When running a limited company, it’s important to understand the different legal concepts involved, from both an accounting and company law perspective. In particular, a number of key UK tax provisions turn, in part, upon the meaning of ‘ordinary share capital’. Equally, it’s important to understand the benefits and drawbacks of ordinary share capital, when compared against other types of share capital, when any decision is made to issue shares.
Below we examine exactly what’s meant by ordinary share capital, as well as the advantages and disadvantages of ordinary shares, and the tax implications arising from this.
What is share capital?
To understand what is meant by ‘ordinary share capital’, we must first consider the meaning of ‘share capital’. This reflects the equity or ownership interests of the shareholders in the company, either by way of their right to dividends or profits declared, or a right to share in any company’s assets in a winding-up after creditors have been repaid.
As a distinct legal entity, a company’s assets are strictly owned by the company itself, and not by the shareholders individually, although the shareholders as members together have ownership of the company through what’s known as their ‘equity’. The shares therefore express the shareholders’ proprietary interest in the company, where if shares represent ownership, then the share capital is the total value of the shares issued by that company.
When a company is limited by shares, its members hold shares in the company’s share capital, where shareholders are only personally liable for what they put into the business. A company can also be formed without share capital, with the members’ liability limited by guarantee. In these cases, rather than taking profit from the company, any money is usually put back into the business to help promote the non-profit objectives of the company. Companies limited by guarantee are typically formed by non-profit seeking members — known as guarantor owners — who wish to operate via a corporate entity, and are commonly used for charities.
What is ordinary share capital?
Businesses can issue different types of shares — including ordinary shares, preference shares and redeemable shares — which give shareholders different rights to dividends, profit-sharing and voting, although most businesses issue ordinary shares.
Also known as common shares, the ordinary shareholder has the right to vote on company decisions and receive dividend payments from the company’s net profits. In contrast, preference shareholders don’t have any voting rights but they do get dividends ahead of ordinary shareholders. The dividend is typically fixed and annual, which means that this doesn’t change with the company’s profits. Redeemable shares give the company the right to buy back shares in the future, either at a fixed point in time or at the company’s discretion.
Under the statutory definition of ‘ordinary share capital’, this includes all of the issued share capital of a company: ‘… 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’ (s.989 Income Tax Act 2007). The general meaning of ordinary share capital therefore depends on identifying and excluding any capital which the holders have a right to a fixed rate dividend, but have no other right to share in a dividend. In contrast, ordinary shares have no pre-defined dividend.
To be within the excluded class of shares, the shares in question must therefore constitute:
- capital that the holders of which have a right to a dividend
- which dividend is at a fixed rate, and
- where that dividend right is exhaustive of the right to share in the company’s profits.
The statutory definition of ordinary share capital looks solely to the dividend rights and any additional right to share in the company’s profits attached to a share.
Provided share capital doesn’t fall within an excluded class of shares, it will be classed as ordinary share capital, regardless of how this is described or treated for accounting purposes. The question of whether or not a share is ordinary share capital is essentially determined by the rights attached to the share, and not by either the subjective intentions of the parties as to its tax status, what happens in practice or how the shares are described.
What types of shares fall within the meaning of ordinary share capital?
The general principle behind ordinary share capital is to distinguish equity capital from loan capital, excluding instruments that are in legal terms shares but in effect represent perpetual debt, namely fixed rate preference shares. In accordance with guidance issued by HMRC in the context of applicable tax provisions, a broad interpretation is given to the meaning of ordinary share capital, where the following will usually fall within its scope:
- a share with no dividend right: in the case of HMRC v McQuillan [2017] UKUT 344, the Upper Tribunal held that having a right to a dividend at a rate of 0% was not the same as having a right to a dividend at a fixed rate. In this case, the taxpayers were denied entrepreneurs’ relief, where in order to access the 10% capital gains tax (CGT) rate available under the entrepreneurs’ relief rules, it’s necessary for a seller of a trading company to have held, for a period of at least one year, at least 5% of the company’s ordinary share capital;
- a fixed rate preference share with a zero coupon: again, if the shares carry no right to a dividend, there can be no question of the shares falling outside the definition of ordinary share capital, ie; a right to nothing is not a right to anything at all.
- a fixed rate of 10% non-cumulative: as no dividends will be paid in some years, there’s no fixed rate, where this is treated more like equity than debt;
- a preference share with a right to tiered dividends: dividends can change depending on the tier, potentially increasing over time;
- a share which has a right to the greater of a specified sum or dividend paid in respect of another class of shares: as with tiered dividends, the rate is not fixed here, rather there’s a right to a return at one of two fixed rates;
- a preference share with two alternative fixed rates: here, the rate varies between two fixed levels, depending upon certain events during the year, such as the level of profits;
- a fixed rate preference share but with right to further dividend payment were certain events to occur, such as breach of banking covenants: although the holder is entitled to a fixed rate of return, there exists another right to share in the company’s profits;
- LIBOR, plus a fixed percentage: where the London Interbank Offered Rate fluctuates daily.
In accordance with the same guidance issued by HMRC, the following shares will not usually be considered as falling within the scope of ordinary share capital:
- a fixed rate preference share with a small coupon: this can be fact dependent, especially where there are avoidance concerns;
- a fixed rate of 10% cumulative: the return is fixed even when profits are not available;
- a fixed rate of 10% cumulative where a dividend is only paid on authorisation of the Financial Conduct Authority: there’s an underlying fixed rate where it’s cumulative and the regulator can only prevent payment, where it’s irrelevant that a third party is involved;
- a fixed rate preference share but with rights in liquidation: this is finely balanced and may depend on the facts of the case. A distribution in liquidation is of surplus assets rather than profits but, depending on the circumstances, a different conclusion may be drawn.
There are also other categories of shares considered by HMRC to be borderline cases, including preference shares where a coupon compounds over time, or a preference share where a rate of interest is added if a dividend is unpaid.
What are the advantages and disadvantages of ordinary share capital?
When issuing shares, it’s important to understand what risk and reward attaches to these, with the advantages and disadvantages involved for both shareholders and the business.
The principal rights for shareholders that usually attach to an ordinary share are:
- the right to dividends (of profits) declared
- the right to vote, and
- the right to share in the company’s assets in a winding-up.
Ordinary shareholders have the right to a dividend, but this isn’t guaranteed. The company will first distribute dividends among its preferred shareholders, and only then are dividends, if any, made available to the ordinary shareholders. The right to dividends will therefore depend on the company’s performance, as well as the decision of the company directors as to whether or not dividends will be paid out on ordinary shares and how much these will be.
Ordinary shareholders are also the last to be paid if the company is wound up, putting them on the same footing as unsecured creditors. However, despite the greater economic risk faced by ordinary shareholders than preferred shareholders, they’re much more likely to receive a higher return on their investment. This is because preferred share dividends are fixed or limited, while ordinary shares can generate much more profit if the company performs well.
What are the tax implications of ordinary share capital?
Depending on the factual scenario in question, or the particular tax provision in play, classification of shares as ordinary share capital may be what the taxpayer seeks or what that person seeks to avoid. For example, in the context of the provisions for entrepreneurs’ relief, by holding a specified percentage of ordinary share capital for the relevant 12-month period prior to disposal, provided all the other requirements are met, an individual will qualify for relief, providing a lower CGT rate on the disposal of their shares.
In HMRC v McQuillan [2017] the taxpayers sought to avoid classification of redeemable shares held by other shareholders as ordinary shares, in this way giving them greater than 5% ordinary share capital to qualify for entrepreneurs’ relief. However, it was held on appeal that as no right to a dividend attached to these shares, this couldn’t be construed as a right to a dividend at a fixed rate of zero. Consequently, these shares were treated as ordinary shares, thereby reducing the McQuillans’ shareholding of ordinary shares to less than 5%.
In contrast, in HMRC v Warshaw [2020] UKUT 0366 (TCC) the taxpayer sought and succeeded in arguing the classification of preference shares as ordinary shares. In this case, it was held that the 10% cumulative preferential dividends which were compounded for unpaid dividends was not a dividend at a fixed rate. The shares carrying such rights were to be treated as ordinary share capital, meaning that Mr Warshaw was entitled to entrepreneurs’ relief on a disposal of his shares. This decision is, however, contrary to HMRC’s stated position on cumulative preference shares, where much may depend on the facts involved.
Ordinary share capital FAQs
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Legal disclaimer
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.
Before acting on any of the information contained herein, expert professional advice should be sought.
Author
Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.
Gill is a Multiple Business Owner and the Managing Director of Prof Services Limited - a Marketing & Content Agency for the Professional Services Sector.
