Published in Taxation on 3rd July 2023.

When advising on various types of corporate restructures and takeovers, preference shares are a common form of security to issue. 

Take, for example, a management buyout where the vendors may be retaining an interest in the company. In the absence of preference shares or loan notes to reduce the ordinary share capital to nominal value (or the incoming management team investing their own funds), it is difficult to mitigate an income tax charge on the transfer of value under the employment related securities (ERS) regime of ITEPA 2003, Part 7.

Therefore, preference shares are a useful mechanism for ensuring there is no such transfer of value and, depending on the ordinary share capital retained by the vendor shareholders, HMRC may insist that any deferred consideration be irredeemable until a more complete exit.

Therefore, it is crucial to understand the impact of preference shares in a number of areas. In particular, how they should be accounted for, their capital gains tax consequences and how they are treated for inheritance tax purposes. Ensuring all three areas are carefully considered and understood by the client is essential in any planning exercise.

Accounting for preference shares

How preference shares should be treated for accounting purposes will be an important commercial consideration and should not be ignored when designing the restructuring for tax purposes. In particular, preference shares that must be treated as a financial liability on the balance sheet may have a negative impact on the credit rating of the company and its ability to raise third-party debt finance.

In the case of owner-managed businesses, the existence of the preference shares may not be considered a 'debt' in the same way as external finance but if it restricts the company's ability to borrow this could have a serious impact on the future prospects of the company.

The relevant provisions of FRS 102 are set out in section 22, and section 22.3 defines the terms as follows:

• Equity - The residual interest in the assets of the entity after deducting all its liabilities.
• Financial liability - A contractual obligation to deliver cash or other financial assets to another entity, or to exchange financial assets/liabilities with another entity under conditions that are potentially unfavourable to the entity.

With that in mind, we must consider the characteristics of the preference shares in relation to how they may be redeemed and the extent to which dividends are payable.

Taking the redemption provisions first, FRS 102, s 22.5e states that a preference share is a financial liability in the following circumstances:

• Where the company must redeem them at a fixed (or determinable) amount and at a fixed (or determinable) future date.
• Where the shareholder has the right to redeem them at or after a particular date for a fixed (or determinable) amount.

The conclusion here is that redeemable preference shares will usually create a contractual obligation for redemption, and would be treated as a financial liability, while irredeemable preference shares (or redeemable at the company's discretion) are equity instruments (but see below in relation to non-discretionary dividend payments creating a compound financial instrument).

The second characteristic we must consider in determining the accounting treatment is whether the preference shares carry a right to a fixed or minimum dividend and therefore create a contractual obligation resulting in further financial liability characteristics.

Therefore, a fixed coupon preference share carries, at least in part, an element of a financial liability.

Accounting treatment summary

Equity instruments - preference shares will be shown in equity where they are both irredeemable (or redeemable at the company's discretion) and either have no right to a dividend or dividends are payable at the discretion of directors. Any dividends paid, just like ordinary shares, are a distribution out of distributable profits.

Compound financial instruments - where the redemption rights are as outlined under equity instruments (irredeemable or redeemable at the company's discretion) but the payment of dividends is not at the discretion of directors, eg they carry a fixed coupon rate, the shares have characteristics of both equity and debt meaning a liability is recognised (calculated as the net present value of future cash flows on the dividends) and the residual value is shown in equity.

Financial liabilities - preference shares are treated as debt where the company must redeem them at a fixed or determinable future date or where the shareholder has the right to redeem them. The dividend rights in this case should not matter as compulsory dividends are a characteristic of financial liabilities and no/discretionary dividends would not have a value for equity purposes.

The table Accounting treatment of preference shares summarises the accounting treatment of preference shares.

Capital gains tax issues

For CGT purposes, a preference share will be a form of security. Therefore, considering the provisions of TCGA 1992, s 135 exchange of securities, where preference shares of any description are issued in exchange for other securities (and the remaining conditions of s 135 are satisfied} the paper for paper provisions of s 127 will be in point.

However, it is common for the number of preference shares in issue to be significant in comparison to the number of 'ordinary' shares in issue.

Take a management buyout as an example as mentioned at the start of this article. A company worth £5m and owned by husband and wife is subject to a management buyout whereby the four key managers will each hold 20 ordinary shares and, in exchange for their shares in TradeCo, BidCo will pay, as consideration, 5 ordinary shares in BidCo, £1m excess cash on the balance sheet and £1.5m preference shares to each of the existing shareholders (see Capital gains tax).

Definition of ordinary share capital

For capital gains tax purposes, 'ordinary share capital' is defined as 'all the 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' (ITA 2007, s 989).

Therefore, preference shares, in many instances, will be treated as ordinary shares for tax purposes.

It is also worth noting that McQuillan v HMRC [2017] UKUT 344 confirmed that a preference share with a zero coupon did not represent a 'fixed rate' for the purposes of the above definition on the basis that a right to nothing does not constitute a right to something with a quantum of zero.

As to whether a preference share with a very trivial coupon rate would be sufficient to meet our 'fixed rate' requirement above, based on the decision of McQuillan HMRC may consider an artificially contrived rate to be a form of avoidance on similar terms.

Furthermore, whether the return on a preference share is cumulative or non-cumulative may have little or no effect on the accounting treatment but, for tax purposes, a non-cumulative preference share is considered more akin to equity on the basis that there may be some years in which no dividend is paid and no future right exists either.

Therefore, for CGT purposes, preference shares that hold no (or zero) coupon rate, or are non-cumulative, will be treated as ordinary share capital.

Effect on business asset disposal relief

Turning back to our management buyout example, where the £1.5m preference share constitutes ordinary share capital, the nominal value held by the management team will be 0.001% rather than being 20% of the 'ordinary' share class.

For BADR purposes, a disposal of shares or securities will qualify for relief provided, amongst other things, the company has been the individual's 'personal company' for at least two years prior to disposal (TCGA 1992, s 1691(6)).

A 'personal company' requires that the individual holds at least 5% of the ordinary share capital, voting rights and is either beneficially entitled to at least 5% of profits available for distribution or 5% of the proceeds on sale (TCGA 1992, s 169S).

Thus, in our example above, if the preference shares constitute 'ordinary share capital' in accordance with ITA 2007 s.989, regardless of the profits available for distribution or entitlement to proceeds on sale, the Manager will never be able to qualify for BADR whilst the preference shares are in existence.

In many cases, the choice is between:

• ensuring eligibility to BADR, but accepting the preference shares are shown as a liability on the balance sheet; or
• ensuring the preference shares are shown as equity on the balance sheet but accepting some shareholders will not qualify for BADR.

There is, however, the option of issuing a compound financial instrument by the preference shares being irredeemable (or redeemable at the company's discretion) but with a fixed cumulative coupon rate.

The coupon rate must be discounted to net present value and recognised as debt on the balance sheet, whilst the balance will be treated as equity. We must of course then consider what a sufficient coupon rate is to ensure there is no doubt that it is a genuine 'fixed rate', however, the higher the coupon rate, the greater the debt recognised on the balance sheet.

Inheritance tax implications

For IHT purposes, we are typically concerned with whether the shares will qualify for business property relief (BPR).

For BPR purposes there are two forms of 'relevant business property' that are likely to be in point in this case, particularly in the owner-managed business sector where the majority of securities will be unquoted. These are:

• securities of a company which are unquoted and which either by themselves or together with other such securities owned by the transferor and any unquoted shares so owned gave the transferor control of the company immediately before the transfer (IHTA 1984, s 105(1)(b)); and
• any unquoted shares in a company (IHTA 1984, s 105(1)(bb)).

In both of the above circumstances, BPR should be available at a rate of 100% subject to certain exceptions such as the excepted asset rules.

So, for the purposes of this analysis, the important question is whether preference shares qualify as shares, or as securities, in which case the preference shares would require the holder to have overall control in order for BPR to be available.

Furthermore, if the preference shares are securities rather than shares, s 105(1)(b) requires them to have voting rights in order to count towards the definition of control.

IHTA 1994 does not define 'share' further so it is reasonable to assume we should use the Company Act definition for these purposes. CA 2006, s 540 states that 'share ... means share in the company's share capital'.

While most preference shares are likely to fall within this definition caution is advised to ensure that the preference share is a genuine share and not merely a loan disguised as a share. Clearly, preference shares that fall within the financial liability classification for accounting purposes are more of a concern here, however, this is by no means conclusive.

BPR on capitalised loan accounts

While the majority of this article has focused on the issues concerning takeovers which include preference shares as consideration, it is worth a brief comment on the planning opportunities where shareholder loan accounts exist.

In particular, a loan account does not qualify for relief under BPR as it does not fall within the definition of a share or security.

However, it may be possible for this loan account to be capitalised, by issuing either preference (or ordinary) shares as consideration, subject to the warning in relation to the preference share being a 'share' for these purposes. Of course, it is important to consider the two-year holding period requirement of IHTA 1984, s 106.

Planning may be possible to ensure the two-year holding period includes the holding period of shares already held and this was considered in The Executors of Mrs Mary Dugan-Chapman & Anor v HMRC [2008] SpC 666.

The premise is that IHTA 1984, s 107(4) allows us to include the newly acquired shares within the holding period of existing shares where the new shares were acquired under a reorganisation within TCGA 1992, ss 126 to 136. Therefore, if the loan is capitalised as a result of (say) a rights issue of shares, the holding period of the new shares will take on the same holding period as existing shares.

While part of the planning failed in the Dugan-Chapman case, this was only because the rights issue was not implemented correctly.

Importantly, a rights issue requires all shareholders to be offered shares in proportion to their existing shareholdings and it is also for this reason that this planning may not always be suitable where other shareholders are expected to take up this right.

Conclusion

While preference shares are a common security issued by a company, it is important to consider all aspects and implications when advising in this area. This includes the accounting and commercial consequences as well as the tax implications outlined above, and it is often the case that there needs to be a trade-off between the CGT and accounting treatment.

Nick Wright
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07891 203889

Published in Taxation on 3rd July 2023, written by Nick Wright.
https://www.taxation.co.uk/articles/preference-shares-what-are-the-issues-