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Mark McLaughlin CTA (Fellow) ATT TEP considers a recent Inheritance Tax case on the ownership period test for Business Property Relief for shares in respect of rights issues.

Mark McLaughlin

The Ownership test

A potential problem with Business Property Relief (BPR) for Inheritance Tax (IHT) purposes is the general rule that no BPR is due unless the relevant business property has been owned by the transferor for a minimum period of two years (IHTA 1984, s 106). However, there are certain exceptions to this basic two-year ownership requirement, in connection with replacement property, acquisitions on death and successive transfers respectively.

With regard to replacement property, the ownership test is treated as satisfied if the property replaced other business property eligible for relief, provided that the combined period of ownership is at least two years out of the preceding five years (IHTA 1984, s 107(1)). The replacement property rule is potentially helpful in certain specific circumstances, such as on the incorporation of a business (i.e. the acquisition of the business by a company controlled by the former business owner), or in respect of changes resulting from the formation, alteration or dissolution of a partnership.

Company reorganisations

In addition, the replacement property rule can apply in respect of company reorganisations and amalgamations. If holdings of unquoted shares would (under the Capital Gains Tax rules in TCGA 1992, ss 126-136) be identified with other qualifying shares previously owned, the owner may treat their period of ownership as including the ownership period of the original shares (s 107(4)). For example, if a capital reorganisation took place within six months of the shareholder’s death, and the original shares were held for two years, the ownership period of the original shares would be taken into account in respect of the new shares, if the earlier shares themselves would have qualified for relief.

In The Executors Of Mrs Mary Dugan-Chapman & anor v Revenue & Customs Commissioners (2008) SpC666, Mrs Dugan-Chapman (Mrs DC) was allotted one million ordinary shares in the company on 27 December 2002, two days before her death. The issue was broadly whether those shares could be identified with other shares in the company which, together with her husband, she had held for at least two years prior to her death. It was agreed that the shares owned by Mrs DC for at least two years before her death qualified for BPR. In addition, 300,000 shares had been allotted to her on 23 December 2002 as a pro-rata entitlement on a rights issue, following the conversion of a loan account of £300,000 that Mrs DC had with the company. It was also agreed that those shares qualified for BPR, as a result of IHTA 1984, s 107(4).

However, in relation to the one million shares allotted to Mrs DC two days before her death, the Special Commissioner dismissed the executors’ appeal against HMRC’s determination that the value of those shares could not be reduced by BPR. HMRC contended that the shares had been issued as the result of a simple subscription for shares. The Special Commissioner held there had been no reorganisation of share capital within TCGA 1992, s 126, and therefore the shares did not qualify for BPR as they did not satisfy the conditions in IHTA 1984, s 107(4). The allotted shares could not be identified with shares previously owned by Mrs DC for the purposes of s 107(4), as there was insufficient evidence or documentation to support the executors’ argument that a reorganisation had actually taken place. Only Mrs DC took shares on 27 December 2002. A rights issue would involve the other shareholders renouncing their pro-rata entitlement, so that Mrs DC could acquire the full million shares.

The Duomatic principle

In the above case, the executors stated that the company conducted its affairs with relative informality. They relied on a principle established in Re Duomatic Ltd [1969], which broadly allows certain formalities to be treated as satisfied, to support their argument that the rights issue had effectively taken place so that events should be interpreted as if they had. The Duomatic principle was previously summed up by Neuberger J in EIC Services Ltd v Phipps [2003] BCC 931 as follows:

“The essence of the Duomatic principle, as I see it, is that, where the articles of a company require a course to be approved by a group or shareholders at a general meeting, that requirement can be avoided if all members of the group, being aware of the relevant facts either give their approval to that course or so conduct themselves afterwards as to make it inequitable for them to deny that they have given their approval. Whether the approval is given in advance or after the event, whether it is characterised as agreement, ratification, waiver or estoppel, and whether members of the group give their consent in different ways at different times, does not matter.”

However, the Special Commissioner held that the Duomatic principle could not give the character of a rights issue to a share subscription. There was confusion over events in the case, and the Duomatic principle could not be extended to select from a range of possible alternatives the one that gave the desired IHT result. In addition, as the members had not understood the relevant facts, the principle could not be applied.

Whilst the Duomatic principle did not assist the appellants in the above case, practitioners acting for family or owner-managed companies in particular may find it helpful if clients have not taken advice, and/or have acted informally on certain matters. The principle is recognised by HMRC in the Employment Income Manual, in cases where there is no company resolution to determine directors’ remuneration. It states (at EIM42300): “If there is no such specific resolution, but the directors’ remuneration is approved by the shareholders entitled to attend and vote at a general meeting, this has the same effect as a resolution passed by the company in general meeting.” In addition, the Insolvency Manual includes the following illustration of when the Duomatic principle might apply in practice (INS44205): “A common example will be a husband and wife being the only shareholders; they would always have agreed to their own remuneration as directors.” Of course, the best course of action would be to ensure that the proper paperwork is prepared, and to relying on this principle if possible.