Taylor & Anor v Revenue & Customs [2010] UKFTT 115 (TC) (11 March 2010)

DECISION

1. N R J Taylor (“Mr Taylor”) and N Haimendorf (“Mr Haimendorf”) appeal against assessments made on the basis that income tax relief under the Enterprise Investment Scheme (EIS) is not available to them. Mr Taylor’s appeal relates to the years 2003/4 and 2004/5. Mr Haimendorf’s appeal relates to the years 2001/2 and 2002/3.

2. The EIS related to shares in Wrapit Plc, an unquoted company which, in all relevant years, carried on a trade of providing an internet-based service for weddings enabling guests to order gifts on line. Mr Taylor and Mr Haimendorf were both directors of Wrapit. Both subscribed for shares in Wrapit. (When referring to both appellants, we describe them as “the Claimants”.)

3. The rules of the EIS, in Chapter III of Part VII of ICTA 1988, imposed conditions on companies and investors if investors in those companies are to qualify for relief. Those conditions on the company were satisfied in the present circumstances. The dispute arises because of the particular circumstances of the Claimants’ investments in Wrapit.

4. Section 291(1) and (2) provide that the individual in question qualifies for relief when he subscribes for eligible shares in the “issuing company” and he is not, at any time in the period beginning two years before the issue of the shares and ending three years from the subscription date, connected with that company. The state of connection in issue here depends on the proper construction of section 291B.

5. Section 291B provides, so far as is relevant, as follows:

“(1) An individual is connected with the issuing company if he directly or indirectly possesses or is entitled to acquire more than 30% of –

(a) the issued ordinary share capital of the company or any subsidiary,

(b) the loan capital and issued share capital of the company or any subsidiary, or

(2) An individual is connected with the issuing company if he directly or indirectly possesses or is entitled to acquire such rights as would, in the event of the winding up of the company or any subsidiary or in any other circumstances, entitle him to receive more than 30% of the assets of the company … which would be available for distribution to equity holders of the company in question.

…

(7) For the purposes of this section the loan capital of a company shall be treated as including any debt incurred by the company –

(a) for any money borrowed or capital assets acquired by the company;

(b) for any right to receive income created in favour of the company, or

(c) for consideration the value of which to the company was (at the time when the debt was incurred) substantially less than the amount of the debt (including any premium on it).

…

(9) In determining for the purposes of this section whether an individual is connected with a company, no debt incurred by the company or any subsidiary by overdrawing an account with a person carrying on a business of banking shall be treated as loan capital of the company or subsidiary if the debt arose in the ordinary course of that business.

…”

6. The issue in these appeals is whether Mr Taylor and Mr Haimendorf were connected with Wrapit, as issuing company, on account of subsection (1)(b) of section 291B. We refer to this as “paragraph (b)”. At the material times both of them had holdings of issued share capital in Wrapit; those holdings were at all times well below 30% of Wrapit’s issued share capital however measured. But HMRC claim that both Claimants on occasions possessed more than 30% of the loan capital and the issued share capital, being 30% of an aggregate figure derived by adding together the loans obtained by Wrapit at the particular moment of time plus the nominal amount of the share capital. The primary question therefore is whether connection under section 291B exists where, as HMRC claim, the individual in question possesses more than 30% of the aggregate of the loan capital plus the issued share capital or where, as the Claimants contend, the individual in question possesses more than 30% of the loan capital and 30% of the issued share capital.

7. If we decide the primary question in favour of Mr Taylor and Mr Haimendorf the inquiry ends and their appeals succeed. If we decide in HMRC’s favour we then need to address two questions. One is what amount should be ascribed to issued share capital? Should it be the nominal amount of the shares issued or should it be the sum of the actual amounts subscribed for the issuing company’s issued share capital? The other is, what amount should, at the relevant point of time, be ascribed to the “loan capital” of the company? Should it be the amounts actually paid to the company by its loan creditors: or should it include the amounts that they were, at that particular moment, committed to pay?

The proper construction of section 291B(1)(b) (“paragraph (b)”)

8. Paragraph (b) reads equally clearly whichever of the two constructions is adopted though HMRC’s reading scores better grammatically. The 30% is found in the opening words and, on HMRC’s reading, relates to each category as a single unit falling to be apportioned. That approach works well with paragraphs (a) and (c). The difficulty in HMRC’s reading of paragraph (b) lies in the impracticability of mixing issued share capital and loan capital in order to produce a single apportionable unit. That reading can, as we will show, lad to unexpected and capricious results. Issued share capital and loan capital connote different relationships. The former measures the rights and obligations as between the shareholders, the latter represents the state of indebtedness of the company itself. Issued share capital and loan capital are not just legally different; as a matter of accounting they are kept separate. Each expression covers a range of rights. Issued share capital covers all share holdings, whether equity shares (i.e. ordinary share capital) or other shares carrying less extensive rights; loan capital, having regard to the wide definition in section 291B(7), embraces every state of the company’s indebtedness except its rights and obligations under a bank overdraft. There is no statutory guidance as to how the mixing exercise is to take place. Is it an exercise in simple enumeration of shares and indebtedness or do valuations have to be made? To ascertain the aggregate unit that falls to be apportioned, adopting HMRC’s construction, requires guidance which the Act does not give.

9. The first step in the process which is common to both approaches is to bring in an amount for issued share capital for purposes of determining both the unit to be apportioned and the holding of the particular shareholder. Where there is only one class this will be ordinary share capital and, whether it be taken at its nominal value (i.e. one penny in the present case) or at the amount subscribed (i.e. as a proportion of the “share premium account”) or as a fair proportion of shareholders’ funds, there will normally be no difficulty. It is when you have to mix the share capital with the loan capital to provide an aggregated amount for apportionment under paragraph (b) (on HMRC’s reading) that the problem arises. The problem arises in an acute form where the nominal value of each share is small, say one penny, while at the same time the real value of, or the amount subscribed for each share is high. A relatively modest temporary loan to the issuing company may turn the holding of the individual claiming EIS relief, as a proportion of the total mixed holdings of issued share capital and loan capital, from being a small minority holding into a disproportionately large part of the issued share capital plus the loan capital: which is HMRC’s case here.

10. The wide definition of loan capital in subsection (7) puts even greater pressure on HMRC’s construction of paragraph (b). Most shares by their nature cannot be compared with, for example, loans repayable on demand. And when shares have to be brought into the mix required (on HMRC’s reading of the paragraph (b) test) at their nominal values while loans are brought in on a pound for pound basis, unexpected results follow. An EIS investor who subscribes at a premium for a modest holding of shares loses the relief if at a later stage he makes a short-term loan to the enterprise which, when mixed in with his shares, puts him temporarily over the 30% threshold. Or take four EIS subscribers who have subscribed at premiums for 5% holdings of shares and who later agree between themselves to simultaneously introduce equal amounts by way of loan. Assume that the payment of one of those four is overdue for a period. On HMRC’s reading of paragraph (b) the other three would, during that period, have overtopped the 30% threshold. They would lose their EIS relief: the slow payer would retain it. Those are just two types of examples given in argument. They test the construction adopted by HMRC; they show how precarious and uncertain the EIS regime can be if that construction is applied.

11. Where there are two or more classes of issued share capital in the issuing company or the loan capital takes the form of notes convertible into issued shares other difficulties will have to be confronted when coping with HMRC’s construction of paragraph (b).

12. By complete contrast to the application of paragraph (b) (as HMRC construe it), the other tests for connection in section 291B(1) are relatively easy to apply. Determination of ownership of ordinary share capital and possession of voting power in the company (and entitlement to acquire those) are, in principle, straightforward matters. The same goes for the test in subsection (2) which involves the determination of whether an individual’s rights in the winding up of the company would entitle him to receive more than 30% of the assets of that company. The Claimants’ reading of paragraph (b) produces a test that is clear and easy to apply and does not trap the bona fide investor. The message, in essence, is this. Watch your holding of ordinary share capital, your votes, your powers of control and your rights in a winding up. If any of those exceed 30 per cent you will be connected and lose EIS relief. And if your holding of issued share capital overtops 30 per cent, do not become more than a 30 per cent creditor of the company; or if you are a 30 per cent creditor do not allow your holding of issued share capital to overtop the 30 per cent threshold.

13. The real objection to HMRC’s construction of paragraph (b) arises from the need to combine two quite different ingredients to produce a single apportionable amount. The exercise, as we have briefly demonstrated, can produce an uncertain outcome. The individual who in good faith makes an investment in an EIS company may for reasons outside his control find himself connected with the “issuing company” and consequently deprived from the EIS relief that he had expected. We mention this because both Claimants in the present appeal were concerned to be sure that their holdings fell fairly within the EIS regime. They risked their own funds by making short term loans to Wrapit to relieve the seasonal cash shortages. Seen in that light, the interpretation of paragraph (b) as advanced for the Claimants produces a reasonable degree of certainty and maintains a realistic level of protection for HMRC against abuse of the system. It shows why the framers of a legislation saw no need to give any explanation as to how to mix holdings of issued share capital and of loan capital and as to how the aggregate amount should be apportioned.

14. For those reasons we are in favour of the Claimants and allow their appeals. Our summary decision was released on 25 November 2009. The Claimants have however asked for a full reasoned decision. This includes the issues on which they failed to persuade us.

What amounts are to be ascribed to “loan capital” for purposes of the test in paragraph (b)?

15. HMRC rely on the accounts of Wrapit Plc for the 12 months to 31 December 2004 and to 31 December 2005 as showing that Mr Taylor and Mr Haimendorf were both connected with Wrapit in the relevant sense.

16. The “loan capital” position at the end of 2004 was that £400,000 of funds had been received by Wrapit from “related parties” of which £150,000 had come from Mr Haimendorf and £100,000 from Mr Taylor. (£100,000 had come from a Mr Reid, a director, and £50,000 from Donna Gelardi, the sister of one of the directors of Wrapit.)

17. In February 2005 a further £50,000 had been paid to Wrapit by Donna Gelardi and in March 2005 Mr Taylor paid a further £50,000 to Wrapit. (A note to those accounts states that following the year end Donna Gelardi and Mr Taylor had each advanced further loans of £50,000.)

18. At 31 December 2004 therefore Mr Haimendorf’s proportion of loan capital, being the amount actually contributed to Wrapit, was 37.8%: Mr Taylor’s proportion was 25%. By the time of Mr Taylor’s further payment of £50,000 in March, when Wrapit’s loan capital had become £500,000, Mr Haimendorf’s proportion had gone down to 30% and Mr Taylor’s had gone down to 30%.

19. We mention in this connection that Wrapit went into administration in 2008. Some of the relevant paperwork relating to its financing has not been available at this hearing. The evidence before us showed that in anticipation of a recurring seasonal demand for funds in the first quarter of each year, Mr Haimendorf and Mr Taylor had agreed with each other and with Wrapit (in 2004 and in 2005) to provide Wrapit with working capital; they each agreed to provide £150,000 for each season. Hence the £50,000 introduced by Mr Taylor in March 2005.

20. £650,000 of loans were provided to meet Wrapit’s requirements for the first quarter of 2006. £450,000 of that amount represented directors’ loans and £200,000 came from Strand Associates Ltd (a corporate finance and advisory company). £150,000 each had been provided by Mr Haimendorf and Mr Taylor in pursuance of the agreement referred to above: the two payments had been received by Wrapit by 31 December 2005. Those payments resulted in Mr Haimendorf and Mr Taylor each being credited with £150,000 of “Directors Loans” in the year end balance sheet. The balance sheet for that year records £200,000 from Strand Associates with the following words of description:

“In addition the company has issued a loan note of £200,000 to Strand Associates repayable on 30 June 2007. Interest on this loan note is 4% above LIBOR and Strand Associates hold a warrant to purchase up to 5% of the issued share capital at £120 per share for the period of the note.”

The Strand Associates loan agreement was dated 17 January 2006. Payment was not made by Strand Associates until after that date. We are satisfied from the evidence, both oral (given by Mr Taylor and Mr Haimendorf) and documentary, that Strand Associates was not committed to make the loan until 17 January 2006 at the earliest.

21. At 31 December 2005 therefore the actual amount of directors’ loans stood at £450,000 of which 33.33% was credited to each of Mr Haimendorf and Mr Taylor.

22. For the purposes of determining this issue (and contrary to the conclusion that we have reached on the primary issue) we assume that HMRC were correct in their construction of the paragraph (b) test (i.e. that the £150,000 lent by each of Mr Haimendorf and Mr Taylor is to be aggregated with the nominal amounts of the shares owned by each of them). HMRC say that relief should be denied to both Claimants on the grounds that Mr Haimendorf’s aggregated holdings of issued share capital and loan capital overtopped the 30% limit at 31 December 2004 and that the aggregated holdings of each of Mr Haimendorf and Mr Taylor overtopped the limit at 31 December 2005. The argument for the Claimants is that HMRC’s contention is wrong because it fails to take account of commitments made by other lenders in favour of Wrapit at the relevant point of time.

23. Take the end of 2004. At that time £400,000 of loans had been received by Wrapit and a further loan of £50,000 was due from Mr Taylor under his agreement to lend and a loan of £50,000 was due from Donna Gelardi. Those two latter amounts should, so the argument for the Claimants runs, be brought into the reckoning in determining the amount of loan capital of Wrapit and the relevant proportion of Mr Haimendorf’s holdings in Wrapit. Mr Haimendorf’s actual contribution of £150,000 represented 30% of Wrapit’s loan capital. Mr Taylor’s actual contribution of £100,000 when added to his committed contribution of £50,000 likewise represented 30% of Wrapit’s loan capital.

24. Moving on to the position at the end of 2005, Mr Haimendorf and Mr Taylor had each lent 33.33% of Wrapit’s “loan capital”; but, say the Claimants, the £200,000 of loan capital due from Strand Associates should also be taken into account.

25. We think that the Claimants are wrong in contending that the expression “loan capital” covers amounts that that company is entitled to receive as well as amounts actually received by the borrower company, i.e. Wrapit. The Claimants say that principles of accrual accounting required by Financial Reporting Standard 5 (FRS5) demands that Wrapit should recognise both the amounts actually paid by way of directors’ loans and amounts that are committed to be paid later; these latter amounts should be recognised as assets or liabilities in its balance sheet. We quote paragraph 20 of FRS5 which reads as follows:

“Where a transaction results in an item that meets the definition of an asset or liability, that item should be recognised in the balance sheet if –

(a) there is sufficient evidence of the existence of the item (including, where appropriate, evidence that a future inflow or outflow of benefit will occur), and

(b) the item can be measured at a monetary amount with sufficient reliability.”

26. Focussing on Mr Taylor’s commitment to provide a further £50,000 of loan to Wrapit at the end of 2004, it seems to us that at most Wrapit then had the benefit of his covenant to advance that amount. The covenant may have been enforceable but the £50,000 had not by then become “loan capital” within the meaning of that expression in section 291B. Subsection (7) defines loan capital as including “any debt incurred by the company … for any money borrowed by the company”. At that time Wrapit had not borrowed the £50,000 and Mr Taylor had not lent it. There was no “loan” of the £50,000 that could have ranked as such in law. We acknowledge that FRS5 might require the benefit of Mr Taylor’s undertaking to lead £50,000 to be recognised in Wrapit’s balance sheet for the period to 31 December 2004. But that does not make that amount “loan capital” for the purposes of section 291B.

27. The position of the Strand Associates loan is different. Its terms had not been formally agreed until 17 January 2006. The evidence of the correspondence between Wrapit and Strand Associates shows that Strand Associates were not under any legal obligation to make the £200,000 loan until then. Mr Taylor’s evidence did not change our conclusion on that point; still less could the £200,000 be classed as “loan capital” at 31 December 2005.

The evaluation of the issued share capital of Wrapit

28. The remaining argument for the individual Claimants is directed at the value to be placed on the total issued share capital of Wrapit. If that value is taken as the aggregate of the nominal values of those shares, i.e. 1p per share, then the proportion of the loan capital owned by each Claimant will have overtopped 30% at the relevant time. But if the value of the share capital is taken at the amounts subscribed, i.e. adding in the total “share premium account”, then the proportion that loan capital bears to share capital will diminish to such an extent that the holdings of share capital plus loan capital of both Claimants will have dropped to well below 30%.

29. The argument for the Claimants, if and to the extent that it is relevant to the present issue, depends on the meaning to be given to the expression “issued share capital”. Those words were examined by Megarry J in Canada Safeway Ltd v IRC [972] 1 All ER 666 where the question related to the test of 90% issued share capital relationship between two companies which had to be satisfied for purposes of relief for stamp duty on inter-company transfers. The transferor company owned shares of two classes in the transferee company. Measured in value terms, the holding of ordinary share capital well overtopped 90%: but as a proportion of the nominal share capital at the date of transfer the holding was well below that percentage. The judge went for nominal share capital because that was an unchanging yardstick for measurement. He observed on page 671 that there was no good reason for ousting that prima facie construction of the phrase because, in contrast to actual value, it produced a simple and workable test and, above all, it related to the words “share capital”. The Claimants contend that in the present context the words “issued share capital” can be read as enabling the “share premium account” to be added to the nominal share capital when determining both the totality of the issued share capital of Wrapit and the proportions held by each Claimant.

30. There is, we recognise, some merit in the Claimant’s argument. A share premium account produces a constant amount (and unless increased by further subscription monies) a fixed yardstick of measurement of shareholders’ capital. But while it may be a sufficiently reliable measurement of the totality of the issued share capital of a company, it may bear little relation to the holding of a particular shareholder whose subscription cost per share has differed from the amount charged on the occasion of an earlier or later subscription. The construction could therefore produce an uneven state of affairs as between shareholders claiming EIS relief. We would therefore prefer the simple and workable test adopted in Canada Safeway. If HMRC were correct on their reading of paragraph (b), this construction of issued share capital would at least lead to certainty.

31. In this connection we mention the decision of the Hong Kong Court of Final Appeal in Collector of Stamp Revenue v Arrowtown Assets Ltd [2003] HKCFA 46, (2004). In that case the Court decided to ignore the rights attaching to a class of B non-voting shares; those shares had been inserted to create the required shareholding relationship in order to obtain stamp duty relief on a transfer. The Claimants in the present case argued that our approach should be to adopt the approach of the Court in Arrowtown and focus on the real factual analysis. The reality, adopting that approach, was a vastly greater amount of capital attributable to the issued share capital than to the relatively short term loan arrangements. Had we been persuaded by HMRC’s argument on the main issue of construction of paragraph (b) and decided that issued share capital must be aggregated with loan capital, we might have been tempted to adopt the Arrowtown approach and look at the reality here. But we do not have to take that route. We only observe that the need to deploy such an argument to make the paragraph (b) test, as HMRC construe it, work drives home the correctness of the simple and workable construction that the Claimants have sought.

32. For all those reasons we allow the appeals.

33. The Respondents have a right to apply for permission to appeal against this decision pursuant to Rule 39 of the Tribunal Procedure (First-tier Tribunal) (Tax Chamber) Rules 2009. The parties are referred to “Guidance to accompany a Decision from the First-tier Tribunal (Tax Chamber)” which accompanies and forms part of this decision notice.

First-tier Tribunal (Tax)

THE COMMISSIONERS FOR HER MAJESTY’S

REVENUE AND CUSTOMS (Income Tax) Respondents

SIR STEPHEN OLIVER QC

CHAMBER PRESIDENT

RELEASE DATE:11 Match 2010

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You are here: BAILII >> Databases >> First-tier Tribunal (Tax) >> Taylor & Anor v Revenue & Customs [2010] UKFTT 115 (TC) (11 March 2010) URL: http://www.bailii.org/uk/cases/UKFTT/TC/2010/TC00426.html Cite as: [2010] UKFTT 115 (TC), [2010] SFTD 579, [2010] STI 2126