On 23 April 2025, an article was published in the Tax Journal (‘An undesirable preference: EIS shares and ‘any’ preferential rights on a winding up’) by Oliver Twentyman (Azets) (the “April Article”) which questioned whether shares with what Mr Twentyman called ‘liquidation priority’ features were compatible with the Enterprise Investment Scheme (“EIS“) rules, specifically under s.173(2)(aa) of the Income Tax Act 2007 (the “Act“). This section requires that EIS qualifying shares must not “carry any present or future preferential right to a company’s assets on its winding up”.

For reasons that will become clear in this article, we consider ‘liquidation priority’ to be a misleading description of the arrangements which the April Article then calls into question, and so we shall refer to them herein as ‘ratio-based capital rights’.

As the April Article notes, these structures are commonplace in EIS investing and, prior to the April Article’s publication, it was well established and settled that they did not pose an issue under the EIS regulations. That is to say, prior to the publication of the April Article, there was almost no question that to fall foul of the relevant section a ‘preferential right’ must be just that: an actual preferential or prior right, not merely an arrangement that is economically more favourable to one class of shareholders than another in an agreed ratio.

This analysis considers, but ultimately rejects, the arguments put forward that ratio-based capital rights contravene the EIS legislation.

Flix Innovations Ltd v Revenue and Customs Commissioners

The April Article recalls the decision in the Upper Tribunal in the case of Flix Innovations v HMRC ¹. The central issue in this appeal was whether the ordinary shares issued by Flix Innovations Limited (the “Company“) carried a preferential right to the Company’s assets on a winding up, contrary to section 173(2)(aa), thereby disqualifying the holders of ordinary shares from EIS relief.

The articles of association of the Company required holders of ordinary shares to receive payment of the nominal value on those shares before the holders of the deferred shares receive the nominal capital on their shares. The Appellant accepted that the ordinary shares carried a preferential right on a winding up to the extent of the nominal value of those ordinary shares, but argued that the preferential right was negligible and should therefore be ignored under the de minimis non curat lex principle of statutory interpretation. That is to say, that Parliament should be taken to have intended that purely trivial preferential rights should be ignored and EIS relief obtained on subscription for the ordinary shares should be retained.

As the April Article emphatically reminds us, the Tribunal rejected this and affirmed that “any” preferential right (no matter how small or commercially insignificant) to a company’s assets on its winding up disqualifies shares from EIS relief. For the Tribunal, the use of the word “any” was an indication of an intention to exclude the application of the de minimis rule – Parliament intended zero tolerance for preferential rights, including trivial ones.

Accordingly, the appeal was dismissed.

Following Flix Innovations, it is clear that if one shareholder (“Shareholder A“) is entitled to company assets on a winding up in advance of another shareholder (“Shareholder B“), then Shareholder A has a preferential right, even if the amount in question is tiny.

That being the case, common market practice has long been to employ ratio-based capital rights, primarily as a means of the investor recovering the majority of their initial capital without benefitting from a true preferential right which offends the EIS legislation.

Using the simplified scenario of two shareholders, Shareholder A takes 99% of the available proceeds in the first step of the waterfall until and up to the point at which they recover the cost of their investment, at which point the waterfall swivels onto the second step where the balance of proceeds is distributed in a mirrored ratio favourable to Shareholder B until they have ‘caught up’, at which point the remaining balance is often shared equally between Shareholder A and Shareholder B.

It is our firm’s view that a preferential right is a right which denudes the rights of others, in circumstances of want. Another way of putting it might be that one person’s right must be satisfied in priority to or before the rights of another if that first person is to enjoy a preferential right over the other. This was the case in Flix Innovations and the court held that, notwithstanding the negligible size of the amount preferentially received, it was indeed received in priority to another class of shareholders and so EIS relief was lost.

However, in our view, ratio-based capital rights do not create preferential rights. The parties instead agree that each shall be entitled to a fixed ratio of the available profits at each step of the notional waterfall. The ratio might be 50:50, 70:30 or 99:1 but, regardless, the rights that each party enjoys are agreed between them and one does not take preference over another (even if the ratio is in their favour) because all rights are satisfied simultaneously and in full.

What does the April Article say?

The April Article asserts that this “type of drafting […] goes well beyond what many may view as a negligible right in the Flix Innovations case to a highly valuable piece of commercial protection, reducing risk for investors.”

Whilst it is correct that such arrangements may not have a negligible impact, the April Article’s first error, in our view, is taking Flix Innovations, and the harshness of its outcome, as implying that the court was mandating a strict and universal prohibition against commercial protection delivered through the mechanism of share rights – as opposed to merely saying that the EIS legislation should be strictly interpreted.

The April Article also leans heavily on the court’s use of the word “any” in s.173(2)(aa) in arguing for a literal, absolutist interpretation, only to bemoan that it is not “common sense” to say ratio-based arrangements do not create preferential rights. Surely it must cut both ways and the term “preferential right” must be given its ordinary meaning as a right that takes priority over the rights of other shares, i.e. a prior right.

As the Tribunal was at pains to point out, it is not the task of the courts to import a different meaning to the provision in question than can properly be attributed to it, merely because of a perception that such meaning would better suit the purpose so identified. In the context of the “highly articulated” provisions of Part 5 of the Act, one can hardly ignore the term “preferential right” when applying s.173(2)(aa). To say that “any” means any economic advantage whatsoever is to read out the term “preferential right” entirely, which would create absurd results.

The disqualifying feature in Flix Innovations was not that the ordinary shareholders got £933 and the deferred shareholders got nothing; it was that the ordinary shareholders were entitled to receive that amount before the deferred shareholders receive anything.

Moreover, the comparison in Flix Innovations was between ordinary shares and deferred shares – the latter being a class deliberately created with no meaningful rights. Using Flix Innovations to argue that any disproportion – even among economically meaningful share classes – is disqualifying, misapplies the case in our view.

Where does this leave ratio-based capital rights structures?

Overall, the April Article opens up questions of interpretation where previously no such uncertainty existed. Whilst ratio-based capital rights have been approved by HMRC on many occasions in the past, the April Article will no doubt put pressure on HMRC to reconsider their approach.

The April Article cautions the EIS adviser against the defence that the wording is contained in model articles of association obtained from a “random platform,” so it must be all right. We can only assume the random platform referred to is the British Private Equity & Venture Capital Association (“BVCA“) whose model documents have long contained ratio-based capital rights which are used industry-wide by EIS investee companies and their investors and which HMRC have promoted as a compliant approach.

Notwithstanding, and until such time as HMRC issue clarification or the matter is tested directly in the courts, ratio-based capital rights in the EIS context are clearly not without risk and it would be sensible for advisers to warn clients accordingly. A prudent approach would be to only deploy such rights where an advance assurance in respect of the investment has first been secured from HMRC.

It should be noted that an advance assurance is not necessary with a VCT investment because a VCT may rely on the advice of a competent adviser that ratio-based capital rights do not constitute a preferential right.

The no pre-arranged exits requirement

Could it separately be argued that ratio-based capital arrangements are vulnerable to attack under section 177 of the Act? The section reads as follows:

(1) The issuing arrangements for the relevant shares must not include—

[…]

(d) arrangements the main purpose or one of the main purposes of which is (by means of any     insurance, indemnity or guarantee or otherwise) to provide partial or complete protection for persons investing in shares in the issuing company against what would otherwise be the risks attached to making the investment.

The purpose of a ratio-based capital right might certainly be considered to fall within the compass of arrangements under section 177 which “otherwise” provide partial or complete protection of EIS investors as “persons investing in shares … against what would otherwise be the risks attached to making the investment” because they can benefit one class of shareholder over another simply by giving them a larger slice of the pie.

However, in our view the ejusdem generis rule is of key importance here. This rule of statutory interpretation holds that where general words follow a list of specific items, the words are interpreted to include only items of the same type or nature as those specifically listed. Applying this principle here, the general phrase “or otherwise” falls to be construed in light of the preceding specific terms: “insurance, indemnity or guarantee.” Each of these denotes a mechanism that seeks to transfer or eliminate investment risk by third-party intervention or pre-arranged risk transfer devices. Ratio-based capital rights do not function in this way. Crucially, they still subject investors to significant risk, including the potential for total loss if the liquidation proceeds are insufficient to return capital, whatever ratio may have been agreed. There is no equivalent of section 177 in the VCT rules.

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(1) [2016] UKUT 301 (TCC)

George Tack

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