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	United Kingdom Special Commissioners of Income Tax Decisions
You are here: BAILII >> Databases >> United Kingdom Special Commissioners of Income Tax Decisions >> Fletcher v Revenue & Customs [2008] UKSPC SPC00711 (29 September 2008) URL: http://www.bailii.org/uk/cases/UKSPC/2008/SPC00711.html Cite as: [2008] UKSPC SPC00711, [2008] STC (SCD) 1219, [2008] UKSPC SPC711

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Spc00711

Claim to set capital loss against income under S. 574 Taxes Act 1988 - Appellant's claim to have a loss of £50,400, resulting from the initial subscription of Ordinary Shares for £400 and the capitalisation of £50,000 of a loan in return for B Ordinary Shares with restricted rights - Respondents contention that the B Ordinary Shares were worthless at the point of the capitalisation of the debt, such that the allowable loss was restricted to £400 - Rights issue analysis - Appeal allowed in full

THE SPECIAL COMMISSIONERS

JOANNE ELIZABETH FLETCHER Appellant

and –

THE COMMISSIONERS FOR HER MAJESTY'S REVENUE & CUSTOMS Respondents

Special Commissioner: HOWARD M NOWLAN

Sitting in public in London on 16 September 2008

Stephen Matthews, former Director of Articsoft Limited, for the Appellant

Fred Cook, Inspector of Taxes, and Mr Wheeler, senior HMRC officer, for the Respondents

© CROWN COPYRIGHT 2008


 


DECISION

Introduction

1. This was a case where I considered at the end of the hearing that it would not be possible, whilst applying the law correctly, to confirm the Appellant's entitlement to the loss that she claimed in respect of the capitalisation of £50,000 of her loan to the company, Articsoft Limited ("Articsoft") for 50,000 £1 B Ordinary Shares, and the later feature that all her shares, including her 400 Ordinary Shares in the company, proved worthless. The Respondents had contended that where assets are taken in satisfaction of debt, the base cost of the assets acquired is restricted to the value of those assets. Since the B Ordinary Shares had strangely drafted rights that arguably made them worthless at the point of the capitalisation, the Respondents contended that this meant that the deemed disposal of those shares under section 24 TCG Act 1992 occasioned no loss. Thus there was no capital loss eligible to be set against income under section 574 Taxes Act 1988.
2. The case before me was argued almost entirely on a valuation basis, addressing both the value of the company generally at the point of the capitalisation, and the specific rights attaching to the B Ordinary Shares, and the impact that those rights had on the value of the B Ordinary Shares at their acquisition. The case for the Appellant was advanced by Mr. Matthews, who had been the Appellant's co-shareholder and co-director in Articsoft, and Mr. Matthews confirmed that whilst he had done considerable research into valuation principles in order to assist the Appellant, he was not remotely a tax expert. The Appellant's case was thus advanced largely by reference to valuation principles, and in reliance on numerous quotations from valuation text-books and articles.
3. The circumstances surrounding the capitalisation were that Mr. Matthews and the Appellant each held 400 of the 800 issued Ordinary Shares prior to the transactions (including the capitalisation referred to above) that occurred on 16 May 2003. On that date, a venture capital fund, South East Growth Fund ("SEGF") contributed £250,000 for 150,000 Preference Shares and 100,000 A Ordinary Shares in Articsoft. Those shares had preferential rights, ahead of the 800 Ordinary Shares, but in the event that the company was successful, the A Ordinary Shares would ultimately take 25% of the residual equity profits, leaving 75% in the hands of the two holders of the 800 Ordinary Shares. Not surprisingly SEGF insisted on each of the two shareholders capitalising £50,000 of their loan accounts. The shares issued on that capitalisation had curious rights, in that whilst SEGF would doubtless not have objected had the B Ordinary Shares issued on the capitalisation been given rights that, whilst deferred behind the preferential rights attaching to the shares that SEGF subscribed, would nevertheless have secured that the acquired 100,000 B Ordinary Shares were the next shares to attract value, i.e. ahead of the original 800 Ordinary Shares, the draftsman in fact attached rights that arguably made the B Ordinary Shares worthless. Needless to say the prime reason for the capitalisation was to protect the position of SEGF and to ensure that the directors' loan accounts did not rank ahead of their shares, and so no attention was given to whether the consequence of the capitalisation was to attach any value to the B Ordinary Shares subscribed, or largely to pass value instead into the original two holdings of 400 Ordinary Shares.
4. During the hearing I did explain to the Appellant that her case would have been dramatically stronger had the B Ordinary Shares been taken up effectively as a rights issue, "in respect of and in proportion to her holding of Ordinary Shares", for then instead of concentrating on the value of the B Ordinary Shares in isolation, the original Ordinary Shares and the B Ordinary Shares would have been treated as one asset, and as a "new holding" for capital gains purposes, and the addition to base cost of the whole holding would have been geared to the lower of the consideration given in the capitalisation and the increase in the value of "the new holding" over the pre-existing value of the original Ordinary Shares. Accordingly if value flooded into the original Ordinary Shares, whilst the B Ordinary Shares were nearly worthless, the addition to base cost would be geared to the amount just indicated, and the Respondents would have been wrong to focus their whole argument on the low value of the B Ordinary Shares.
5. At the hearing I did not unfortunately take the further step that now seems to me to be obvious which is to observe that on the authority of Dunstan v. Young Austen Young Ltd [1989] STC 69, the circumstances of the capitalisation are properly to be analysed on the rights issue approach just indicated in paragraph 4. After all, each of the two original investors in Articsoft held 400 Ordinary Shares; they each capitalised £50,000 of loan account; they each subscribed 50,000 B Ordinary Shares; and the reason each of them was indifferent to the specific rights attaching to the B Ordinary Shares was that they both held Ordinary Shares in similar proportions. Clearly had the loan creditors owned no Ordinary Shares, they would have insisted on the B Ordinary Shares being given rights that would rank them ahead of the original Ordinary Shares, or rights that at the very least would not have led to the current arguments that they just acquired worthless shares. It was precisely because the directors held Ordinary Shares that they were indifferent to the rights attaching to the B Ordinary Shares, and as they each held the same number of Ordinary Shares, and capitalised the same amount of loan for the same number of B Ordinary Shares, it seems to me that it is unarguable that the Dunstan v. Young Austen Young analysis applies in this case.
6. I have considered whether I should have called the parties back for further argument on the point on which I actually base my decision, but since it is a simple legal point, I have decided that there is no need to do that. I base this conclusion in part on the point that I have subsequently noted (which I will refer to below) which is described in an extract from some HMRC Guidance Notes on capital gains tax that were included amongst the substantial correspondence that I have read since the hearing. Somewhat to my surprise I see that the extract from this Guidance Note that the Inspector challenging the valuation issue, looking solely at the value of the B Ordinary Shares, has sent to the Appellant makes it perfectly clear that when debt is capitalised in the circumstances that prevailed in this case, the Dunstan v. Young Austen Young analysis is appropriate. Since I imagine thus that the Respondents will concede that they have failed to note this fundamental point, and that this point completely transforms the position, I have considered it unnecessary to reconvene the hearing.
7. There remain of course several valuation issues that I must address, albeit not those on which I was principally addressed. In case the Respondents should appeal against the "rights issue" basis of this decision, I will add comments on the acquisition value that I would put on the B Ordinary Shares in case a higher court allows the appeal, so that the quantum of the loss on the B Ordinary Shares depends after all on the value, at acquisition, of the B Ordinary Shares in isolation.
8. In the meantime, my decision is that the consideration given by each of the Ordinary Shareholders on the capitalisation was £50,000, and the aggregate increase in value of the Ordinary Shares and B Ordinary Shares held by each of the shareholders, over the pre-existing value of just their Ordinary Shares before the capitalisation was £50,000, so that the Appellant's appeal is allowed in full. I do not hesitate to say that this result accords with the reality, justice and common sense of the situation, as well as with the proper application of the capital gains rules, so that I am pleased to be able to reach this decision.

The facts in more detail

9. The Appellant and Mr. Matthews were the founders and initial shareholders of Articsoft. Each of the Appellant and Mr. Matthews had subscribed 400 of the issued 800 £1 Ordinary Shares in the company. The company was incorporated in late 2001 and commenced trading, in trying to market two or three software products that it had devised and developed, on 1 July 2002. The software in question all related to packages that would protect against theft of confidential information from computers. At some time before May 2003, the two directors had advanced between them, from their own resources, approximately £115,000, each of them having advanced at least £50,000.
10. As is naturally common with start-up companies, the initial accounts for the 8-month period of trading to 28 February 2003, showed few sales, considerable expenditure and a resultant loss. Sales had amounted to only £7019; programming costs were £63,500 and other expenses £47,976, and the loss was £104,455. The Respondents also pointed out that as the company was operating from the Appellant's house, it was operating on an economical basis, but it still made the loss in question.
11. Articsoft considered that it needed additional finance in order to increase its marketing effort. In February 2003 the company produced a business plan with a view to obtaining finance from a venture capital fund. Naturally the business plan contained glowing projections of future income. Negotiations commenced in February with SEGF, but they initially foundered. By May 2003 the negotiations had resumed and SEGF had commissioned an independent report on the business and prospects of Articsoft. This report, which I was shown, was relatively positive. It indicated that the software packages promoted by the company were relatively attractive, and in some respects one at least was technically superior to that available from a very much larger US company with an established market presence. Naturally the report concentrated on the difficulty of breaking into a market where there was an existing market-leader, and it advocated that the company should initially concentrate on various suggested niche markets.
12. Whatever the reservations in the report, and notwithstanding that SEGF was fully conversant with the results shown in the 28 February accounts, SEGF agreed to inject £250,000, as a first instalment of new capital, in return for £150,000 Preference Shares and £100,000 A Ordinary Shares. This subscription was made on 16 May 2003, it then being the intention that SEGF would subscribe further shares after an interval if initial trading justified the further investment. I might add that in the following month, the company won a Smart Award of £45,000 for further funding of the development and marketing of its products.
13. As part of the deal in which SEGF subscribed shares in May 2003, it required the two directors each to capitalise £50,000 of their advances to the company by taking 50,000 £1 B Ordinary Shares. The essential aim of this was of course to reinforce the preference attaching to both the Preference Shares and the A Ordinary Shares that SEGF subscribed, and to ensure that they did not rank behind loan creditors in the event of a liquidation.

The rights attaching to the various classes of shares

14. The Preference Shares subscribed by SEGF were entitled to a fixed cumulative dividend of 8% per annum, and also had redemption rights that envisaged that they were to be redeemed at an early point, were the company successful.
15. The A Ordinary Shares carried a right to a fixed 7% dividend, and then a dividend geared to a rising percentage of group profits, rising from 3% for the period ending 28 February 2008 by 1% steps to 8% of group profits for the period ending 28 February 2013 and 8% for each period thereafter.
16. Next in line were the B Ordinary Shares, but their dividend entitlement was only to "such amount as the Directors may determine by majority vote up to" a maximum of 7%. One of the main arguments advanced by the Respondents was that, looking at the B Ordinary Shares as isolated assets, that might be acquired by people who owned no other shares and were not Directors of the company, these rights, accompanied by absolutely no voting rights, actually conferred no right at all, or at least only a right to a minute dividend. There were other pre-conditions even to the payment of this dividend.
17. The 800 Ordinary Shares were then entitled to a catch-up dividend to match the fixed and the participating dividends paid on each A Ordinary Share.
18. Finally, further profit were to be distributed if the holders of 75% of the A Ordinary Shares so consented, on the basis that 25% of the profits distributed would be paid to the holders of the A Ordinary Shares, and 75% to the holders of the 800 Ordinary Shares.

The fate of the Company

19. Articsoft did not unfortunately succeed in the manner hoped, and SEGF did not subscribe the further tranche of capital at the envisaged second stage, and in 2005 the company was placed in liquidation. No distributions were made to any of the shareholders in that liquidation.

The claim for loss relief by the Appellant

20. Having received no distribution in the liquidation in respect of either her 400 Ordinary Shares or her 50,000 B Ordinary Shares, the Appellant claimed a capital loss of £50,400 under section 24(2) TCG Act 1992, and claimed to be able to set that loss, effectively as an income loss, against her taxable income pursuant to the provisions of section 574 Taxes Act 1988.
21. HMRC conceded a loss of £400 in respect of the Ordinary Shares, but contended that there was no loss in respect of the B Ordinary Shares. This was on the ground that the B Ordinary Shares had no value at the point of their acquisition, and that as section 251(3) TCGA 1992 provided that where "property is acquired by a creditor in satisfaction of his debt or part of it …. the property shall not be treated as disposed of by the debtor or acquired by the creditor for a consideration greater than its market value at the time of the creditor's acquisition of it….", the base cost of the B Ordinary Shares (and thus any loss) was nil.

The contentions on behalf of the Appellant

22. Whilst the Appellant did not dispute the premise of the case advanced by the Respondents (namely that everything hinged upon the stand-alone value of the B Ordinary Shares) most of the Appellant's arguments were based on general valuation principles, and quotations from textbooks on valuation. In fairness, it was certainly suggested that a fundamental point in the valuation was that, on the day when the B Ordinary Shares were acquired, there was an acquisition of shares by an independent party who knew of the loss record of the company to date, and who relied in turn on an independent, and quite favourable, report as to the chance of the company succeeding. Whilst it was perhaps over-stretching matters to say that if the independent party subscribed shares that would ultimately be entitled to 25% of the residual equity profits for £250,000, this implied a total valuation for the company of £1 million, this third-party transaction was nevertheless the best indicator of the value of the company on the precise date for which the valuation was required. And this subscription confirmed at the very least that the software concepts owned by and to be exploited by Articsoft were of some significant value, and had considerable promise.
23. In terms of specific arguments in relation to the value of the B Ordinary Shares, it was contended that, in addition to being entitled to a return of capital in liquidation, it would be improper for the directors to pay only nominal dividends on the B Ordinary Shares (however the share rights were drafted), particularly if the directors were then minded to proceed to pay dividends on shares ranking for dividend after the B Ordinary Shares.
24. We also noticed in the course of the hearing, that there was a curious provision in the Articles that provided that if the holder of the A Ordinary Shares received an offer for the A Ordinary Shares, it had the option of requiring an offer to be made on the same terms for the other shares in the company. I will refer below to how this provision might be interpreted, but I now consider that it is of little significance in relation to the outcome of this appeal.

The contentions on behalf of the Respondents

25. It was contended on behalf of the Respondents that:

•    no loss could arise for capital gains purposes merely because the B Ordinary Shares ended up with no value, because they had to "become of negligible value" under section 24(2) TCG Act 1992, which indicated that they needed to have had value at an earlier point;

•    the base cost of the B Ordinary Shares was what was in issue and this had to be determined (under section 251(3)) by reference to their value at acquisition, and not by reference to the consideration given for them, namely the relinquishment of the creditor's rights on the satisfaction of the previous debt;

•    the value of the company as a whole was negligible when the B Ordinary Shares were acquired, having regard to the losses incurred, and the negative book value of its assets;

•    the transaction by SEGF was of little relevance in considering the value of the B Ordinary Shares, since the shares acquired by SEGF had preferential rights, rendering their value much higher, and certainly no pointer to the value of the B Ordinary Shares; and finally

•    since the B Ordinary Shares had a right only to a return of their £1 capital in liquidation, no votes, and only an illusory right to dividend, those shares were in fact worthless on acquisition, so that the Appellant realised only a loss of £400 for capital gains purposes on making her negligible value claim.

My decision

26. This has been a somewhat extraordinary case, because I should start by saying that I found the Skeleton Argument prepared by Mr. Cook on behalf of the Respondents to be first-class and clear, and I began the hearing considering that the Respondents' case was regrettably bound to prevail. I say "regrettably" because it was impossible to have no respect and concern for an Appellant who had tried to succeed in a competitive market; who had lost a substantial sum; who would have incurred losses for income tax purposes had she traded in partnership or had she subscribed all her cash for Ordinary Shares in the first place. In addition to that she had the further misfortune that the negligible value attaching to the subscribed B Ordinary Shares resulted from the fact that she also held 400 Ordinary Shares so that the relative split in value between the 400 Ordinary Shares and the B Ordinary Shares was in reality irrelevant, and no-one thus cared that the curious rights were attached to the B Ordinary Shares.
27. Having said quite fairly that the Skeleton Argument prepared by the Respondents was first class, I nevertheless decide that each of the points contended by the Respondents, and listed in paragraph 25 above, was wrong.
28. The first very minor error was that there was no need to stress the feature of an asset becoming of negligible value to establish that losses were only available under section 24 when a negligible value was contrasted with a higher base cost. After all, section 24 only deems there to be a disposal, whereupon it is self-evident that a loss will only arise if the base cost of the asset was higher than the disposal consideration.
29. It was remiss of me not to note during the hearing that the second crucial point advanced by the Respondents was also wrong. I at least got as far as observing that, had the rights issue approach of paying regard to the combined increase in value of the Appellant's 400 Ordinary Shares and her B Ordinary Shares been in point, the Appellant's case would have been transformed, in that nothing would then have hinged on the stand-alone value of the B Ordinary Shares. It was slow of me not to note the obvious further point that the decision in Dunstan v. Young Austen Young Ltd was clear authority for the proposition that all the factors for dealing with this case on "rights issue" and "combined new holding" lines were plainly present. It was even worse to have missed this point, having dwelt on the feature (as I did) that it was only because the Appellant and Mr. Matthews each held 400 Ordinary Shares, when they both capitalised £50,000 of loan account and subscribed 50,000 B Ordinary Shares, that they were indifferent to the rights attaching to the B Ordinary Shares.
30. As I said in paragraph 6 above, once I had noted, when thinking about this case, that the "rights issue/new holding" analysis plainly applied, I was amused to see that in the copious correspondence, the Inspector at one point sent the Appellant a copy of an extract from the HMRC Capital Gains Manual, namely CG 53516A, headed "Debts: satisfied by issuing shares or securities: share reorganisations", which reads as follows:

"TCG Act 1992 s.251(3) operates where a creditor acquires property in satisfaction of his debt. If

a loan is converted into shares, and

the shares are issued as part of a reorganisation of the company's share capital (TCG Act 1992 s.126 - see CG 51700 onwards)

TCG Act s. 127 provides that the transaction is treated as involving no acquisition of the shares issued, so s.251(3) cannot apply. If the transaction was not a bargain made at arm's length the allowable cost of the new shares [at which point the Manual incidentally means "the new holding" meaning the combined holding or original shares and the shares subscribed] may be restricted by TCG Act s. 128(2). [The rule at s. 128(2) is the rule that I have already paraphrased at the middle of paragraph 4 above].

However, in many cases the conversion of a loan into shares is not a share reorganisation. For example, the shares may not be

issued to people because they were shareholders in the company, or

issued to the shareholders in the company in the same proportions as their previous holdings of shares in the company.

The special rules on the satisfaction of debts in s. 251(3) will then apply. These may restrict the allowable cost of the new shares to their market value when they were issued whether the transaction was a bargain made at arm's length or not."

31. The above extract does not itself indicate precisely when a capitalisation of debt into shares, by people who already hold shares, should be treated as a reorganisation. Of course the second paragraph indicates the points that were manifestly present in this case, absence of which is likely to undermine a "reorganisation" analysis, but I should still make a further comment on the circumstances where a capitalisation of debt for shares by existing shareholders will rank as a reorganisation. Again the Capital Gains Manual is helpful, CG 51748 reading as follows:

"Share reorganisations: bonus and rights issues: Dustan v. Young

"The examples in TCG Act s. 126(2)(a) do not form an exhaustive definition of the term share reorganisation as it applies to an increase in share capital. This was considered in the leading tax case on the subject, Dunstan v. Young, Austen & Young Ltd. In that case the Court of Appeal held that an increase in share capital can be a reorganisation even if it does not come within the precise wording of Section 126(2) "provided that the new shares are acquired by existing shareholders because they are existing shareholders and in proportion to their existing beneficial holdings". This means that there are a range of cases which do not take the form of a conventional bonus or rights issue which should still be treated as a share reorganisation."

32. The paragraph that I have just quoted from the Capital Gains Manual is itself slightly misleading, because it almost implies that s.126(2) contains a definition of "reorganisation" that specifically refers to bonus issues and rights issues, and that Dunstan v. Young provides that an increase in share capital can be a reorganisation even if it does not come within the precise wording of Section 126(2). In actual fact however, s. 126(2) does not refer specifically by name to either bonus or rights issues but refers to "any case where persons are, whether for payment or not, allotted shares in or debentures of the company in respect of and in proportion to (or as nearly as may be in proportion to) their holdings of shares in the company or of any class of shares in the company". Those words do obviously apply to bonus issues and rights issues but the decision in Dunstan v. Young is simply that they also apply to other transactions.
33. My decision is that s. 126 TCG Act 1992 applies to the issue of B Ordinary Shares in the present case. The capitalisation involved each of the two Ordinary shareholders capitalising identical amounts of debt for an identical number of B Ordinary Shares, both initially holding 400 original Ordinary Shares. Thus the new issue was plainly in proportion to the holdings of Ordinary Shares. It was also "in respect of" them, in that it was the very feature that each shareholder held the Ordinary Shares that rendered it irrelevant whether the value on the capitalisation flowed into the subscribed B Ordinary Shares alone, or into the combined holding of B Ordinary Shares and the original Ordinary Shares. Had one creditor held Ordinary Shares, whilst the other did not, it is inconceivable that the one with no Ordinary Shares would have participated in the capitalisation on the basis that he would get worthless shares, and filter value into the Ordinary Shares held by the other, whilst that other would get a double jump in the value of her Ordinary Shares. The pre-existing ownership of Ordinary Shares was thus a vital factor influencing the terms of the capitalisation, so that I conclude that the new issue of shares was "in respect of" the existing holdings of Ordinary Shares, and that the transaction was a reorganisation.

Valuation issues

34. The above conclusion in relation to the rights issue analysis does not of course conclude the case, and I now turn to various valuation points.
35. Whilst the key valuation points are going to relate to the consideration given by the Appellant in the capitalisation, and the increase in the value of the combined holding of Ordinary Shares and B Ordinary Shares over the pre-capitalisation value of the Ordinary Shares, I will start by considering the value of the company as a whole, and the Respondents' next contention that the past losses, and negligible or negative net assets position, rendered the company itself valueless immediately prior to the 16 May transactions.
36. By far the best indicator of the value of Articsoft as a whole on 16 May 2003 was the transaction undertaken by SEGF. SEGF was fully aware of the losses that had so far been incurred, and was of course aware that the company had liabilities and few tangible assets. SEGF had however had an independent, and relatively favourable, analysis done in relation to the company's prospects and it was in the hope that the various software products being promoted by the company would be successful that SEGF invested.
37. I accept that SEGF acquired shares with preferential rights, but I also consider that the value of those preferential rights has been over-played by the Respondents. Were the company simply to deposit the cash contributed, and thereby make sufficient profit to pay at least the Preference Dividend, or some of it, the existence of the cash that SEGF contributed and the preferential rights attaching to their shares would have preserved at least some of the value of their shares. SEGF knew perfectly well however that the cash, and indeed more cash (since a further subscription was contemplated) would all be spent on marketing or marketing and software development, so that the cash would disappear. Thus any return to SEGF, and indeed the repayment of any of their capital was entirely dependent on the company succeeding. Had it succeeded, they would have enjoyed a somewhat preferential return, but essentially they would have ultimately derived most of their return from the 25% equity participation. And in the meantime, their preferential rights would be unlikely to safeguard their investment, were the products not to "take off".
38. The reality has to be therefore that SEGF would have realised that they would lose their investment (as indeed they did), regardless of the preferential rights, and thus it was only because of the reasonable prospect of success that they invested. And that prospect of success was based on a judgment as to the worth of the software concepts, and not on any record of past losses or the lack of tangible assets.
39. It follows from this conclusion that, whilst SEGF were naturally keen to eliminate the prior charge consisting of £100,000 of the directors' loan accounts, the value that SEGF put on the business as a whole strongly suggests that the company's prospects were good enough to suggest that the existing Ordinary Shares also had quite a significant value, even whilst the directors' loan accounts subsisted. If SEGF were prepared, as a quite independent new investor, to subscribe shares that would ultimately enjoy various preferential rights, and 25% of the residual equity profits for £250,000, it must follow that the shares that were entitled to 75% of those residual equity profits had some considerable value. I certainly do not suggest that they were worth three times the amount contributed by SEGF. For the purposes of this appeal however, it seems to me that the Ordinary Shares owned by the Appellant and Mr. Matthews needed merely to have a value of some positive amount, whilst the debts to the directors subsisted, such that their value could and would be increased by the capitalisation. Having regard to my conclusion that the preferential rights did not and could not transform the valuation reality of the shares subscribed by SEGF, and that those shares were ultimately only entitled to one third of the proportion of residual equity profits attributable to the original Ordinary Shares, I conclude that those shares had a very significant value on 16 May 2003. This case is in other words not remotely akin to the line of cases commencing with IRC v. Burmah Oil Co Ltd [1982] STC 30, where worthless debt was swapped for shares in the tax hope of turning an admitted and non-allowable loss on the debt into an allowable tax loss on shares. The capitalisation here was done without any thought to taxation consequences; at the insistence of SEGF which was injecting £250,000 to fund marketing and did not want half of the amount applied in repaying directors' loans, and indeed the capitalisation was effected at a time of great excitement and optimism about the company's future. And I repeat that the terms of the third party subscription must render it inconceivable that the Ordinary Shares and the directors' loans were valueless on 16 May 2003.

The taxation tests for ascertaining the addition to base cost of the "new holding" held by the two ordinary shareholders, as a result of the capitalisation effected by those shareholders

40. It seems to me that I must now address the following questions in order to ascertain the addition to base cost derived by the Appellant from the capitalisation that she effected on 16 May 2003. It is arguable that I need not in fact address all of the following points, but out of caution I will do so.
41. I will thus address:

•    what actual consideration the Appellant gave, on taking up the B Ordinary Shares, and I will address that from both the perspective of the Appellant giving the consideration and the company receiving it;

•    I will then consider whether the amount of consideration thus ascertained is exceeded by the total value, after the capitalisation and the investment by SEGF on the same day, of the Appellant's holding of Ordinary Shares and B Ordinary Shares; and finally

•    I will consider whether the capitalisation increased the value of the Appellant's new holding of Ordinary Shares and B Ordinary Shares, over the pre-existing value of her Ordinary Shares, by the amount of the consideration given by the Appellant, or whether the value was only increased by a lower amount.

42. By relinquishing a debt of £50,000 it seems to me that the Appellant gave consideration of £50,000 in the relevant transaction. Certainly from the perspective of the company, the obtaining of the release represented value of £50,000. It might arguably not do so if the company had no chance whatsoever of discharging the debt, but in this case the terms of the contemporaneous subscription by SEGF indicate that the company had some valuable assets as well as the near certainty of the value of those assets leading to an injection of cash by an independent party that, the release apart, would have given it the cash to discharge the debt.
43. From the perspective of the Appellant as well, the capitalisation involved giving consideration of £50,000. Whilst it is true that the company did not have available cash or cash flow with which to repay the debt, it still had the valuable assets and expectations, which enabled it to raise cash. Whilst the new investor was not content to invest £250,000, if £115,000 of its cash was immediately to be applied in repaying the directors' debts, the implicit value that SEGF placed on the software exceeded the amount of the debts, and of course the directors themselves, in searching for new money to fund development and marketing effort, were not seeking to obtain repayment or immediate repayment of their loan accounts anyway.
44. I thus conclude that the consideration given by the Appellant in the capitalisation was £50,000.
45. It is unnecessary for me to put a total value on the Appellant's holding of Ordinary Shares and B Ordinary Shares after the capitalisation. Were that value lower than £50,000 it would necessarily follow that the increase in the value of the total holding would have fallen short of the consideration given by the Appellant and the restriction to the increase in base cost provided for by section 128(2) TCG Act 1992 would inevitably have applied. Without putting a value on the holding and in particularly on the key element of the holding, namely the Ordinary Shares, I repeat the points made in paragraph 39 above, to the effect that the terms of the SEGF transaction indicate that on 16 May 2003, the implicit value of the Appellant's Ordinary Shares, both before and after all of the transactions on that day was in excess, if not well in excess, of £50,000.
46. The final question, therefore, is whether the Appellant's capitalisation increased the value of her combined new holding by £50,000 over the value of her Ordinary Shares before the capitalisation. I consider that it did. I must treat the consideration given for, and the value of the shares subscribed by SEGF as a given. The subscription was made on the basis of the capitalisation and all the terms reflected that capitalisation. Accordingly it is the residual value of the company and the value of the remaining shares that is affected and increased by the capitalisation. Since the capitalisation removed a prior charge of £50,000 (or £100,000 in total) of debts that could have been discharged, the capitalisation did increase the value of the Appellant's new holding of Ordinary ad B Ordinary Shares by that amount over the pre-existing value of the original Ordinary Shares.
47. I accordingly decide that the increase to base cost of the Appellant's total holding on 16 May 2003 was £50,000 and that her loss, in the negligible value claim, was £50,400.

The stand-alone value of the B Ordinary Shares

48. I said that I would indicate what I thought the value of the B Ordinary Shares in isolation was, in case the Respondents should successfully appeal against my decision and the "rights issue" approach to calculating the loss, so that the stand-alone value at acquisition of the B Ordinary Shares becomes relevant.
49. The B Ordinary Shares were entitled to £1 back in liquidation; to the strange and possibly illusory right to dividend already mentioned, and had no votes. Any third-party investor who was not a director and who held no Ordinary Shares in the company would thus be facing a double risk in that first, and most obviously, the company might fail, and secondly, it would hold the broad equivalent of an undated, or perpetual, interest-free loan or deep-discount note. I remarked in the introductory paragraphs that there was a strange provision in the Articles that indicated that if SEGF received a third-party offer for its shares, it could call for the offer to be extended on the same terms to the holders of "the other shares" in the company. I can, however, make no sense whatever of this provision, since whether the "other shares" contemplated just the 800 Ordinary Shares, or the combined holding of Ordinary Shares and B Ordinary Shares, it would make not the slightest sense for any offer to be made for either block of shares, on the same terms. Perhaps the provision meant something along the lines of "on equivalent terms, and at a broadly equivalent p/e ratio, having regard to the then dividend performance of the other shares". Whatever this provision meant, it was only optional for SEGF to require the offer to be so extended, and so I will pay no further regard to it.
50. On the reasoning that I must therefore value the B Ordinary Shares by reference to their liquidation entitlement and to their nebulous dividend right, and having regard to the double risk associated with any third-party purchase of these shares, I cannot put a higher value than 5% on the relevant shares. I was not addressed on whether there would be any company law pressure on the directors to pay reasonable dividends, up to the 7% ceiling on the shares, were the directors paying large dividends on other shares. I would, however, be surprised if the holder of the shares, who would have invested in the knowledge that the directors could choose to pay any lower amount of dividend below 7%, could complain and seek any remedy if the directors chose to do precisely what it was indicated that they could do.
51. On a stand-alone basis, I thus consider that the B Ordinary Shares were worth only £2,500 when subscribed on 16 May 2003.

HOWARD M NOWLAN

SPECIAL COMMISSIONER

RELEASED: 29 September 2008

SC 3083/2008