The Court of Appeal’s decision in Chalcot Training Ltd (the “Company”) v Ralph (“Ralph”) [2021] is the first appellate decision on the allotment of shares at a discount under section 580 and the prohibition of commissions, discounts and allowances under section 552 of the Companies Act 2006 (the “Act”). As such this judgment, coupled with the High Court’s decision, provides a useful commentary and summary on the purpose of these sections.
FACTUAL BACKGROUND
Allotment of shares at a discount is where a company issues shares at less than nominal value (Section 580 the Act). If shares are allotted in contravention of this section, the allottee is liable to pay the company an amount equal to the amount of the discount. Section 552 of the Act prohibits a company using its shares or capital money in payment of any commission, discount or allowance to any person in consideration of their subscription for shares in the company. It should be noted that only payments made out of a company’s capital money, not a company’s trading income, are prohibited under section 552 of the Act.
Parties need to be aware that the court places great emphasis on whether a company entitles to a total amount of nominal share capital. If not, it would be the allotment of shares at a discount which breaches section 580 of the Act.
In this case, Mr Ralph and Ms Stoneman were the only directors and shareholders of the Company, each owning half of the ordinary shares in the Company. They sought to mitigate their tax liability by transferring the Company’s business to NKD limited liability partnership (the “LLP”). The Company, Mr Ralph and Ms Stoneman later entered into an employment share scheme (the “Scheme”) to avoid corporation tax payable on the Company’s profit (as the Scheme did not include distributable profits which was taxable).
The Company, Mr Ralph and Ms Stoneman later entered into the first iteration of this Scheme as the Scheme’s members. They signed documents, including subscriptions of a new class of “E” shares in the Company’s shares. Mr Ralph and Ms Stoneman paid only 1% of the nominal value of the E shares and as such were still liable to the Company for any call for the outstanding amount.
Corporate tax is a tax payable on all income profits which arise during the accounting period, with salaries to certain employees classified as necessary business expenditures. Therefore, these salaries are not considered as a company’s taxable profits and are viewed as allowable expenditures; as such, they are fully tax-deductible. Accordingly, in this case, payments were made from Company profits to both Mr Ralph and Ms Stoneman regarding their employment as directors. Thus, these expenses were tax-deductible for the Company under corporate tax purposes. Additionally, in respect of Mr Ralph and Ms Stoneman’s subscription for E shares under the Scheme, the Company claimed that additional taxes such as pay as you earn (“PAYE”), and national insurance contributions (“NIC”) were not payable. This meant overall that as employees of the Company, neither Ms Stoneman nor Mr Ralph incurred any taxable earnings during the relevant accounting period.
Her Majesty’s Revenue and Customs (“HMRC”) later challenged the Company in respect of the Company’s tax treatment of the payments to its employees. HMRC believed the payments to Ms Stoneman and Mr Ralph were in their capacity as directors. Thus, payments to Ms Stoneman and Mr Ralph were directors’ remuneration and were subject to tax.
Accordingly, the Company commenced proceedings in the High Court and argued against Mr Ralph, Ms Stoneman, and HMRC by claiming that the transactions under the Scheme amounted to unlawful distributions under section 580 and an unlawful commission under section 552 of the Act. The Company argued that Ms Stoneman and Mr Ralph were in their capacity as shareholders characterising the Scheme payments as distributions of assets to shareholders and not as remuneration in their capacity as directors of the Company. Therefore, arguing the payments made to Ms Stoneman and Mr Ralph in this regard should be set aside on the grounds that they were unlawful. Alternatively, claiming that the payments and credits the Company made under the Scheme amounted to unlawful commission under sections 552 and 553 of the Act.
The High Court held that the payments were genuine remuneration for Mr Ralph and Ms Stoneman as employees of the Company and not unlawful distributions under section 580 of the Act. In the Company’s accounts, payments were clearly described as employment expenses. Both Mr Ralph and Ms Stoneman had entered into multiple documents, for instance, those documents concerning share subscriptions in the first iteration of the Scheme in their capacity as directors. These documents clearly indicated that the payments to Mr Ralph and Ms Stoneman were for their provision of services as directors of the Company and accordingly that the payments then were an award for their performance as directors. Hence, these payments could not have been distributions to shareholders, and ultimately, could not amount to a discount on shares or a commission for subscriptions for shares under the Scheme. The High Court then rejected the Company’s claim regarding unlawful distributions and an unlawful commission.
THE CASE AT THE COURT OF APPEAL
The Court of Appeal upheld the High Court’s decision and dismissed the Company’s appeal on both accounts of unlawful distributions under section 580 and an unlawful commission under section 552 of the Act.
In relation to section 580 of the Act, the Court of Appeal concluded that payments in return for both shareholders’ subscriptions were not a discount. Thus, it did not fall within this section. The Court of Appeal acknowledged that payments for subscriptions of shares would be a discount if the allottees retained no liability for the amount of the nominal value of the given shares that were credited fully paid. In this case, the Court of Appeal was not convinced that the Company would never receive the full amount of the nominal share capital under the Scheme because both shareholders remained fully liable for the unpaid amount at anytime upon the Company’s request.
Furthermore, the Court of Appeal upheld that the payments by the Company to Mr Ralph and Ms Stoneman were employee/director remuneration, as explicitly stated in the transaction documents. Both director-shareholders were also obligated to pay the remaining amount from their own funds. Accordingly, the Court of Appeal emphasised that payments, in this case, were not payments for Mr Ralph and Ms Stoneman to subscribe for shares.
The Court of Appeal made clear that a discount under section 580 of the Act directs to the depletion of the Company’s nominal share capital. In this context, payments were made out of the Company’s trading income which had been calculated for corporation tax purposes. Consequently, the Court of Appeal held that the allottees did not receive shares at a discount.
Section 552 of the Act makes clear that a company cannot apply its shares or capital in the payment of commissions for subscription of shares, either directly or indirectly. Therefore as the Company was also entitled to the outstanding balance of issued shares upon its requisition, the Court of Appeal determined that the payments in question were not prohibited by section 552.
CONCULSION
To distinguish between remuneration and distribution, the High Court has provided useful guidance for re-characterising remuneration as a distribution to shareholders as follows:
- the legal test for re-characterising is not purely objective;
- the subjective states of mind of those deciding on the relevant transaction are significant to determine the true purpose and substance of the transaction;
- the way the parties had chosen to describe the transaction, both in the transaction documents and other documentation, are vital; and
- the court would have to decide whether there was a genuine exercise of the board’s power to award remuneration or if the power was being used to give a true nature of payments, to be really distributions to shareholders. In this regard, the court would not interfere in commercial decisions which directors took.
PRACTICAL TIPS
Accordingly, companies should where possible allot shares less than a nominal value; otherwise, the allottees may be liable for the amount of the discount (including any appropriate interest rate) for falling foul of section 580 of the Act.
Where payments are being made out of a company’s balance sheet, it should be carefully considered as to which account the payment will be made out of. As payments out of a company’s capital account in relation to a subscription for or an agreement to subscribe for shares in another company may contravene Section 552, a company has more flexibility to make such a payment if it is not related to or affects its own capital, for example, via a company’s trading income. However, as always, each payment will need to be considered appropriately and in the context of the larger transaction to ensure compliance. In addition, an unpaid amount of subscribed shares would not contravene section 552 of the Act as long as a company is entitled to that outstanding amount.
In regard evidencing the genuine purpose of a transaction, the parties should create a clear audit trail through appropriate documentation to evidence the parties’ intention in relation to each transaction and the board’s genuine exercise of power to award a remuneration. This means parties may need to consider factors such as the context, purpose, and words used in documents concerning such a payment. These considerations will define whether the true nature of a transaction, for instance, is remuneration or distributions.
To review the Court of Appeal’s decision please click here.
To review the High Court’s decision please click here.
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