The Enterprise Investment Scheme: Beware preferential rights attaching to shares

The Enterprise Investment Scheme: Beware preferential rights attaching to shares

The background

The recent First-tier Tribunal case of Flix Innovations Ltd v HMRC, highlighted the risks involved in changing the rights attaching to a company’s shares where investors hope to qualify for tax relief under the Enterprise Investment Scheme (EIS).

The circumstances of the case

The company had ‘A’ shares and ‘B’ shares which were held, respectively, by the founders of the company and by outside investors. The outside investors agreed to subscribe for further shares and it was agreed that, ideally, to maintain a commercial balance some of the founders’ ‘A’ shares would be cancelled.

There were company law factors that made it difficult -or impossible- to cancel these shares and instead a reorganisation took place under which some of the ‘A’ shares were converted into valueless, non-voting deferred shares and the others, together with the ‘B’ shares, became a single class of ordinary shares. Following that, the outside investors subscribed for new ordinary shares of that single class.

The question that arose was whether EIS relief was available for the new subscription of shares. EIS shares must meet the requirement, inter alia, that they do not carry a preferential right to a company’s assets on its winding up.

The company’s new Articles of Association provided that on a liquidation, the company’s assets were to be applied first to repaying the nominal value of the ordinary shares and then to repaying the nominal value of the deferred shares, and that any surplus should be distributed to the holders of the ordinary shares.

HMRC maintained that, as a result, the ordinary shares had a preferential right to assets on a winding up, by comparison with the deferred shares.

The taxpayer contended that this preferential right should be ignored: either on the basis that the legislation should be construed ‘purposively’, and that the new shares were the kind of shares for which Parliament had intended to give relief, or else on the basis of the general principle of statutory construction that ‘de minimis non curat lex’ (the law takes no account of trifles).

The Tribunal’s decision

The Tribunal rejected these submissions. This was principally on the ground that the EIS legislation was so detailed and ‘closely articulated’ that if Parliament had intended for minor preferential rights to be ignored the legislation would have said so (just as, elsewhere in the EIS legislation, it specifically provides for receipts of insignificant value from the company to be ignored).

This conclusion was reached despite the fact that the Tribunal fully accepted that the share reorganisation had been made for purely commercial reasons, and not simply in order to obtain the tax relief.

The tax implications

Companies seeking EIS investment should note the need to take great care in any reorganisation of share capital. Professional advice should always be sought. In particular, it must be appreciated that for a preferential right to arise it is not necessary that advantages be specifically conferred on the shares in question; it is sufficient that other shares lack those advantages.

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