Business Asset Disposal Relief (BADR), formerly known as Entrepreneurs’ Relief, is a relief which allows an individual to benefit from a reduced rate of 10% Capital Gains Tax (CGT) when selling shares in a trading company.

There have been a few cases recently where HMRC has challenged whether BADR should be available on a disposal of shares, and this has come down to how the definition of ordinary share capital is applied. A recent case, HMRC V Warshaw, is a good example of this and it is what I’d like to focus on in this blog.

There are numerous conditions that need to be met throughout the two year period before a sale, in order to qualify for this tax relief, and two of these are likely to be impacted by the recent findings in this case. The two relevant conditions are:

• The shareholder needs to hold 5% of the ordinary share capital, measured by nominal value, and
• The shareholder needs to be entitled to 5% of the proceeds payable to the holders of ordinary share capital

The critical thing here is what shares need to be included within the definition of ordinary share capital, which is defined in the legislation as: “Any share capital (irrespective of its name) which does not have a fixed right to the profits of the company”.

Often “preference shares” should fall out with the definition above of ordinary share capital. However, the Upper Tribunal, in the case of HMRC V Warshaw, agreed with the findings of the First Tier Tribunal that cumulative, compounding preference shares should be classed as ordinary share capital for the purpose of determining whether the 5% tests have been satisfied. This was on the basis that the compounding element of the preference share made the dividend payable to the shareholder variable rather than fixed.

The findings in this case have set a tax precedent for following; in other words, tax advisers must now consider the outcome of this case when submitting a claim for BADR on behalf of a client.

Who will this ruling impact?

While this ruling will clearly be beneficial for some shareholders, it is likely to have a negative impact on senior executives of private equity-backed companies.

Following the introduction of the corporate interest restriction rules in April 2017, there has been a trend over the past few years for the shareholder debt of private equity-backed companies to be provided in the form of cumulative compounding preference shares, rather than cumulative compounding loan notes. Executive management teams of private equity-backed companies who hold at least 5% of the regular ordinary shares, but do not also hold 5% of the cumulative compounding preference shares, may no longer qualify for BADR.

What is the impact?

For those individual shareholders that benefit from this ruling, the good news is that BADR should still be available so any CGT owed upon a sale will be charged at the reduced rate of 10%, subject to the shareholder’s remaining lifetime allowance (see below). 

However, as mentioned above, for senior executives in private equity-backed companies with cumulative, compounding preference shares, BADR is unlikely to be available.  With the lifetime allowance for BADR presently at £1,000,000 and the rate of CGT at 20%, this could lead to an additional CGT liability of £100,000.

What can be done to protect BADR status for senior executives of private equity-backed companies?

Unless HMRC is granted the right to appeal the tribunal’s decision and successfully win, presently we do not see any options to protect those impacted, unless a wider reorganisation is being considered for commercial purposes. We believe it is unlikely that investors will agree to “switch off” the valuable compounding element of their cumulative compounding preference shares. Furthermore, if investors do agree to switch off the compounding, we have concerns that the Disclosure of Tax Avoidance Schemes rules could apply.  However, there may be solutions for new private equity backed company structures.

This could all become a moot if BADR is scrapped in the Chancellor’s Budget, due 3 March 2021

Get in touch

If you have any questions about this case and how it may apply to your share options, please do not hesitate to get in touch with me, Max Chassels on: max.chassels@jcca.co.uk.