The First-tier (Tax Chamber) Tribunal (FTT) has decided in RKW Limited v HMRC4 that consideration payable by an individual in future instalments for subscribing for shares in an unconnected close company, as defined in section 414 Income and Corporation Taxes Act 1988 (ICTA), is not a loan or debt within the meaning of section 419 ICTA (section 419).
RKW Limited (RKW), a close company, carried on a UK business described in the decision as “the provision of authentic table dancing and cafes”. RKW identified John Gray, a US citizen, as a potential new investor in RKW. He had extensive knowledge and experience of this business, but was not at that time connected to RKW or its shareholders. RKW and Mr Gray executed a shareholder agreement by which it was agreed that he would subscribe for shares in RKW for a consideration of over £2m payable in four annual instalments (the first payment being £500,000). None of these instalments were paid. HMRC assessed RKW to tax under section 419 on the basis that Mr Gray was a participator in RKW and had advanced over £2m to him. RKW appealed to the FTT. An alternative Section 419 assessment was later made on RKW in relation to the £500kfirst instalment.
The ICTA close company provisions applied to the facts of this case. The relevant equivalent provisions are now contained in Corporation Tax Act 2010 (CTA). Section 414(1) ICTA (see sections 439 and 442 CTA) defined a close company broadly as a UK resident company that was privately owned and controlled by five or fewer persons. Section 419(1) (see section 455(1), (2) and section 456(1) CTA) provided that, if a close company made a loan or advance to a participator, or a participator’s associate, otherwise than in the course of a lending business, the company was liable to a 25% corporation tax charge on the sum in question, refundable when the loan was repaid. Section 419(2) (see section 455(4) CTA) extended the meaning of loan to include where a person incurred a debt to the close company.
The parties’ contentions before the FTT
RKW contended that the extended meanings of “loan” and “debt” in section 419(2)(a) did not apply as Mr Gray had not incurred a debt to RKW. In the context of section 419 the word “debt” does not extend to a liability to pay for shares by instalments on future dates and so no section 419 liability arose. Investing in a company is far removed from the purpose of section 419 and the mischief at which it is aimed (namely, a participator’s untaxed extraction of money from a close company).
HMRC contended that the words “loan” and “debt” in the context of section 419, have a wide meaning as the purpose of the section was to reduce the scope of tax avoidance involving close companies. Mr Gray became a debtor of RKW on entering into the shareholder agreement, the whole subscription price being a debt that was due and payable (albeit in the future on fixed instalments). They argued that an extraction can cover both an act and an omission, including forbearing to recover a debt and in any case there is nothing absurd in the notion of a person being both investor and debtor.
RKW contended in the alternative that the meaning of “debt” is informed by relevant company law. Accordingly, when shares are issued for a subscription price payable in instalments, no debt arises until an instalment becomes due. The only liability under section 419 related to the first instalment of £500k, which became payable one year after the shareholder agreement was executed.
HMRC contended that a subscriber “incurs a debt” to an issuing company within the meaning of section 419(2)(a) where the shares are allotted fully paid and called up, and the subscription price is not paid immediately on allotment.
RKW contended that even if there was a debt for the purposes of section 419, Mr Gray was not a participator in RKW when that debt was incurred. It was in fact incurred in consequence of his share subscription.
HMRC contended that, where the subscription price becomes due and owing on entering into an agreement to subscribe for shares but the consideration is payable by instalments, the subscriber is a participator and incurs a debt within section 419(2). On signature of the agreement, Mr Gray simultaneously acquired in relation to RKW the status of participator and loan debtor.
Analysed objectively and in the context of the relevant mischief, there was no section 419 debt as Mr Gray was effectively an investor who owed RKW nothing. He had no liability to repay monies borrowed or owed. His liability was to honour an investment promise (a share subscription), not a share purchase. The subscription agreement referred to “fully issued”. Nothing in the terms relating to Mr Gray’s investment referred to “fully paid and called up”. In any event, the FTT thought that it probably would not realistically have been possible to extract assets or profits from the “impecunious” RKW.
If HMRC was correct in saying there was a section 419 “debt” or “loan”, tax would be payable on a truly arbitrary figure (the subscription price). If tax was payable under section 419, more or less tax would be payable depending on the amount invested by way of subscription. Tax would be payable on a figure which had no relevance in terms of extraction of funds from the company. The greater the subscription or investment the greater the tax, irrespective of whether the company had any assets or generated any profit. The FTT concluded that this would be illogical and could not be correct.
Mr Gray had secured control of RKW and perhaps could at some future date extract untaxed profits or value from RKW, but if that situation arose section 419 should then apply. Securing control of a close company is not within the contextual or purposive meaning of incurring a “debt” under section 419.
As RKW succeeded under argument A, it was not necessary for the FTT to consider Argument B. However, the FTT rejected HMRC’s contention, deciding that RKW could not sue on any such debt until the instalment became due and payable.
The use of the present tense in section 419 (is a participator) means it does not include a prospective participator. Mr Gray was not a shareholder of RKW when he subscribed for the shares. He was therefore not then a participator (“a person having a share or interest in the capital or income of the company”) within the meaning of section 417 ICTA.
HMRC is strongly of the view that section 419 applies on an issue of shares by a close company where a previously unconnected person subscribes for those shares in consideration of a subscription price payable in future instalments. This issue has been the subject of considerable debate among tax practitioners. While the better view appears to be that there is no debt/loan at that stage, a reasonable argument can be made to the contrary based on the extended meaning of loan/debt. However, it seems unarguable that the person subscribing for the shares could not have been a participator at the time of the share subscription.
Although this decision is not a binding precedent, it represents a welcome clarification of the relevant law. Interestingly, the FTT preferred a purposive/mischief approach to construction, distinguishing the “ordinary meaning” approach adopted in Aspect Capital Limited v HMRC5. It is likely that HMRC will appeal this decision to the Upper Tribunal. To read the decision click here.