Share loss relief claim succeeds in Lewis

Share loss relief claim succeeds in Lewis

Wed 18 May 2016

A First Tier Tribunal (FTT) case that would have looked unpromising at first sight has been decided in the taxpayer’s favour (John Lewis v HMRC[2016] UKFTT 0254). John Lewis (John) represented himself in appealing against an HMRC closure notice refusing him any relief in respect of shares in his son’s (Dominic’s) company that he had paid for by converting his loan to the company. Lewis had provided a number of loans totalling just over £100,000 over a period of time, finally converting those loans into shares just months before the company was forced to cease trading when it ran out of money to develop a promising software product.

Loans that were converted into shares

Dominic formed the company in 2009 with the understanding that John would lend up to £100,000 as needed from time to time, on an “equity equivalent basis”. The mechanism for the loans was odd in that John provided the money to Dominic personally who then filtered it into the company as required. The only evidence in support of the loans was the Lewises’ and the company’s bank statements in which the various payments did not precisely match up: there were no written records of the transactions at the time they took place, only a letter written after the event. Matters were not helped when the only accounts that could be produced showed the loan in the company’s books as due to Dominic, not John. But this was explained as being a mistake due to those draft accounts being prepared by an assistant who assumed that Dominic was the creditor because the money had been transferred in from his bank account. Discrepancies between the amounts lent by John and introduced by Dominic to the company were explained as Dominic retaining small amounts to live on because the company was not able to pay him enough to live on.

The company developed slowly through 2009 and 2010 but by 2011 needed to raise further funds from outside investors. The heavy debt owed to John was regarded as a factor that would deter investors and that, taken with the equity equivalence in the minds of the Lewises and the company led them to convert the loan into equity on 1 March 2011, the date when 99,900 £1 shares were issued to John. At that time the Company was negotiating with an independent third party introduced by its accountant about introducing a substantial amount of share capital. Those negotiations broke down because the investor was not prepared to accept anything less than a 51% stake in the Company for an investment of £75,000. The failure to secure that investment left the Company insolvent and it ceased to trade in May 2011.

John then claimed share loss relief under ITA 2007 s 131 for £99,900. Share loss relief gives income tax relief when a loss is realised, calculated according to CGT principles, on disposal of shares, issued to the claimant, on which EIS relief was, or might have been claimed.

The arguments

HMRC refused the claim and issued a notice of closure giving no relief.

There was no real argument about the shares being qualifying shares for the purposes of the relief, the arguments concerned:

  • whether John had subscribed for them;
  • if so, what consideration he had given, i.e. had he made a loan to the Company or to Dominic; and
  • what the value of the shares was at the date of issue.

The subscription

The issue of John’s shares was clearly recorded in the Company’s books and board minutes (“the one clear piece of formal written evidence presented to us”). The Judges did not doubt that that was what was intended and there was no question of John having received the shares in any capacity other than as absolute owner.

The loans

The Judges commented on the unconventional way in which the loans had been arranged, in particular the discrepancies between sums John transferred to Dominic and those that Dominic then filtered into the Company. The fact that Dominic retained some of the monies personally indicated that he regarded those monies as belonging to him but in the end the Judges said they “cannot see any logical reason for the shares to be issued to [John] in this manner if the loan had in fact been made by Dominic.” They also accepted evidence that John’s accountant had not raised the possibility of a s 131 claim until he began preparing the relevant tax return, so the Judges were satisfied that this was not a contrived arrangement to obtain the relief.

Valuation

John could not rely on the fact that he had paid £99,900 for his shares as establishing that sum as the base cost because the issue of the shares was a transaction other than at arm’s length so that their base cost was their market value at the date of issue (if John had been a subscriber at arm’s length his base cost would have been the actual amount paid, even if that had been a bad bargain).

HMRC argued that the shares were worthless when they were issued because the company was on the brink of insolvency. John’s argument was that the Company did still have a value at that point, otherwise it would have been unable to attract the independent potential investor who was prepared to offer £75,000 for a 51% majority stake in the Company. However, at the time of John’s investment the other investor, a Mr. Harding, was known about, so John was effectively only acquiring a 49% minority stake in the Company. This size of interest would require discounting as against a value pro rata to Harding’s prospective interest because John would have had no control but for the ability to block special resolutions requiring a 75% majority. The Judge applied a minority discount of 10% and a further discount for the possibility at the time of investment that Harding might not proceed, arriving at a value of £60,000 for John’s shareholding when it was issued to him. That was the amount of his loss because he recovered nothing from the Company.

It is interesting to note that neither John Lewis nor HMRC appear to have put forward any detailed arguments about the value of the shares and certainly no valuation was made to form the basis of the price John paid but nevertheless the Judges came to a decision.

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