FC Case Feature: Share schemes – Jack Rivett of Erskine Chambers considers a Court of Appeal decision in relation to unlawful discounts and commissions contrary to ss 580 and 552 Companies Act 2006

2nd February 2022

In Chalcot Training Ltd v Ralph [2021] EWCA Civ 795, the Court of Appeal dismissed an appeal against a decision of the High Court in relation to whether payments made by Chalcot Training Ltd (Company) to its two employed shareholders/directors pursuant to a commercially marketed tax avoidance scheme were unlawful on the grounds that the arrangements:

– amounted to the allotment of shares at a discount contrary to s 580 Companies Act 2006; and/or

– involved the payment of the company’s shares or capital money in consideration of an agreement to subscribe for shares contrary to s 552 CA 2006.

The Company argued that the payments under the scheme were in breach of either or both these provisions, and that it was therefore entitled to have the scheme set aside on the grounds of mistake. However, the Court of Appeal concluded that the scheme was not contrary to the relevant provisions of CA 2006 and therefore the question of mistake did not arise.

Background

The Company was owned 50/50 by Mr Ralph and Ms Stoneman, who were also employees and the only two directors of the Company. Following professional advice, in 2011 the Company entered into a tax scheme (E Shares Scheme) that was designed to avoid corporation tax payable on the company’s profits. Under the E Shares Scheme, payments would be made by the Company to a scheme beneficiary in recognition of their services. The payment would be accounted for as an employment expense, which was deductible for corporation tax. The idea behind the scheme was that the payments to a beneficiary would not be subject to PAYE, income tax or National Insurance contributions, as they were subject to an obligation to subscribe for E Shares. This meant that the payments would not constitute taxable earnings. Under the E Shares Scheme, only 1% of the nominal value of the E Shares was paid up at the outset, with the remaining 99% not called up. Three separate rounds of payments were made between 2011 and 2013 under the E Shares Scheme and a further identical scheme involving F Shares.

In 2016, HMRC challenged the tax treatment of the payments under the E Shares Scheme. It demanded payment from the Company of PAYE, income tax and National Insurance contributions on the grounds that the payments to Mr Ralph and Ms Stoneman were remuneration. The Company contested HMRC’s demands on the grounds that the transactions entered into under the E Shares Scheme were unlawful as a matter of Company law, had been entered into by mistake and were therefore void.

In 2017, the Company brought proceedings against Mr Ralph (who resigned as a director in 2012) seeking a return of the monies paid to him under the E Shares Scheme on the basis that they were an unlawful disguised distribution of assets to a shareholder, and/or repayable on grounds of mistake. Ms Stoneman had tried to reverse the E Shares Scheme as far as she could, and the Company brought separate proceedings against Ms Stoneman and HMRC seeking rectification of the Company’s register to remove her as a holder of E Shares.

High Court decision

Michael Green QC (sitting as a deputy judge of the Chancery Division) held that the payments should be characterised as they were described in the relevant documents, namely as remuneration for Mr Ralph and Ms Stoneman’s services to the Company as directors and employees. In addition, the payments were recorded in the accounts of the company as ’employment expenses’. The judge considered that Mr Ralph and Ms Stoneman had genuinely and properly exercised their power as directors to award themselves remuneration for the purposes of effecting the E Shares Scheme, and therefore the payments were not unlawful disguised distributions to shareholders.

As an alternative or additional claim, the Company argued that the payments under the E Shares Scheme constituted unlawful discounts against the nominal value of E Shares contrary to s 580 CA 2006, and/or unlawful commissions or discounts paid in consideration of Mr Ralph and Ms Stoneman agreeing to subscribe for E Shares, contrary to s 552 CA 2006. The judge considered the Company’s argument was “fundamentally misconceived” and determined by the outcome of the characterisation issue, on which the Company had failed. However, the judge went on to consider whether the E Shares had been allotted at a discount and made the findings set out below:

– s 580 (shares must not be allotted at a discount) – a company cannot agree to accept less than the nominal value of the shares that it issues. It does not matter if those shares remain unpaid as to part of their nominal value, so long as the shareholder remains liable to a call for the unpaid amount. S 580 is not intended to cover payments by a company to a proposed allottee but is simply concerned with the allottee’s obligation to pay the full nominal value of the shares. Mr Ralph and Ms Stoneman remained liable to a call for the full nominal value of the E Shares, and therefore there could be “no question” that the E Shares were issued at a discount.

– s 552 (general prohibition on applying any of a company’s shares or capital money in payment of any commissions, discounts and allowances as consideration for subscribing for shares) – the reference in s 552 to ‘shares or capital money’ is to the actual share issue in respect of which commission is being paid. The restriction will therefore only apply if commission is being paid from the proceeds of that share issue or by the issue of shares credited as fully paid. In this case, the payments were paid to the individuals from the Company’s profits, and not from the shares or capital money arising from the E Shares Scheme.

The Company appealed to the Court of Appeal on the ss 580 and 552 CA 2006 arguments.

Court of Appeal decision

The Court of Appeal unanimously dismissed the appeal and upheld the High Court decision.

The discount issue – s 580 CA 2006

The Court of Appeal began its analysis by noting that the prohibition on issuing shares at discount long predated s 580 and had its origins in the principle of limited liability and capital maintenance. This (in short) is the principle that an investor shall purchase immunity from liability beyond a certain limit, on the terms that there shall be and remain a liability up to that limit. That limit is represented by the nominal value of a share. The Court of Appeal considered a number of late nineteenth century and early twentieth century cases which demonstrated the scope of this principle, including   the decisions of the House of Lords in Ooregum Gold Mining Co of India Ltd v Roper [1892] AC 125, Welton v Saffery [1897] AC 299 and Hilder v Dexter [1902] AC 474 (in the context of s 8(2) CA 1900, a predecessor to s 552 CA 2006). Having considered the origins of the prohibition, Lewison LJ (with whom Arnold LJ and Edis LJ agreed) rejected the argument that the E Shares had been allotted at a discount contrary to s 580 CA 2006. On the facts, Mr Ralph and Ms Stoneman remained liable to pay the whole amount of the uncalled capital on each E Share under the articles of association and the share application form as and when a call was made, and the Company therefore remained entitled to receive the full nominal value. The court distinguished that situation from the situation where shares are credited as fully paid but are in fact given to the allottee with no future liability to contribute to the company’s capital.

The Company submitted that, when determining whether shares have been allotted at a discount to nominal value, account must be taken of any payment made by the company to the subscriber in order to subscribe for the shares. Thus (the Company submitted) if a company pays someone £100 ‘to subscribe for shares’ with a nominal value of £100, the company is not getting in the required nominal value. It argued that was what had happened on the facts of the case before the Court.

Lewison LJ rejected that argument. He considered that the answer to the issue depended, to a large extent, on: (a) the characterisation of the payments to Mr Ralph and Ms Stoneman; and (b) the source of funds. If, as the High Court found, it was an exercise by the board in good faith to award remuneration, then the payment could not be said to have been a payment ‘to’ subscribe for shares. It was remuneration, which the payees were free to do with as they wished, apart from the 1p which they had contractually agreed to pay as part payment for the shares.

The Company sought to counter this point by alleging that, if they were properly characterised as remuneration, the payments were in respect of past services performed by Mr Ralph and Ms Stoneman; but past services could not have amounted to valid contractual consideration for the payments made to them. The Court of Appeal rejected this argument too. Whether a director has any right to remuneration depends on the provisions of the articles and, in this case, the articles provided that the ‘directors are entitled to such remuneration as the directors determine…for their services to the company as directors’. As a result, the court held that when Mr Ralph and Ms Stoneman performed services for the Company, they did so on the legally binding basis that the directors would exercise the powers conferred on them by the articles in a rational manner and in good faith. In any event, the question was not whether there was good consideration for the payments, but whether there was good consideration for the shares. Here, the Company received cash for the shares: 1p was paid up immediately, and 99p was payable when called.

As to the funding source from which the payments were made, the court considered that the mischief against which s 580 CA 2006 is directed is the depletion of a company’s nominal share capital. Observing the link between issuing shares at a discount and a company’s share capital made in Welton, the court noted that the payments to Mr Ralph and Ms Stoneman were funded from what would otherwise have been trading income (which would have been taken into account for the purposes of calculating the company’s corporation tax liability), and not share capital.

The court also noted that the Company’s argument that the shares had been allotted at a discount would have ‘startling consequences’ of double recovery. Under s 580(2), the payee would be required to pay an amount equal to the discount to the company but would also remain liable to a call for the amounts unpaid on the shares.

The court held that the payments therefore did not contravene s 580.

The prohibited commission issue – s 552 CA 2006

The court went on to consider whether the payments to Mr Ralph and Ms Stoneman were an unlawful discount contrary to s 552 CA 2006.  In the court’s view, s 552 (like s 580) is directed at a company’s capital and since the payments to Mr Ralph and Ms Stoneman were made from the Company’s trading income (as they had to be in order to benefit from the intended tax treatment for the purposes of the E Shares Scheme), they were not caught by the prohibition in s 552. The Company remained entitled to the unpaid capital on the E Shares, as and when it was called.

Comment

Superficially, at least, ss 580 and 552 are ‘unloved’ provisions of CA 2006. Prior to the decision in Chalcot, there was no modern authority on either provision. Indeed, neither s 580 nor any of its statutory predecessors had received any judicial treatment. As a result, their consideration by both the High Court and the Court of Appeal in Chalcot is welcome. As those decisions make clear, ss 580 and 552 are manifestations of a fundamental principle of company law, namely the principle of capital maintenance, and are not to be overlooked.

On the other hand, ss 580 and 552 have a clearly defined scope. It does not follow from the fact that the company is the source of the money which is ultimately used to pay for the shares that there has been a breach of either provision. Rather, the task is to see whether the transaction under scrutiny involves any depletion of the company’s capital.

Finally, the decision of the Court of Appeal is of interest not simply because of its commentary on ss 580 and 552 CA 2006. Lewison LJ also made some novel observations about directors’ entitlement to remuneration under article 19 Model Articles (Private). Noting that article 19 is framed in the language of entitlement, he concluded (by analogy with the position under employment law) that, as and when directors performed services for the company, they did so on the legally binding basis that the directors would exercise the power of determination given to them by the articles in a rational manner and in good faith. This conclusion will be of interest to all companies whose articles of association confer on directors a right to remuneration, not least those which have adopted the 2008 Model Articles for private or public companies.