The question of what does or does not constitute a preferential right to income or assets on a liquidation under section 173 of the Income Tax Act 2007 (“ITA07″) can be elusive, potentially creating room for doubt and uncertainty when structuring share rights for EIS companies.

Under section 173 of ITA07, shares issued after 6 April 2012 must be ordinary shares that carry:

• No present or future preferential right to dividends;
• No present or future preferential rights to the company’s assets on its winding up, and
• No present or future right to be redeemed.

Essentially, this provision is aimed at restricting the class of investors who can access tax relief under the EIS to those investors who do not shelter themselves (in any way other than explicitly provided for by the legislation) from the inherent risks of investing in SMEs.

What is a “preferential right”?

With regards to a company’s assets on its winding up, preferential rights may exist where a class of securities has an entitlement, by dint of its particular rights, to the the vast majority, say 99%, of a company’s assets.  Because this class of shares would be entitled to a greater proportion of assets than the other class or classes, one might naturally conclude that the former should be deemed to have a preferential right over the latter.

Another way in which a class of securities may be said to have a preferential right is where, again on a liquidation, it ranks ahead of another class.  So, given a hypothetical “waterfall” that ranks shareholders according to the class of shares they hold, a preferential right here would exist where one class recovers potentially, but not necessarily, the entirety of their entitlement, before the other recovers any of its own.

Other permutations of preferential rights are also possible, for example, where one class of securities ranks ahead of the other but for a smaller proportion of assets.  Would in such a case the existence of one type of preferential right be extinguished by the other comparable disadvantage affecting the same class of securities?

The view of HMRC is not entirely clear.  Currently, HMRC do not consider the first example given above to constitute a preference which offends section 173. The latter, however, has always been considered a preference by HMRC. There is always the risk of this interpretation changing, hence the importance of obtaining advanced assurance approving specific share rights on a case-by-case basis.

Also potentially difficult is determining if and when a preference is too small to amount to such. This was the crux of the recent decision in the First Tier Tribunal in the case of Flix Innovations v HMRC.

Here the company, which trades in the technology sector, decided, in order to raise capital by a share issue, to first convert about a third of its ordinary “A Shares” into deferred shares which, with regards to rights on liquidation, were subordinated to the ordinary shares in that they would recoup only after the ordinary shares had recouped the entirety of their entitlement.

Two points should be noted. Firstly, it was not disputed that this restructuring was carried out for entirely commercial reasons.  Secondly, that the maximum amount that holders of ordinary shares could receive on a liquidation in preference to holders of deferred shares was £933, i.e. the total nominal capital of the ordinary shares.  It was therefore also beyond dispute that £933 was a very small, if not entirely negligible amount, compared to £2.77m total share capital of the company immediately after the restructuring.

Since it was established that a preference, however small, existed, the question became whether Part 5 of ITA07, and section 173 in particular, could be interpreted so as to allow for such a “de minimis” preference to be discounted.

The judgment accepts the de minimis principle (and to some extent the guidance provided in HMRC commentary in the Venture Capital Manual) but goes on to say that a “bright line” approach should be applied, which does not allow for any leeway.  In other words, it was decided that statute should be applied strictly so that any preferential right, however minuscule, would offend section 173.

Following Flix, those seeking to implement complex, structured share rights under the EIS should proceed with extra caution.

Giacomo Stucchi-Prinetti