cumulative, and non-cumulative, fixed rate preference shares, do not form part of the OSC.

The meaning of OSC is important for a number of UK tax purposes.

Ability to claim BADR

One of the most significant relates to the ability to claim Business Asset Disposal Relief (BADR). This is a relief which can apply to disposals of shares and is usually dependent (alongside meeting all other tests) on the holding of at least 5% of a company’s Ordinary Share Capital. The exception to this rule is where shares are acquired under an Enterprise Management Incentive Plan. 

OSC       

Ordinary Share Capital refers to all of a company’s issued share capital (however described), other than capital, the holders of which, have a right to a dividend at a fixed rate but have no other right to share in the company’s profits. 

Classification of shares

The classification of a company’s shares is therefore critical in determining whether BADR is available. If a company has issued preference shares, these typically ‘swamp’ the number of ordinary shares in issue. This would mean that the holder of ‘plain’ ordinary shares would not hold 5% of the total shares in issue (unless they also hold sufficient number of preference shares). And this could be a problem in claiming BADR if those preference shares were considered part of the OSC. 

Fixed rate

The meaning of OSC, and in particular the meaning of ‘fixed rate’, has therefore been the subject of a number of cases heard in Court. For example, in McQuillan v HMRC [2017] UKUT 344, the Court concluded that a preference share with a zero coupon (0%) did not represent a ‘fixed rate’.

In the case of HMRC v Stephen Warshaw [2020] UKUT 0366, the Court judged that cumulative and compounding fixed rate preference shares did not represent a ‘fixed rate’ because the compounding element meant the rate of dividend could vary.

Where case law had not provided answers to the question of what a ‘fixed rate’ was, it has been common to rely on HMRC’s guidance.

At first glance, it is not entirely clear. HMRC’s manuals refer to Warshaw as the reason for treating cumulative and non-cumulative preference shares the same way. But that case was about the classification of cumulative and compounding preference shares.

However, looking more closely at the transcript of that decision, the Judges do make this point, ‘In our opinion, it is clear that a fixed rate dividend right does not cease to be fixed rate merely because it is cumulative. The right remains a right to a dividend at a fixed rate.’

Reading the above, it is perhaps not surprising that HMRC have published the view that both non-cumulative and cumulative fixed rate preference shares should have the same classification.

A key problem is that HMRC’s previous guidance on non-cumulative preference shares had not been particularly contested; it was common practice to treat such shares as part of the OSC. Does this mean their new guidance should be scrutinised?

The opinion of the Judges in Warshaw could be seen as endorsing HMRC’s current guidance. Does that mean the old guidance was wrong? What is the position if someone claimed BADR previously, but only on the basis of the old guidance?

There are perhaps more questions than answers arising from this updated guidance. What is paramount is that companies and shareholders review share structures in light of this change and consult with tax professionals to understand the impact this may have on their financial and tax planning strategies.

If you would like to discuss this further, get in touch with Steve or any member of the Old Mill Tax team here.