Business Law and Practice – Workshop 1

Partnerships
Traditional Partnerships

Introduction
• Traditional partnerships are governed by the Partnership Act 1890 (PA 1890).
• Definition – a relationship between persons carrying on a business in common to make
a profit.
• A partnership is NOT a legal entity separate from the partners themselves
• There must be at least two persons to form a partnership

Formation of partnerships
• No need for intention for parties to form a partnership
• Arises if meets criteria in s1(1) PA 1890
• Section 2 PA 1890 contains rules determining the existence of a partnership
o Evidence of profit sharing
o All individuals take part in decision making
• Whether a partnership actually exists will be determined by the facts.

Use of Partnerships
• Sometimes clients ask for help in avoiding creating a partnership.
• Legislation is old and does not suit the modern business environment
• Clients will have concerns about being subject to unlimited liability.
• There are advantages to partnerships:
o Costs nothing to create one
o No formality is required
o No filing for disclosure requirements, in contrast to heavily regulated
companies
o A high degree of confidentiality regarding the business’s affairs

Relationship of partners to one another: fiduciary relationship

• There is an overriding duty of good faith in a partnership
• Similar to that owed by a trustee to a beneficiary
• Equitable principles:
o Honest and full disclosure – s28 PA 1890
o Unauthorized personal profit – s29(1) PA 1890
o Conflict of duty and interest – s30 PA 1890

Personal liability for partnership debts

 • No separate legal personality
• Partners are personally liable in relation to contracts which are binding on the firm
• In some circumstances, non-partners can also become personally liable
• Nature of partners liability (ss 9, 10 and 12 PA 18900
• Contractual liability
o Every partner in a firm is liable jointly with the other partners for all the debts
and obligations of the firm incurred whilst they are a partner (s 9 PA 1890)
• Tortious liability
o In tort, the partners’ liability is joint and several (ss 10 and 12 PA 1890)

The partnership agreement

Introduction
PA 1890 provides the framework for regulating traditional partnerships, but the statutory
provisions are really ‘fall-back’ provisions in the absence of a partnership agreement, or where
the agreement is silent on any matter. Other than ss 1 and 2 which regulate when a partnership
comes into existence and ss 5 – 18 which determine the relationship between partners and
third parties as well as liability for partnership debts, which you considered in the previous
element, most of the sections of PA 1890 may be overridden by agreement.

The partners’ mutual rights and obligations (under an agreement or under PA 1890) can be
varied at any time by their unanimous consent (s 19 PA 1890), and this can be express or
inferred from a course of dealing.

The PA 1890 contains a default code which applies to relations between the partners
themselves in the absence of any contrary agreement; whether written or oral, express or
implied. Most traditional partnerships will have a formal written partnership agreement, which
will set out the terms on which the partners have agreed to run the business. In this element
we consider the clauses that should be considered for inclusion in such a partnership
agreement, with reference to the fallback provisions of PA 1890 in each case.

The Partnership Agreement or Deed

Most partnerships will have some form of express written partnership agreement governing the
way in which the partnership will be run. As a minimum, this will normally include provisions
concerning the matters set out below:
• Commencement and duration
• Partnership name and place of business
• Partnership property
• Capital, profits and losses
• Drawings / Salary
• Accounts
• Dissolution of the partnership
 • Duties, powers and restrictions on partners:
• Work input and roles; any limits on the authority of partners
• Partnership decision making
• Incoming partners
• Retirement/expulsion of existing partners
• Non compete / other restrictions

Common provisions in partnership agreements

Commencement and duration

Although a partnership will commence when s 1(1) PA 1890 is satisfied, it is useful for the
agreement to set out a date on which the partners agree that the particular rights and
obligations contained in the agreement will commence. If the partners begin working together
prior to the commencement date then the default provisions of PA 1890 will apply until the
commencement date of the agreement.

The agreement may have a fixed term or may continue until terminated in accordance with its
provisions.

If the agreement has a fixed term but the partners continue in business after the expiration of
that term without entering into a new agreement, they are presumed to be partners on the
same terms as before (s 27 PA 1890).

Partnership name and place of business

The partnership name must not contain include ‘limited’, ‘ltd’, ‘LLP’, ‘public limited company’ pr
‘plc’, be offensive, be the same as an existing trademark, contain a sensitive word or expression
or suggest a connection with government without permission. The place of business should also
be set out as well as the nature of the business.

Partnership property
As a partnership does not have a separate legal personality, each partner is deemed to own a
share in the property belonging to the partnership. An individual partner does not have a right
to any particular partnership asset.

The default provisions of PA 1890 are set out below.

Whether or not a particular asset is partnership property is a question of fact, depending on the
intentions of the partners at the time they acquire it. This subjective element can be difficult to
prove, so it is sensible for partners to agree which assets are partnership property to minimise
the potential for dispute later.
Partnership property (ss 20 – 21 PA 1890)
Section 20 PA 1890 provides that all property brought into the partnership whether by
purchase or otherwise, on account of the firm or for the purposes and in the course of the
partnership business, is partnership property.

Section 21 PA 1890 provides that all property bought with money belonging to the
firm/partnership is deemed to have been bought on account of the firm/partnership, unless the
contrary intention is shown.

Shares in income and capital and profits and losses

The default provisions of PA 1890 provide that all partners are entitled to share equally in the
capital and profits of the business, and to contribute equally towards the losses of the business.

This is the case even where the parties have contributed to the capital unequally.
Often, the default provisions will not accord with the partners’ wishes therefore it is extremely
important that there is an express provision in the agreement setting out a profit sharing
ratio (‘PSR’).

Capital and profits (s 24(1) PA 1890)

Partners are entitled to share equally in the capital and profits of the business, and to
contribute equally towards the losses of the business.

Drawings / Salary
Partners own the business and may take ‘drawings’ of income profits. The partnership
agreement should set out how much each partner may draw in any given period. In the
absence of agreement, s 24(1) provides that all partners are entitled to share equally in income
profits.

In some partnerships, the partners may intend that each receives a salary in addition to
income profit share. This must be expressly set out in the agreement as the default position is
that there is no entitlement to salary.

Remuneration (s 24(6) PA 1890)

Without an agreement a partner is not entitled to a salary.

Work input and roles; limits on authority

Under PA 1890, every partner may take part in the management of the partnership business (s
24(5)) but are not required to do so. The partnership agreement should therefore set out the
requirements for each partner in terms of the work they do for the business. Commonly, the
agreement will state that all partners must devote the whole of their time and attention to the
business.

The roles of partners and any limits on their authority should also be clearly defined.
Management (s 24 PA 1890)
Every partner may take part in the management of the partnership business.

Decision making
The agreement should deal expressly with decision making and management.
All partnership decisions must be decided by a majority, other than the following which
require unanimity:
• Changes to the nature of the partnership business (s 24(8));
• Introducing a new partner (s 24(7));
• Varying the rights and duties of partners (s 19).

Decision making (s 24 PA 1890)

Decisions arising during the ordinary course of the business are decided by a majority, except
for any change to the nature of the partnership business.

Incoming partners
Under s 24(7) PA 1890, the unanimous consent of all partners is required for a new partner to
join the partnership.

Whilst this may be what the partners themselves want, it is still advisable to include an express
clause requiring written consent of all partners for a new partner to join the partnership, to
avoid any doubt as to whether consent was in fact given.

New partners (s 24 PA 1890)

No person may be introduced as a partner without the consent of all existing partners.

Expulsion
Under PA 1890, a partner cannot be expelled by majority vote unless all of the partners have
previously expressly agreed that a majority can do this. This effectively means that in the
absence of prior agreement, it is impossible to expel a partner, unless they agree to their own
expulsion (highly unlikely).

The partners should therefore agree expulsion provisions in advance, otherwise it will be
impossible to remove a partner without dissolving the partnership.

Expulsion (s 25 PA 1890)
A partner cannot be expelled by majority vote unless all of the partners have previously
expressly agreed that a majority can do this.

Partner leaving
If there is no partnership agreement or if the agreement is silent on retirement or termination,
the effect of a partner leaving is that the partnership is dissolved (s 26 PA 1890).
This is because ‘partnership’ is a collective noun meaning ‘all the partners’, so the continuity of
a partnership is broken when there is a change in the identity of the individuals who constitute
it.

In most cases this is a ‘technical dissolution’. This means that a new partnership is formed by
the remaining partners who continue the business.

However, it is open to any of the partners to apply to court to have the old partnership wound
up (ie sale of the assets for the repayment of the partnership debts and for the distribution of
the assets or liabilities amongst the partners).

To prevent dissolution when a partner retires, the partnership agreement should state
explicitly that the partnership will continue as between the remaining partners and should
contain details of how a partner can leave (which may include a provision in the event of
death) or be expelled without the partnership being wound up. This would usually include a
mechanism for the remaining partners to buy out a departing partner's share and for
calculation of the value of such share.

Automatic dissolution (s 26 PA 1890)

Where no fixed term has been agreed for the duration of the partnership, the partnership will
be dissolved by any partner leaving.

Non-compete clauses
It is common for a partnership agreement to contain an express clause preventing current
partners from competing with the firm. This is implied by default under s 30 which states that if
a partner, without the consent of the other partners, carries on any business of the same
nature as and competing with that of the firm, they must account to the firm for all profits
made by them in that business.

Duty not to compete with the firm (s 30 PA 1890)

Restrictions on outgoing partners

The partners may wish to also put limitations on the powers of outgoing partners to compete
with the partnership after leaving. There are no such default clauses in PA 1890.
Restrictions on outgoing partners can be provided for in the partnership agreement by using
any of the following:
• Non-compete clauses: prevent former partners competing with the business;
• Non-solicit clauses: prevent former partners from soliciting business from the
partnership’s clients;
• Non-dealing clauses: prevent former partners from entering into contracts with clients,
former clients or employees of the partnership.
These types of clauses are known as restraint of trade clauses and will only be enforceable if
they are reasonable in terms of duration, geographical area and scope and are necessary for
the protection of a legitimate business interest of the partnership.

Dissolution of partnership
A partnership can be dissolved (terminated) in a number of ways under PA 1890:
• automatic dissolution (subject to contrary agreement) under:
• expiry of fixed term (s 32(a))
• completion of specific venture (s 32(b))
• death or bankruptcy of any partner (s 33)
• dissolution of partnership by notice from any partner (ss 26 and 32(c)). This applies
where the partnership has no fixed duration;
• dissolution of partnership if the partnership business becomes unlawful (s 34);
• dissolution by the court as a last resort (s 35).

If an event occurs which causes a partnership to be dissolved, the partnership relationship

ceases, and any partner may demand that the assets of the business are realised. Since
automatic dissolution is undesirable, it is important to ensure that the partnership agreement
deals with when a partnership may be dissolved and the effect of this, as detailed above in the
discussion on partners leaving.

Collecting in and distributing assets on the dissolution of a partnership

Subject to any written partnership agreement, where a partnership is wound up, once all
debts and liabilities have been paid, any money/assets left will be distributed so that each
partner is paid back their original capital first (s 44(b)(3) PA 1890).

It is common for a partnership agreement to have a provision dealing with the proportion in
which any surplus assets are to be shared out following dissolution. This is called the asset
surplus ratio or ‘ASR’.

If there is no agreed ASR then s 44(b)(4) PA 1890 applies, and surplus assets are shared in
accordance with the agreed profit share ratio (PSR).

If there is no PSR then the surplus assets are shared equally in accordance with s 24(1) PA 1890.

Summary
• Partners are strongly advised to set out their rights and obligations in an express written
partnership agreement.
• If the partners do not sign a partnership agreement, or if the partnership agreement is
silent, the PA 1890 contains default provisions on a number of matters. These include:
• Commencement and duration
• Partnership property
 • Shares in income and capital and profits and losses
• Drawings and salary
• Decision making
• Incoming partners
• Expulsion, retirement and the effect of a partner leaving.
• A partnership may be dissolved automatically in certain circumstances or by notice. The
agreement should contain provisions dealing with dissolution and the collection and
distribution of assets.

Limited Liability partnerships

Introduction
An LLP is a hybrid vehicle. This means it has elements of both a company (legally it is a body
corporate and is treated as a separate legal entity from its members: s 1(2) Limited Liability
Partnerships Act 2000 (‘LLPA’)) and a partnership (it is treated as tax transparent).

Consequently, an LLP has the flexibility of a partnership with the added advantage of limited
liability for its members. Because an LLP is a body corporate, it has a legal personality which is
separate to that of its members. As a result, it is liable for its own debts, and is able to contract
with third parties.

The LLPA was enacted for several reasons, chief of which was the perception amongst
professional partnerships that as a result of the growth in litigation, the current partnership
model, whilst having many commercially useful features, did not provide the kind of protection
that was available to limited liability corporations (this is because partners in traditional
partnerships have unlimited liability for the debts of the partnership).

LLPs are increasingly important, and many law firms are now run as LLPs.

Commercial Uses for LLPs

Apart from being commonly used for professional partnerships, such as solicitors, surveyors or
accountants, the LLP is also a flexible business vehicle for joint ventures, certain investment
schemes and some venture capital investments.

LLPs are particularly useful for investment structures (despite certain tax avoidance measures
being applicable to LLPs which may impinge on private investors who are members of an LLP).

This is because, as stated, LLPs are tax transparent, so they allow a high level of participation
in management by the members whilst giving the members the benefit of limited liability.
LLPs are also increasingly being used by property developers involved in one-off joint venture
development projects.
Applicable legislation
LLPs are incorporated pursuant to the LLPA. The LLPA is supplemented by two statutory
instruments:
• the Limited Liability Partnerships Regulations 2001 (SI 2001/1090) (as amended) (the
‘2001 Regulations’) which deal with insolvency and the internal governance of LLPs and
• the Limited Liability Partnerships (Application of Companies Act 2006) Regulations 2009
(SI 2009/1804) (as amended) (the ‘2009 Regulations’).which govern the corporate law
aspects of LLPs. In particular, the 2009 Regulations apply provisions of CA 2006 to LLPs
(with appropriate amendments). You will note, therefore, that LLPs are primarily
governed by a company (rather than partnership) law framework.

The Insolvency Act 1986 (’IA’) and the Company Directors Disqualification Act 1986 have, since
LLPs were introduced, applied to LLPs in modified form. This has important consequences, so
that, for instance, s 213 IA (fraudulent trading), s 214 IA (wrongful trading), as well as the
disqualification of director provisions and the greater part of the insolvency and winding up
procedures apply equally to LLPs and their members as for companies.

Formation of an LLP
Section 2(1)(a) LLPA states that two or more persons associated for carrying on a lawful
business with a view to profit can incorporate an LLP. A ‘person’ in this context can be a
company as well as an individual. The use of the word ‘business’ requires that there must be
some commercial activity, so LLPs are not normally used by non-profit organisations as business
vehicles.

Registration at Companies House

The subscribing members fill out a Form LL IN01, which is sent to Companies House with the
relevant fee. The form must state, inter alia, the name of the LLP, its registered office’s
address and which members, if not all of them, are to be designated members (s 2(2) LLPA).

Certificate of Incorporation
Once registered, the Registrar of Companies issues a certificate of incorporation as conclusive
evidence that all legal requirements have been complied with. The name of the LLP will be
entered on the index of company names and given a number.

Continuing Registration Regime

Once registered, LLPs are obliged to continue to file information with Companies House as
follows:
• change of name,
• change of registered office,
• changes in membership,
• creation of a charge,
• annual confirmation statement, and
 • accounts(under the Limited Liability Partnerships (Accounts and Audit) (Application of
Companies Act 2006) Regulations 2008).

In addition to its obligations to file information at Companies House, an LLP must maintain
certain in-house records, including registers of its members and of its ‘people with significant
control’ (‘PSCs’ who are, broadly speaking, those with at least a 25% interest in the LLP).

Members
The members of an LLP are those who subscribed to the incorporation document and those
who became members at a later date by agreement with the existing members. Section 4(2)
LLPA states that persons, not just individuals, can be members of an LLP – therefore corporate
bodies may be members of an LLP.

An LLP must have at least two formally appointed members at all times. There is no limit on
the maximum number of members an LLP can have.

At least two members of the LLP must be ‘designated members’. Their obligations include,
amongst other things, signing the accounts on behalf of the members, making filings at
Companies House and acting on behalf of the LLP if it is wound up.

Section 4(3) LLPA states that a member will cease to be a member of the LLP upon:
• their death;
• agreement with the other members of the LLP;
• giving notice to the other members of the LLP; or
• dissolution (if the member is a body corporate).

The LLP Agreement

An LLP has no Memorandum or Articles of Association. The LLPA and the 2001 Regulations do
not lay down any particular management structure to be adopted, in contrast to companies.
LLPs therefore have complete flexibility in terms of management. Therefore, it is necessary in
practice to have an LLP or Members’ Agreement stating how these issues are to be dealt with
by the LLP and its members, in a very similar way to how a partnership agreement is designed
to operate.

The LLP Agreement is a private document which sets out the formal procedures and
arrangements which the members have agreed to be the basis of the operation of their
business.

Note that members of an LLP are not obliged to have a formal Members’ Agreement to
regulate their relationship.

In the absence of any such agreement, the 2001 Regulations contain eleven default
provisions in regulations 7 and 8. Note that any other gaps will not be filled by partnership law
under PA 1890, since PA 1890 is disapplied with respect to LLPs by s 1(5) LLPA.
Regulations 7 and 8 of the 2001 Regulations: default provisions

The eleven default provisions in the absence of an agreement to the contrary are as follows:
• Members share equally in capital and profits(Reg 7(1));
• An LLP must indemnify its members for payments made and personal liabilities incurred
by them in the ordinary and proper conduct of the business of the LLP (Reg 7(2));
• Every member may take part in management (Reg 7(3));
• No member is entitled to remuneration for managing the LLP (Reg 7(4));
• No person can become a member or assign their membership without the consent of all
existing members (Reg 7(5));
• Ordinary decision making may be by the majority of the members. Any proposed change
to the nature of the business requires the consent of all the members (Reg 7(6));
• The books and records of the LLP must be available for inspection by the members at
the registered office (Reg 7(7));
• Each member must give true accounts and full information of all things affecting the LLP
to any member or his legal representative (Reg 7(8));
• If a member (without consent) carries on any business of the same nature as, and
competing with, the LLP then they must account for and pay over to the LLP all profits
made by them in the business (Reg 7(9));
• Every member has a duty to account for benefits derived from transactions with the LLP
and its business or property (Reg 7(10));
• There is no implied power of expulsion of a member by the majority unless the
members have expressly provided for such a power in a Members’ Agreement (Reg 8).

Taxation of LLPs
One important difference between an LLP and a company is that, for tax purposes, the LLP is
treated as a partnership.

If two individuals set up an LLP, each will be taxed as an individual, ie liable to income tax or
capital gains tax on their share of the income or gains of the LLP. In other words, an LLP is
‘transparent’ for tax purposes – the LLP is not taxed, but the partners are.

By contrast, a company, established by the same two individuals, would pay corporation tax on
its own income profit and chargeable gains. If the individual owners then receive dividends out
of the company’s profits (after corporation tax), they may be liable to pay income tax on their
dividend income. This could be significant, for example, because different rates and reliefs
might apply.

A trade, profession or business carried on by an LLP with a view to profit will be treated as
being carried on in partnership by the members (not the LLP itself). Many of the same reliefs
available to partners also may be available to LLP members, such as relief on interest, or set off
of losses against other income.
Assets held by the LLP will be treated as being held by the members as partners for capital gains
tax purposes. Accordingly, a disposal of an LLP asset, such as land, will be regarded by HMRC as
a disposal by the members of the LLP while it is trading.

The LLPA gives relief from stamp duty where a partnership is incorporated as an LLP and assets
of the partnership business are transferred to the LLP, subject to strict tax avoidance
conditions. In some circumstances, stamp duty and/or SDLT is payable on the transfer of an
interest in an LLP at the relevant rate.

As regards VAT, the LLP itself may register for VAT, not the members.

Summary of the Characteristics of LLPs

LLPs have characteristics of both companies and partnerships. The different characteristics are
summarised in more detail below.

Corporate Characteristics:
• Separate legal personality;
• Limited liability for members, subject to the restrictions mentioned;
• LLPs have to file accounts at Companies House on much the same basis as companies,
leading to a loss of financial privacy (which is one of the main attractions of using a
partnership structure);
• LLPs, like companies, are capable of creating a floating charge over the assets of the LLP,
unlike a partnership; and
• Some provisions of company law (in particular the CA 2006) and corporate insolvency
law (as contained in the Insolvency Act 1986 and the Company Directors Disqualification
Act 1986) apply to LLPs in modified form.

Partnership Characteristics:
• LLPs have no share capital or capital maintenance requirements;
• No real distinction between members and the management board (unlike a company, in
which the members/shareholders and board of directors have very distinct roles);
• Members can agree amongst themselves how to share profits, management duties, how
decisions are to be made, how new members are to be appointed and what retirement
provisions shall apply;
• The Members’ Agreement (if there is one) is like a private partnership agreement;
• LLPs are tax transparent in the same way as a partnership;
• The corporate insolvency regime also applies to LLPs but there is an important
disadvantage for members of an LLP compared to those of a company. LLPs are subject
to the ‘clawback’ rule, which means that in certain circumstances money taken out of
the LLP by members up to two years before commencement of a winding up of the LLP
can be clawed back into the pool of assets available to repay LLP’s creditors (s 214A IA).
Summary
• LLPs have the advantage of being a separate legal entity.
• LLPs must be incorporated and registered at Companies House similarly to companies.
• LLPs have members rather than partners.
• Clients considering using an LLP should consider drafting a Members’ Agreement.
• An LLP can contract with third parties on its own behalf. This means that liability for its
debts rests with the LLP (rather than its members).
• An LLP also benefits from being transparent for tax purposes.
• This means that the LLP model allows both for limited liability and tax transparency.
Unsurprisingly, it is a very popular vehicle for law firms and accountancy firms.
Module: Business Law & Practice
Formation of a Company

The company's constitution

Introduction
• The critical statute governing company law is the Company Act 2006 (CA 2006)
• CA 1985 required companies to have two constitutional documents:
o The Articles of Association
o Memorandum
• As of CA 2006, the memorandum no longer forms part of the company’s constitution –
it is only required as part of the procedure to register a company at Companies House.
• It is simply a declaration on the part of the company’s subscribers (first members of a
company) that they wish to form a company and become members of that company.
• The only constitutional document under CA 2006 is the Articles of Association only.

Memorandum
• The objects clause – 1985 act
• Companies formed under CA 2006 have unrestricted objects
• Under CA 2006, therefore, the objects clause of an older company continues in force,
operating as a limitation on that company’s capacity unless and until the Articles of that
company are amended to remove its objects clause.

Article of Association (Articles)

• All companies must have articles of association – section 18 CA 2006
• The Articles form the main constitutional document of a company
• The articles regulate the relationship between the shareholders, the directors and the
company.
• Examples of the types of provisions which are included in the Articles of a company are:
o The number of directors required to transact business (both to form a quorum at
board meetings and to take decisions at board meetings)
o The method of appointment of directors
o The powers of directors
o How board meetings are to be conducted
o Any special rights attached to shares
o How shareholder meetings are to be conducted
o How and to whom may shareholders transfer their shares

Relationship between CA 2006 and the Articles

 • The Articles must comply with the minimum provisions of CA 2006 – this is known as the
Legality Test
• A company may in certain circumstances provide a procedure in its Articles which is
more onerous than that contained in CA 2006
• However, there are some CA 2006 provisions which override anything in the company’s
Articles
• There are also powers available to companies by default under the provisions of CA
2006 unless the Articles provide otherwise
• It is important to always check the procedures set out bot in the relevant legislation and
in your client’s Articles

Form of Articles
A company effectively has three choices as to the form of its Articles:
1. Model Articles (MA) / Table A
a. If a new company does not register Articles at Companies House, the CA 2006
provides that the relevant MA will constitute the company’s Articles in default
b. For companies incorporated under the CA 1985, the default Articles were known
as Table A (which may still be encountered in practice)
2. Amended MA
a. Many companies choose to adopt the MA as their Articles but elect to exclude or
modify the effect of some of its provisions.
3. Tailor-made Articles
a. A client may wish their solicitors to draft Articles which are tailor-made for the
particular company concerned
b. This is a very time-consuming process and therefore costly. Most small
companies will prefer to adopt MA, subject to certain amendments.

Amending the Articles

• Once a company adopts Articles, they can be altered later on by a special resolution –
section 21(1) CA 2006
• Basic rule – any alteration must be made bona fide in the interests of the company as a
whole
• The entrenchment of specific provisions within a company’s Articles – section 22 CA
2006
• An entrenched provision of a company’s Articles can only be amended or repealed if
specific conditions are met or if procedures more restrictive than a special resolution
are complied with.
• Entrenched articles can nevertheless always be amended by the agreement of all of the
members or by court order – section 22(3) CA 2006.

Legal effect of the Articles

• The articles evidence a contract between the company and its members in their capacity
as members and with respect to their rights and obligations as members
 • Company → Articles (contract between) →Members

Articles as a contract between the members themselves

• If a member is likely to wish to enforce rights against other members, they should be
advised to enter into a shareholders’ agreement.
• A shareholders’ agreement is a private agreement between the shareholders, which is
enforceable as a contract between the members.

Articles as a contract between the company and its members

• Courts prevent a company from infringing its members’ rights in breach of the Articles
by granting an injunction
• Each member, acting in his capacity as a member, is similarly obliged to the company to
comply with the Articles.
• However, a member may not enforce any rights contained in the Articles against the
company that are not relevant to his capacity as a member.
• Rights contained in the Articles that would be enforceable by members under section 33
CA 2006 would be the right to vote or the right to receive a final dividend once it has
been declared
o i.e. approved by a resolution of the shareholders.

Summary
• Although previously of constitutional significance, in companies incorporated since CA
2006 came into force, the company’s memorandum is now merely a formality.
• The main constitutional document for a company is its Articles.
• The provisions in the company’s Articles bind the company and its members to the same
extent as if they were covenants on the part of the company and each member to
observe those provisions.
• Companies may have the standard Model Articles under CA 2006 or these may be
amended.
• The Articles may be amended by special resolution (s21(1)). Any amendment must be
made bona fide in the interests of the company as a whole.
• The Articles must always be interpreted alongside CA 2006.
• The Articles take effect as a contract between the company and its members in respect
of their rights and obligations as members (s33).

Formation of a company

This element covers:

• How companies are incorporated – either from scratch or using the shelf company conversion
method, and
• Liability for pre-incorporation contracts.
Introduction: Formation of a company
A client wishing to start a business through the medium of a company can either incorporate a
new company from scratch or purchase and then convert an existing shelf company to conduct
its business.

Incorporation from scratch - By submitting relevant information to Companies House / online

Shelf company conversion - Purchase of shelf company followed by formalities to enable

necessary changes

Incorporation from scratch

In order to incorporate a new company from scratch, the following must be delivered to
Companies House (s9):
• a copy of the company’s memorandum;
• Articles (if the company does not intend to use the Model Articles (MA));
• the fee (the applicant may pay a higher fee for a same-day incorporation); and
• an application for registration (Form IN01) containing:
• The company’s proposed name and registered office;
• Whether the company is to be private or public;
• Whether the company is to be limited by shares (or guarantee);
• A statement of capital and initial shareholdings (s 10) (or if it is to be limited by
guarantee, details must be given of the guarantee (s 11));
• A statement of the company’s proposed officers (s 12) and persons with significant
control (s 790); and
• A statement of compliance (s 13).

Once the Registrar of Companies has approved the application for incorporation of the
company, the company is sent a certificate of incorporation authenticated by the Registrar’s
official seal.

The certificate of incorporation sets out:

• the name of the company. This may be changed at a later date;
• the company’s registered number. The company’s registered number will never change
and must therefore be used when drafting any legal agreements to which the company
is a party to ensure that the company can be correctly identified following future
changes to its name; and
• the date of incorporation.

The company becomes a legal entity (s 16(3)) from the date on which the certificate of
incorporation is issued by Companies House. The date of incorporation is set out in the
certificate of incorporation (s 15 CA 2006).
Incorporation by converting a shelf company
It has been more common traditionally for a solicitor to purchase a shelf company on behalf of
the client and then make the necessary changes rather than to incorporate a new company
from scratch. This position however is changing as a result of online incorporation services.

A shelf company is one that has been set up in advance by a company registration agent or law
stationer. Many firms of solicitors also operate an in-house service that sets up shelf companies
for sale to clients.

It is likely that the client will have to make some, or all, of the following changes (amongst
others) to the shelf company to meet their requirements:
• Name – most shelf companies will have a name that has no connection with the client
or its business (eg ABC 123 Ltd). It will therefore need to be changed to a name selected
by the client. Under s 77(1) CA 2006 a company's name can be changed by a special
resolution of the shareholders or by any other means provided by the company’s
Articles (eg a decision of the directors, ‘board resolution’). Form NM01 is required;
• Registered office - the client’s chosen address will need to be substituted for the first
registered office in accordance with s 87(1) CA 2006.Form AD01 is required.
• Articles – it is common for a shelf company to have been incorporated with MA (though
some firms and registration agents incorporate their shelf companies with a different
form of Articles drafted in-house). You will need to consider whether the company’s
existing Articles need to be amended, in accordance with s 21(1) CA 2006, to meet the
specific requirements of your client. A company may alter its Articles by special
resolution.
• Members, directors and the company secretary – representatives of the company
registration agent or law firm will have become the first member(s) (subscriber(s)),
director(s) and company secretary (if the company has one) of the company. It is
therefore essential that:
• the share(s) held by the subscriber(s) (the first members) is/are transferred. The client
becomes the shareholder once it is entered on the register of members;
• the client’s representatives are appointed as director(s) and the company secretary (if
there is to be one). Forms AP01 (directors) and AP03 (secretary) are required, and
• the first director(s) and company secretary (if there was one) resign. Forms TM01
(directors) and TM02 (secretary) are required. The order that appointments and
resignations are made is very important; the company will always need at least one
director.

Company Name: Considerations

A preliminary consideration for a business, whether incorporated from scratch or via a shelf
company conversion, will be choosing a company name. There are various commercial and
legal considerations regarding a company name. The name:
• Must not be offensive (s 53(b) CA 2006);
• Must end in limited/ltd (for a private limited company - s 59 CA 2006);
• Must not be the ‘same as’ another on the index of company names (s 66 CA 2006);
 • Must obtain approval if it suggests a ‘connection with government or public authority’ (s
54 CA 2006) or contains other ‘sensitive words’ (s 55 CA 2006). Companies House
publishes guidance on these names from time to time, so it is advisable to refer to these
each time you advise a client.

Once a company has chosen its name and had it registered, it has an obligation to display it in
certain prescribed locations (s 82 CA 2006).

A new company name becomes effective from the date on which the new certificate of
incorporation on change of name is issued by the Registrar of Companies (s 81(1) CA 2006).

Post-incorporation steps
Once the new company has been formed, there are a number of practical issues that the
directors will need to attend to as follows:
• Chairperson – The Board needs to decide whether to elect a chair and whether the
Chairperson should have a casting vote in the event of a tied board resolution. MA 13
provides for this but they may wish to change this by special resolution.
• Accounting reference date – s 391(4) provides that the default accounting reference
date will be the last day of the month in which the company was incorporated. Often
companies will change this to align with their financial year. Form AA01 is required.
• Auditor – all companies must prepare annual accounts (s 394) and will usually therefore
need to appoint an auditor.
• Tax registrations – the company will need to register for corporation tax, VAT and PAYE
and National Insurance (if it has employees).
• Shareholder agreement – this is a private contract between the shareholders. It is not
required and not all companies have a shareholder agreement, but it may be useful. We
will consider shareholder agreements in more detail later in this module.

Pre incorporation contracts

Pre-incorporation contracts: Section 51 CA 2006

Section 51 CA 2006 seeks to protect third parties who believe they are entering into a
contract with a company which is incorporated and registered by making pre-incorporation
contracts enforceable as personal contracts against the persons purporting to act on the
company's behalf (known as 'promoters').

Section 51 Pre-incorporation contracts, deeds and obligations

(1) A contract that purports to be made by or on behalf of a company at a time when
the company has not been incorporated has effect, subject to any agreement to the
contrary, as one made with the person purporting to act for the company or as agent for
it, and he is personally liable on the contract accordingly.'
Example: If one of the directors of a company purports to enter into a contract on behalf of the
company before the company has been properly incorporated, it is the director themselves
who will be personally liable under the contract. The company, once incorporated, will have no
rights or obligations under the contract (unless the parties take steps to novate the contract).
Note that it is also not possible for a company to ratify a contract made before it came into
existence.

Summary
• A company may be formed either directly at Companies House, or by converting a shelf
company.
• When incorporating from scratch, the following must be sent to Companies House:
o the company’s memorandum;
o Articles (if the company does not intend to use the Model Articles (MA));
o the fee, and
o an application for registration (Form IN01).
• If a shelf company is converted, it will be necessary for meetings of the shelf company’s
directors and shareholders to be held in order to make the necessary changes to the
company name, registered office, Articles, directors, company secretary and
shareholders. The first shares will be transferred from the subscribers (initial shelf
company shareholders) to the company’s shareholders.
• Liability for pre-incorporation contracts rests with the promoter under s 51 CA 2006.

Company decision making

Introduction: Company Decision Making

Much of the standard day-to-day business of a company is carried out by the directors. Unless
the power to take a particular decision has been delegated by the board to a particular director
or committee of directors, a decision of the board of directors of a company must be taken in
accordance with the procedure set out in the company’s Articles.

From time to time however, it will be necessary for specific authority to be given to a director
(perhaps in connection with the execution of documentation on behalf of the company in
respect of an especially important transaction).

Alternatively, a matter may need to be referred to the company’s shareholders. For example,
where:
• a matter is outside the powers of the directors and must be effected by a resolution of
the shareholders (eg amending the company’s Articles); or
• a matter is within the powers of the directors but requires the prior approval of the
shareholders before the directors can be authorised to act (eg making a loan to a
director of the company).
Board resolutions
• Decisions of the directors are taken by passing Board Resolutions at Board
Meetings (BMs).
• Board Resolutions – each director has one vote.
• Board resolutions are passed by simple majority (51%) unless the directors have agreed
that a particular decision requires unanimity (MA 8).

Shareholder resolutions
Decisions of the shareholders are taken by passing Shareholder Resolutions.

Shareholder resolutions may be passed either:

• At a meeting of the shareholders (referred to as a General Meeting (GM)), or
• In writing (for private companies only under s 288 CA 2006).
• There are two different types of shareholder resolution:
o Ordinary Resolutions which are passed by a simple majority – so over 50% of the
votes, and
o Special Resolutions which are passed by a majority of 75% or more of the votes.

Either CA 2006 or the Articles will stipulate what type of resolution is required.

Note that a written resolution is a method of voting, not a different type of vote

Shareholder voting – show of hands and poll votes at General Meetings

Ata GM it is possible for shareholders to vote on a show of hands or on a poll. The votes are
counted out of all the eligible shareholders who are present and voting at the meeting. Note
that shareholders are entitled to appoint another person as their proxy to exercise all or any of
their rights to attend and to speak and vote at any GM (s 324).

When the shareholders vote on a show of hands, each shareholder who is present at the
meeting will be entitled to one vote, regardless of the number of shares held by that
shareholder (provided the share has voting rights under the Articles) (s 284(2)).

When the shareholders vote on a poll, every shareholder has one vote in respect of each
share held by them (s 284(3)).

The right to demand a poll vote is very important and will make a significant difference when
the shareholders are not in agreement over a resolution. Section 321CA 2006 sets out the
conditions that must be met in order for a shareholder to be entitled to demand a poll although
these conditions may be relaxed by a provision in the Articles and in fact they are relaxed in the
MA (see Art 44 MA).
Voting on a Written Resolution
Under s 281 CA 2006 only private companies may pass a shareholders’ resolution by way of a
written resolution.

Section 284(1) CA 2006 states that, where a company has a share capital, every member has
one vote in respect of each share held by them when voting on a written resolution.

There are two types of written resolution:

• written ordinary resolution - passed by a simple majority of the total voting rights of
eligible members (s 282(2) CA 2006).
• written special resolution:
o must state it is a special resolution, and
o passed by a majority of members representing not less than 75% of the total
voting rights of eligible members (ss 283(2) and (3) CA 2006).

Note that there are two decisions that may not be passed as written resolutions (s 288(2),
which are removal of a director under s 168, and removal of an auditor under s 510.

Summary

Company meetings

Board Meetings
Board resolutions can be passed, without great formality, at a BM.

Who calls a BM?: MA 9provides that any director may call a BM or require the company
secretary (if the company has one) to do so at any time. Therefore, the process is fairly informal
and, when acting for a company, it is important to consider what the usual practice is for its
directors.

Notice: In Browne v La Trinidad, the court held that reasonable notice of the BM was
necessary, and that this would be whatever notice is usual for the directors to give. For
example, if all the directors are in the same building, the meeting could be called almost
immediately, if such notice is customary for the directors.

Quorum: Directors may not validly consider business unless a minimum number of directors
entitled to vote are present at the time the meeting takes place. MA 11(2)requires a minimum
of two directors to be present for the meeting to be quorate (unless the articles provide
otherwise).

Voting: Board resolutions are passed by majority vote on a show of hands (MA 7(1)). Each
director has one vote. The chair may have a casting vote to prevent deadlock (MA13 provides
for this but it is possible for the company to amend this).

General Meetings

Who calls a GM?: The Board will usually convene (ie call) a GM.

Notice: For private companies, 14 clear days’ notice is required (s307(1) CA 2006)(subject to a
shorter notice period – see later). In this context, the word ‘notice’ refers to a period of time
(between the board’s act of convening a GM and its actually taking place).
• Section 360(1) CA 2006 states that the clear-day rule applies to s 307(1) CA 2006, and in
counting the days of the notice period, the day of the meeting and the day the notice is
given are both excluded. Note: s 1147 CA 2006 provides that if the notice is posted or e-
mailed, it is deemed to be served 48 hours after sending.
• In order to convene the GM, the board must inform the shareholders of when (and
where) it is taking place, by giving notice to the shareholders. In this context, the word
‘notice’ refers to a document inviting shareholders to attend the GM.
• The directors must approve the form of the notice of the GM and then they must
authorise its circulation to the shareholders.

Quorum: the quorum for a GM is generally two shareholders (s 318(2) CA 2006), although it is
one shareholder for single member companies (s 318(1) CA 2006).

Company meetings – the ‘GM sandwich’

You saw above that it is generally the Board who will call a GM (note that it is possible in limited
circumstances for shareholders to do this and we will explore this later in this module). Where a
shareholder vote is required for a certain transaction, it is therefore necessary for the company
to hold a series of meetings (depicted below):
• A BM is first required in order to call the GM;
• A GM is then required for the shareholders to vote on the resolution;
 • A further BM is then required to put into effect the outcome of the shareholder vote,
and
• There may be post meeting matters (PMM) to attend to such as filings at Companies
House.

We will now look at this process in more detail, starting by looking at the procedure where the
GM is held on full notice.

BM – GM – BM – PMMs

Sequence of Meetings – full notice GM

Board Meeting 1 - A BM is held to decide on the issues to be considered at the GM, to resolve
to convene the GM, to approve the form of notice for the GM and to authorise its circulation.
The notice of the GM will set out the wording of the resolutions to be put before the
shareholders. The notice of the GM is then circulated to the shareholders by the company
secretary (if the company has one) or by the directors.

General Meeting - The GM will take place and the shareholders will vote on the resolutions set
out in the notice.

Board Meeting 2 - A further BM will be held and the directors will be informed as to how the
shareholders voted at the GM and whether the resolutions were passed. The directors will then
authorise the company secretary, or a director, to deal with the post-meeting matters.

Post-Meeting Matters (PMMs) - The PMMs will then be carried out by the company secretary
(if the company has one) or a director (if not). This means that copies of the relevant
documents will be filed at Companies House, and the company’s internal records (minute books
and registers) will be brought up-to-date. We will consider the PMMs further below.

Full notice - summary

BM1 To be held on “reasonable” notice
→
GM to be held at least 14 clear days from BM1
GM
→
BM2 To be held on “reasonable” notice
→
PMMs

Shortening the notice for a GM

You have seen previously in this element that the Board is required to give the shareholders at
least 14 clear days’ notice of the GM. However, you can appreciate that for some companies
(eg those where the same persons are the directors and shareholders) this notice period might
hold up the decision-making process of a company unnecessarily.

The CA 2006 allows for GMs to be called on less than the usual amount of short notice if
sufficient members agree. Section 307(5) CA 2006 provides that, for a private company, a GM
may be called on short notice if this is agreed to by:
• a majority in number of the members who,
• together hold shares with a nominal value of not less than 90% of the total nominal
value of the shares which give the right to attend and vote at the GM.
This percentage may be increased to up to 95% by a provision in the company’s articles of
association but there is no such provision in the MA.

Therefore, where companies have few shareholders, it is often possible for meetings to be held
at short notice.

Sequence of meetings – short notice GM

If all the shareholders are available at the time the directors decide to convene a GM, the
following sequence of events may be possible. All this can be dealt with in under an hour.
• A BM is held to resolve to convene the GM, to approve the form of notice for the GM
and the form of consent to short notice, and to authorise their circulation to the
shareholders. The notice of the GM and the form of consent to short notice are then
given to the shareholders who indicate their agreement for the GM to be held on short
notice by signing the form of consent to short notice. The BM is then adjourned to
enable the GM to take place.
• The GM takes place immediately following the adjournment of the BM and the
shareholders vote on the resolutions set out in the notice.
• The BM is then reconvened. The directors are informed as to how the shareholders
voted and they authorise one of their number to take the relev ant action and deal
with the post-meeting matters.
• The PMMs will then be carried out.

Short notice - summary

1. BM (adjourned)
2. GM – If consent to use SN obtained, GM can take place immediately following
adjournment of BM
3. BM1 (reconvened)
(Possibility of holding all 3 meetings in under an hour)
→
4. PMMs

Written Resolutions – Procedure

Sections 288 - 300 CA 2006 contain the general provisions applying to written resolutions.
• A written resolution is passed when the required majority of those eligible members
signify their agreement to it. If the company does not receive a sufficient number of
 responses to pass the resolution, it will lapse. For a company with MA, the lapse date is
28 days beginning with the circulation date. A company can choose another period of
time in its Articles.
• Section 288(2) CA 2006 provides that resolutions to remove a director or auditor from
office may not be passed by way of written resolutions (essentially to allow the director
or auditor time and opportunity to mount a defence).
• Auditorsare entitled to copies of written resolutions**.**
• Written resolutions must be recorded in the minute books in the same way as minutes
of a GM.

Sequence of meetings – Written Resolution

• A BM is held to resolve to propose the use of the WR procedure and to approve the
form of wording of the WR. The WR is then circulated to the shareholders.
• There are two options to proceed:
• If the shareholders are present (as if there had been a meeting), the BM is adjourned.
The approval of the WR takes place immediately following the adjournment of the BM
and the shareholders vote on the resolutions set out in the WR by signing to signify their
approval or not signing or abstaining (both of which constitute votes against the
resolution); OR
• If the shareholders are not present (eg they are in different parts of the country/world),
the BM is closed. The WR is circulated to the shareholders. The WR is passed once it
receives the requisite level of support or it will deem to lapse after 28 days (for a MA
company).
• The BM is then reconvened OR a second BM is called. The directors are informed as to
how the shareholders voted and they authorise one of their number to take the
relevant action and deal with the post-meeting matters. The PMMs will then be carried
out.

Written Resolution – Summary – option 1

1. BM (adjourned)
2. WR - If shareholders are present, approval of WR can take place immediately following
adjournment of BM
3. BM1 (reconvened)
Possible to achieve in under one hour
→
4. PMMs

Written Resolution – Summary – option 2

1. BM1
2. WR - If shareholders are not present, WR is circulated to shareholders.
Company awaits approval from the required % of shareholders.
WR lapses after 28 days (MA Co)
3. BM2
4. PMMs
Post-Meeting Matters
Essentially the PMMs break down into three categories:
• Internal
o Minutes of all meetings need to be kept for 10 years
o Updating of statutory books eg register of members, directors, PSC register
• Filing at Companies House
o All special resolutions must be filed. Generally ordinary resolutions do not need
to be filed (but you will encounter some exceptions).
o Amended Articles must be filed, along with any forms that the Companies House
requires eg Change of Name form.
• Record Keeping
o You will come across various documents that need to be kept at the registered
office, eg directors service contracts.

Summary of main points in relation to meetings

When dealing with meeting procedures, always consider the following:
• Who transacts the business – the board or shareholders?
• Call - how, and by whom, must the meeting be called?
• Notice - how much notice is required to be given and to whom?
• Quorum - what quorum is required?
• Agenda - what is on the agenda for the meeting and is it set out in the correct order?
The notice of a GM which is given or sent to members must describe in sufficient detail
the business to be transacted in order for members to decide whether they wish to
attend or not (s 311(2) CA 2006). Further, if a special resolution is proposed, the notice
must specify that the resolution is to be passed as a special resolution and must set out
the text of the resolution (s.283(6)(a) CA 2006).
• Voting - who is entitled to vote and how?
• Post-meeting - what documentation must be dealt with for the decision(s) taken?

Summary
• Decisions are made on behalf of the company by directors and shareholders.
• Directors make decisions by passing Board Resolutions in Board Meetings.
• Shareholders make decisions by passing Shareholder Resolutions (Ordinary and Special
Resolutions) in General Meetings or by Written Resolution.
• It is important to appreciate the power held by shareholders with a larger share of the
voting rights: they can block or pass resolutions, sometimes without other shareholders.
• A company must follow a particular order for its decisions and follow the procedure to
make sure the decisions are taken lawfully.
• There are two options open to a company for speeding up decision-making: shortening
the notice for the GM or using the written resolution procedure.
• There are various post-meeting matters which will need to be dealt with after all
meetings.
Business Law and Practice – Workshop 3
Topic: Director's Duties and Responsibilities

The role of directors

Introduction
One key point to remember when considering the role of directors is that, as a company is
inanimate, it is the directors who on a day-to-day basis are responsible for managing the
company through an agency relationship. The directors are accountable to the company itself
rather than to the shareholders directly. The shareholders own the company yet have input
only into certain key decisions. It is therefore important to remember the relationship between
directors and shareholders:

Directors
• Manage the company on a day-to-day basis – on an agency basis
• Certain actions can only be taken by directors if the shareholders have given authority
• Owe duties to the company

Shareholders
• Own the company
• Are able to control key decisions through shareholder resolutions, eg to give directors
authority to change the articles or name of the company.

It is common for directors and shareholders to be the same people in a company.

Directors’ authority to manage the company

CA 2006 reserves certain important decisions for shareholder approval, such as changing the
company’s name (unless the articles provide otherwise), amending the articles of association,
removing directors and so on.

The board is usually free under a company’s articles to make decisions on behalf of the
company on all other matters (MA 3).

The directors can therefore act on behalf of the company to employ individuals and decide
what they will be paid, enter into contracts with customers and suppliers, buy and sell company
property, raise funds by borrowing from banks and authorise the company’s assets to be used
as security. The directors are also responsible for putting together company accounts and for
supplying information to auditors. These are just a few examples of the decisions that directors
are free to make without shareholder approval.
MA 5 allows the Board of Directors to delegate a particular decision to one of the directors or
a committee. For example, an HR Director might be delegated decision-making with regard to
the HR decisions of a company.

Directors’ accountability
The power delegated to the directors is therefore extremely wide and if this power were left
unchecked and unregulated, the less ethically minded might start using companies as a medium
for a variety of corrupt practices. Certain directors may, for example, decide to lend themselves
company funds on very favourable terms or even give false or misleading statements in the
accounts to make the company look more attractive to investors or banks.

In order to prevent such practices and to ensure companies are run for the benefit of,
amongst others, their shareholders and for the protection of the company’s creditors,
directors’ actions and powers are restricted and regulated by statute. The key provisions are
included in Part 10 of CA 2006, which includes directors’ general duties. We will look at
directors’ duties in detail later in this topic.

Directors can be made to account for wrongs done through civil and criminal actions taken
against them for breaching the Companies Acts. They may also be found guilty of criminal
actions and sentenced under other legislation eg fraud under the Fraud Act 2006, and/or
offences under the Theft Act 1968, insider dealing under the Criminal Justice Act 1993, money
laundering under the Proceeds of Crime Act 2002.

What is a director?
The term ‘director’ is not defined in CA 2006; instead s 250 CA 2006 states that ‘director’
includes any person occupying the position of director, by whatever name called.
There are a number of categories of directors which we consider further:

At law:
• de jure;
• de facto, and
• shadow directors

In practice:
• executive and
• non executive directors
The company’s articles may also provide for alternate directors.

De jure directors and de facto directors

A de jure director is a director who has been validly appointed at law.
Under s 154 CA 2006:
• a private limited company must have at least one director and
• a public limited company must have at least two directors.
Although a company can be appointed as a director, every company must have at least one
director who is a natural person (s 155(1) CA 2006) to ensure that for all companies, there will
always be one individual in place to aid accountability.

The CA 2006 does not prescribe a maximum number of directors and neither do the MA, but a
company can put a maximum number of directors into its own articles.
Under s 157 CA 2006 a person may not be appointed as a director unless they are at least 16
years old.

A de facto director is someone who assumes to act as a director but has in fact not been
validly appointed. The fiduciary duties and liabilities apply to de facto directors as they do to
de jure directors.

Shadow directors
Sometimes a person (usually a shareholder) may try to exert influence over the board but
without being appointed as a director, in an effort to avoid the duties imposed on directors
under CA 2006 and the common law.

Section 251(1) CA 2006 defines a shadow director as ‘a person in accordance with whose
directions or instructions the directors of the company are accustomed to act’.

Section 251(2) makes it clear that professional advisers are not to be regarded as shadow
directors eg an accountant providing professional advice on the company’s finances will not
usually be a shadow director, even if the directors follow the advice of the accountant exactly.

This legislation is designed to ensure that anyone who acts as a director, even if they are not
technically appointed as one, is subject to the duties and restrictions which apply to all
directors. For example, a friend of a director who gives advice from 'behind the scenes', which
the directors follow, would be seen as a shadow director.

Most of the provisions in the CA 2006 and the Insolvency Act 1986 imposing duties, obligations
or restrictions on directors, therefore, apply equally to shadow directors. (See for example, s
89, s 162(6), s 223, and ss 230 - 231 CA 2006, s 214 IA 1986.)

Executive and non-executive directors

The CA 2006 does not differentiate between executive and non-executive directors, but in
practice there is a distinction. However, note that the duties, obligations and restrictions placed
on directors under CA 2006apply to all directors, executive and non-executive.

Executive directors
An executive director is a director who has been appointed to executive office. Such a director
will generally spend the majority, if not all, of their working time on the business of the
company and will be both an officer and an employee of his company. Examples include a
Finance Director, Managing Director, Marketing Director.
Non-executive directors
A non-executive director is also an officer of the company but will not be an employee of the
company. Non-executive directors do not take part in the day-to-day running of the company.
Their role is generally to provide independent guidance and advice to the board and to protect
the interests of shareholders.

Alternate directors
The office of the director is a personal responsibility. However, some companies in their
articles provide for alternate directors to take the place of a director where one or more
directors are absent.

An alternate director is usually either a fellow director of the company or someone who has
been approved by a resolution of the board of directors. The alternate director has the voting
powers of the absent director.

The MA does not provide for the appointment of alternate directors and since it is now possible
to hold board meetings over the telephone and to pass board resolutions by means of written
resolutions, the use of alternate directors is becoming quite rare.

Whether or not the provisions of CA 2006 apply to alternate directors is a matter of

construction. Still, it is thought that the duties of directors will apply equally to alternate
directors.

Company secretary
A company secretary's main duties are to keep the company books up-to-date, produce
minutes of board and general meetings, and make sure that all necessary filings are made at
the Companies House. It is not a part of their role to take decisions on behalf of the company,
which is the domain of either the directors or the shareholders.

In the past all companies were required to have a company secretary. But under CA 2006:
• a private company is not required to have a company secretary (s 270(1) CA
2006) unless the articles require it to have one. If a private company does not have a
company secretary, the directors (or any person the directors authorise) may do
anything that the secretary was required or authorised to do (s 270(3)(b) CA 2006).
• a public company must have a company secretary (s 271 CA 2006).
• Part 12 of the CA 2006 applies to all companies with a company secretary. A public
company secretary must have the requisite knowledge and experience and one of the
qualifications set out in s 273(2) CA 2006 (for example, the secretary may be a solicitor
or a chartered accountant). The directors appoint the secretary and are required to
check that the secretary qualifies under these provisions.
Summary
• Directors are responsible for the day-to-day management of the company.
• Directors are agents of the company.
• Directors who are validly appointed may be referred to as de jure directors. These directors
may be executive or non-executive.
• It is possible for other individuals to act as a director where they are not in fact validly
appointed as such. De facto, shadow and alternate directors fall into this category.
• Private companies are not required to have a company secretary. If a private company does
not have a company secretary, any director may fulfil this role.
• Public companies are required to have a company secretary.
• All the different types of directors are governed by the principles of CA 2006.

Appointment and removal of directors

Appointment of directors
CA 2006 does not stipulate a procedure for the appointment of directors, so this is something
that will be governed by the Articles of the company.

The MA deal with the matter simply. Companies with MA may appoint a director:
• By an ordinary resolution of the shareholders - MA 17(1)(a)
• By a decision of the directors - MA 17(1)(b)

It is usual for the board of directors to appoint new directors under MA17(1)(b) because is
easier to put into effect. Unless there is a particular reason for using the ordinary resolution
procedure, a director will be appointed by the majority of the other directors.

Of course, companies may instead have custom Articles setting out an alternative procedure for
the appointment of directors; therefore, you must always check the Articles of a company
before advising on the appointment of directors.

Service contracts
An executive director will be an employee of the company. As an employee, they should be
given a written contract of employment (otherwise known as a service contract), setting out
the terms and conditions of employment including duties, remuneration package, notice
provisions etc. There is no automatic entitlement for directors to be paid for their services –
this is something that the board can determine, subject to the provisions of the company's
articles.

The Company has an obligation to keep its directors’ service contracts at its registered office for
inspection by the members (s 228 CA 2006).
The effect of Art 19 MA is that the terms of an individual director’s service contract, including
remuneration, are for the board to determine. As a general rule, a director’s service agreement
will only require the approval of a resolution of the board of directors. However, shareholder
approval is required to enter into long-term service contracts under s 188 CA 2006. You will
look at this in the next element.

It is worth noting that one individual can be a director, a shareholder and an employee of a
company. These are three separate roles.

Disclosure of identity of directors and secretary

The CA 2006 requires certain details about a company's directors to be disclosed either publicly
or to the members.

Every company must maintain a register of its directors (s 162(1) CA 2006) and secretary (s
275(1) CA 2006) and should keep these registers at its registered office.

Each company must also notify the Registrar of Companies (ie Companies House) of changes
relating to its directors (s 167 CA 2006) or secretary (s 276 CA 2006) using forms published by
Companies House (eg AP01 for Appointment of Director).

The particulars which must be registered in relation to directors are specified in ss 163(1) and
164 CA 2006 (and those for secretaries in ss 277(1) and 278(1) CA 2006).

The information kept at Companies House is available for inspection by the public (s1085(1) CA
2006) and, in addition, the register kept at a company's registered office must be open for
inspection by any member of the company without charge and by any other person on
payment of a fee (ss 162(5) and 275(5) CA 2006 for the register of directors and secretaries
respectively).

Privacy for Officers of the Company

The provisions of CA 2006 allow the directors and secretary more confidentiality than had
previously been the case.

Section 163(1) CA 2006 specifies that only a service address for a director needs to be included
on the company’s register of directors (s 277(5) CA 2006 contains the same provision in relation
to the address to be included on the company’s register of secretaries). This service address can
either be the director’s residential address (if they are not concerned with the need for privacy)
or could simply be the company’s registered office and will be the only address available to the
public generally. Residential addresses that are already on the public register will not be
removed automatically.

Individual directors (but not secretaries) will still have to provide their residential address under
s 165 CA 2006, but this information will be kept on a separate, secure register. This register is
not open to public inspection.
Disclosure required: annual accounts
Section 412 CA 2006 relates to information about directors’ (and past directors’) remuneration
and what information will need to be included in the company’s annual accounts. Two SIs
currently set out in detail the information which needs to be included in the notes to a
company’s annual accounts. This includes information relating to:
• the directors’ salaries, bonus payments and pension entitlements; and
• compensation paid to directors and past directors for loss of office.
Section 412 CA 2006 also requires details to be disclosed of any payments made to, or
receivable by, a person connected to such a director or a body corporate controlled by a
director.

Section 413 CA 2006 relates to the disclosure of information on advances and credits given by a
company to its directors and guarantees entered into by a company on behalf of its directors.
Section 413 CA 2006 applies to a person who was a director at any time during the applicable
financial year.

Removal of a director by the shareholders

The ability to remove a director from office is the ultimate sanction that shareholders have
against a director.

Under s 168(1) CA 2006, a company (ie the shareholders) may by ordinary resolution remove
a director before the expiration of their period of office.

Under s 168(2) CA 2006 special notice (28 days) is required for a removal resolution.

It is not possible for the Board to remove a director (unless the Articles specifically provide for
this).

Directors who are also shareholders are allowed to vote in their capacity as a shareholder on
the ordinary resolution to remove them.

You will learn about the process by which shareholders may remove a director in detail in ‘The
rights and remedies of shareholders’ topic (‘Removal of a Director’ element).

Vacation from office

The other ways in which an individual may cease to be a director are:

Resignation by notice
A director may simply take the decision to resign from the board by tendering a letter of
resignation. This procedure is provided for in MA 18(f). It is usual, although not obligatory, in
these circumstances for the board to pass a board resolution accepting the letter of resignation.

Automatic termination
Under MA 18 a person ceases to be a director as soon as:
• the director becomes disqualified from being a director;
• the director becomes the subject of an individual voluntary arrangement (or similar);
• the director becomes bankrupt, or
• A registered medical practitioner who is treating the director states in writing to the
company that the director has become physically or mentally incapable of acting as a
director and will remain so for more than three months.

Disqualification - Company Directors Disqualification Act 1986 (‘CDDA’)

• The CDDA is the key piece of legislation regarding the disqualification of directors.
Under this Act, the court may make a disqualification order against a person preventing
them, unless they obtain leave of the court, from being a director, liquidator, receiver or
in any other way directly or indirectly involved in the promotion, formation or
management of a company. The purpose of such an order is to protect the public
against the activities of such a director. Grounds for disqualification include fraudulent
or wrongful trading or persistent breaches of company law.
• The period of disqualification is a maximum of 15 years. If a director has been
disqualified under the CDDA, it is a criminal offence to participate directly or indirectly in
corporate management without leave of the court.

Retirement by rotation
• The model articles for public companies require the retirement and reappointment of
directors by the members every three years. In addition, all directors of listed
companies are subject to annual re-election.

Companies House filing requirements

• When a director leaves office, the company must both update the company’s register of
directors and also give notice to Companies House by filing form TM01 (Termination of
appointment of director).

Summary
• The appointment of directors and granting of service contracts are governed by the
provisions of a company’s articles. In general, the board decides on the appointments
and terms of service contracts, although long-term service contracts will require
shareholder approval.
• Companies are required to inform Companies House when they appoint new directors
or when directors leave office and must keep a register of their directors.
• Directors’ personal details must be provided to Companies House although their
residential addresses may be kept private.
• Certain information relating to financial payments to directors need to be disclosed in
the company’s annual accounts which must be filed at Companies House.
• Directors may be removed from office by an ordinary resolution of shareholders.
• Directors may also leave office through resignation, disqualification under CDDA 1986,
rotation or automatically if one of the reasons in MA 18 applies.
Duties and responsibilities of directors I

Introduction: Directors’ duties

As you will have seen, it is the directors who on a day-to-day basis are responsible for managing
the company (MA 3). In order to protect the shareholders and creditors of the company from
directors exploiting or abusing their powers to act in their own self-interest, directors are
subject to the extensive duties. Whenever a director is making a decision, they must always
consider all the duties to which they are subject.

The duties of directors were developed by the common law and equity but were codified in CA
2006, specifically ss 171-177 CA 2006. The statutory general duties should be interpreted and
applied in the same way as common law rules and equitable principles (s 170(4) CA 2006).

The general duties of directors are owed by a director to the company (and not to the
shareholders directly). Any breach of duty by a director is therefore a wrong done to the
company and it is the company who would therefore be the claimant in proceedings in respect
of a breach of duty by a director. Note though that when a company is in financial difficulty, the
position changes and the directors' duties shift to the protection of the creditors. We will look
at this in more detail in the insolvency topics.

The statutory duties apply to all types of directors.

The general duties of directors ss 170 – 177 CA 2006

The general duties are set out in sections 171-177 CA 2006 and are as follows:
• Duty to act within powers (s 171 CA 2006);
• Duty to promote the success of the company for the benefit of the members as a
whole (s 172 CA 2006);
• Duty to exercise independent judgment (s 173 CA 2006);
• Duty to exercise reasonable care, skill and diligence (s 174 CA 2006);
• Duty to avoid conflicts of interest (s 175 CA 2006);
• Duty not to accept benefits from third parties (s 176 CA 2006); and
• Duty to declare any interest in a proposed transaction (s 177 CA 2006).

Note that directors are also subject to duties under legislation other than CA 2006, egthose
obligations contained within the Insolvency Act 1986.

Section 171 CA 2006: Duty to act within powers

This section effectively sets out 2 separate duties:

1. Duty to act within the company’s constitution
a. The company's constitution is defined in s 257 CA 2006 and includes everything
set out in the company's articles of association and decisions taken in
accordance with the articles (ie shareholder resolutions). A director is in breach
 of this duty if they act without authority, eg commit the company to borrow
more than the articles allow without prior shareholder approval.
2. Duty to exercise powers for the purposes for which they are conferred
a. Directors must not use their powers for improper purposes (eg for personal
gain).

Section 172 CA 2006: Duty to promote the success of the company

This duty has been the subject of much debate. It is seen as codifying the previous common law
duty requiring directors to act in the ‘best interests of the company. It forms the central duty
under the new regime.

Section 172 CA 2006 stipulates that a director must act in a way which they consider, in good
faith, would be most likely to promote the success of the company for the benefit of its
members as a whole.

The Government has stated that ‘success’ should normally mean, for commercial companies, a
‘long-term increase in value.

The list of matters to be considered is not exhaustive. It is clear that the list is secondary to the
duty to shareholders under s 172 CA 2006 and that the duty is owed to the company and not to
the third party.

In exercising this duty, a director is required to have regard to a range of non-exhaustive

matters which are set out in s 172(1) CA 2006, including:
• the likely long-term consequences of any decision
• employees’ interests
• the need to foster relationships with suppliers, customers and others
• the impact of the company’s operations on the community and the environment
• the desirability of the company’s maintaining a reputation for high standards of business
conduct
• the need to act fairly among the members of a company

Although many of these matters were not specifically provided for under the common law,
many companies would routinely consider such matters as a necessary part of good business
practice following the concept of ‘enlightened shareholder value’. This is a term used to
describe the ‘middle way’ between, on the one hand, running the company purely to maximise
shareholders’ interests/profits and, on the other hand, a pluralist approach which involves
acting in the interests of a wider group of stakeholders.

Example
The directors of WYZ plc are deciding whether the company ought to install a new oil pipeline.
They need to have regard to the range of matters listed in s 172(1) CA 2006, including the
environmental implications of the pipeline, because these are mentioned in s172(1)(d) CA 2006.
However, having had regard to those matters, the directors may ultimately go ahead and install
the pipeline anyway, causing a degree of environmental damage, if it promoted the success of
the company to do so.

Compliance with s 172 CA 2006

Since the introduction of the statutory duties there has been some uncertainty as to how to
balance the various matters in the list, which will inevitably conflict from time to time.

One fear was that companies may feel the need to respond by having more detailed board
minutes to document how they have considered each area for every decision made. Another
was that the new duty under s 172 CA 2006 may lead to increased litigation. Neither fear has
yet come to pass.

Many companies are taking the common-sense approach of ensuring board minutes clearly
note that consideration has been given to the s 172 CA 2006 duty when taking board
decisions particularly, with regard to significant commercial decisions, there will have been the
requisite amount of research, discussion and briefing of the board to amply demonstrate
consideration of the matters in s 172(1) CA 2006 should the company be challenged.

The courts appear to be backing this approach given the lack of significant case law on the point
since these provisions came into force.

Section 173 CA 2006: Duty to exercise independent judgment

This duty codifies the principle that directors must exercise their powers independently, and
not fetter their discretion.

They can rely on advice from others but must make their own judgments. Directors must be
mindful of the individual nature of this duty when acting.

They cannot blindly follow others’ views without considering the interests of the company.

Section 174 CA 2006: Duty to exercise reasonable care, skill and diligence
The level of care, skill and diligence which a director must exercise is assessed objectively and
subjectively.

The required level is the level of skill, care and diligence which would be exercised by a
reasonably diligent person with:
• the general knowledge, skill and experience that may reasonably be expected of
someone in their role; and
• the general knowledge, skill and experience of that director.
• The minimum standard expected of a director is that objectively expected of a director
in that position. This standard may then be subjectively raised if the particular director
has any special knowledge, skill and experience.
Summary
• In general, directors' duties are owed to the company and not to individual
shareholders.
• The duties shift to the protection of the creditors in an insolvency.
• The duties under s 171 – 177 apply to all directors.
• The common law and equitable fiduciary duties apply to the extent not covered by CA
2006 and remain relevant in the interpretation of the statutory duties.
• The statutory directors' duties are set out in ss 171-177 CA 2006.
• Section 172 CA 2006 is the central duty and causes the most discussion.

Duties and responsibilities of directors II

The general duties of directors ss 170 – 177 CA 2006

You will remember from the previous element that the general duties of directors are set out in
sections 171-177 CA 2006 and are as follows:
• Duty to act within powers (s 171 CA 2006);
• Duty to promote the success of the company for the benefit of the members as a whole
(s 172 CA 2006);
• Duty to exercise independent judgment (s 173 CA 2006);
• Duty to exercise reasonable care, skill and diligence (s 174 CA 2006);
• Duty to avoid conflicts of interest (s 175 CA 2006);
• Duty not to accept benefits from third parties (s 176 CA 2006); and
• Duty to declare any interest in a proposed transaction (s 177 CA 2006).

Section 175 CA 2006: Duty to avoid conflicts of interest

This duty is the first of three duties aimed at dealing with conflicts of interest which directors
might experience.

This duty requires a director to ‘avoid a situation in which they have, or can have, a direct or
indirect interest that conflicts, or possibly may conflict, with the interests of the company.’

This is quite widely drafted and is said to apply ‘in particular to the exploitation of any
property, information or opportunity’. It is no excuse for the director to say that the
opportunity is not one which the company could have exploited itself.

The duty is not infringed ‘if the situation cannot reasonably be regarded as likely to give rise to
a conflict of interest_’_ or if the conflict arises:
• in relation to a transaction with the company (eg a transaction between the director and
the company) (s 175(3) CA 2006); or
• in relation to a matter which has been authorised by the directors (s 175(4)(b) CA 2006).
Example s 175 duty: X is a director of Company A and has been approached to become a
director of Company B (Company A’s biggest competitor). This is a situation to which s 175 CA
2006 applies because there is an obvious potential conflict between the two companies. Board
approval should be sought by X from both boards at the time the Company B directorship is
entered into or, better still, X should refuse the appointment at Company B.
Note that s 175(3) CA 2006 expressly excludes conflicts of interest arising in relation to
transactions or arrangements with the company. These conflicts are subject to the duty of
disclosure in s 177 CA 2006 for transparency purposes but are not prohibited. This seems to be
a statutory acknowledgement that many directors will have interests in other companies, and
most companies' articles permit this, provided such interests are declared.

Example s 175(3) exception: X is a director of Company A and a director of Company B (after

approval by the Board of Company A). If Company B, at some point later, wish to sell an asset
(eg a property) to Company A that is a s 175(3) CA 2006 situation which is an exception from
the duty under s 175 CA 2006. In this instance the duty under s 177 CA 2006, which we will
examine later in this element, will apply.

Section 176 CA 2006: Duty not to accept benefits from third parties
This is the second of the three duties aimed at conflicts of interest. Under this section, a
director must not accept a benefit from a third party which is conferred by reason of them
being a director, or by reason of them doing (or not doing) anything as a director.

However, note that the duty is not breached if the acceptance of the benefit cannot reasonably
be regarded as likely to give rise to a conflict of interest (s 176(4) CA 2006).

Note that, unlike the duty in s 175 CA 2006, the other directors cannot authorise an
arrangement under this section. There is no provision allowing them to do so. It would be
possible for the shareholders to approve a director’s proposed action in advance.

Example: A director accepting a bribe or making a profit at the company’s expense by virtue of
their position of director, would clearly breach this duty. Their conflict of interest would be
obvious.

Section 177 CA 2006: Duty to declare an interest in a proposed transaction

This is the third of the three duties aimed at conflicts of interest. Any director who is interested
in a proposed transaction with the company must declare the nature and extent of their
interest to the other directors. This covers indirect interests, as well as direct interests.

In addition to the duty under s 177 CA 2006 to disclose interests in proposed transactions
entered into by the company, directors are also required to disclose interests in existing
transactions or arrangements entered into by the company (s 182 CA 2006.

Example: If Company A is about to sign a contract with Company B, and a director of Company
A also happens to be a shareholder in Company B, they will have an indirect interest in the
transaction. The exception in s 175(3) applies so there is no breach of s 175. However, the
director stands to gain from their personal shareholding in Company B, if Company A signs the
contract. They must therefore tell the directors of Company A about their shareholding in
Company B, before Company A signs the contract.

Procedural Matters relating to s 177 CA 2006

• Note that s 177 CA 2006 applies equally to ‘indirect interests’. An indirect interest is not
always easy to identify. Where a director has some interest whether through a spouse
or another relative or through a company in which they are a member, the director is
likely to be deemed to have an indirect interest. The director does not have to be party
to the transaction for s 177 CA 2006 to apply.
• A director must declare their interest in a proposed transaction before the transaction is
entered (s 177(4) CA 2006, subject to anything different expressed in the articles).
• The declaration can be at a Board Meeting (s 177(2)(a) CA 2006) or in writing in advance
of the Board Meeting (s 177(2)(b)(i) CA 2006). It is also possible for directors to give a
one-off general notice of their interest (s 177(2)(b)(ii) CA 2006). Best practice suggests
that an interested director will declare that interest at BM1.
• If a director discloses an interest to the other directors by way of written notice rather
than in a meeting of the directors, then the notice must be sent to all directors either
electronically (if agreed) or in paper form (s 184 CA 2006).
• Under s 185, a director can give general notice to the effect that they are always to be
considered interested in any transaction or arrangement with a specified party. This will
be if a director has an interest in a specified body corporate or firm (s 185(2)(a) CA 2006)
or is connected to a specified person (s 185(2)(b) CA 2006).

When does a director NOT need to make a declaration pursuant to s 177 CA 2006?
Sections 177(5) and (6) CA 2006 set out when a director is not required to make a declaration;
namely when:
• the director is not aware of the interest or transaction or arrangement in question (a
director is treated as being aware of the interest or transaction/arrangement if it is a
matter of which they ought reasonably to have been aware);
• the interest cannot reasonably be regarded as likely to give rise to a conflict of interest
or the other directors know about or ought to have known about the conflict of interest;
or
• if the conflict arises because it concerns their service contract and their service contract
has been or will be considered by the board, or a committee of the board, of directors.
• In practice, directors are likely to continue to declare their interests even if the other
directors know or ought to have known about any conflict. This can easily be
documented in the board minutes and avoids the need to rely on an exception that may
or may not apply.

Section 177 CA 2006 and MA 14

MA 14 specifies that a director who is interested in a transaction or arrangement with the
company cannot vote on or count in the quorum for board resolutions in respect of that
transaction or arrangement.

This could cause difficulties in small companies. However, MA 14(2) and (3) allow the conflicted
director to count in the quorum and vote if:
• the company disapplies MA 14(1) by ordinary resolution;
• the director’s interest cannot reasonably be regarded as likely to give rise to a conflict of
interest; or
• the director’s conflict arises from a permitted cause (defined in MA 14(4)).

An alternative, and more permanent, measure would be to remove MA 14 under s 21 CA 2006

and replace it with an article expressly permitting a director interested in a transaction or
arrangement with the company to vote and count in a quorum on board resolutions to approve
the transaction or arrangement.

Remedies for breach of directors’ duties

Directors owe their duties to the company, rather than to individual shareholders. If directors
breach their duties, the company has a claim against them personally in law.

Under s 178 CA 2006, the consequences of a breach of directors’ duties are the same as for
breach of the corresponding common law or equitable principles. With the exception of the
duty to exercise reasonable care, skill and diligence (s 174 CA 2006), the statutory duties are
enforceable in the same way as fiduciary duties owed by directors to their company.

Section 174
The remedy for a breach of the duty of care, skill and diligence (s 174) is damages.

Sections 171 – 173 and 175 – 177

Remedies for breaches of general duties other than s 174 include:
• injunction;
• setting aside of the transaction;
• restitution and account of profits;
• restoration of company property;
• damages.

Shareholder approval in advance

Shareholders may support a director’s proposed action, and be prepared to approve it in

advance, even though it would otherwise represent a breach of the general duties set out in
ss 171-177 CA 2006. Note however that shareholders cannot approve unlawful acts in this way.
The statutory duties under CA 2006 are said to ‘have effect subject to any rule of law enabling
the company to give authority, specifically or generally, for anything to be done (or omitted) by
the directors … that would otherwise be a breach of duty’ (s 180(4) CA 2006).

This represents a continuation of the common law approach.

An authorisation is only effective provided there has been full disclosure by the directors so
that the shareholders are properly aware of the details of the action and can make an informed
decision.

Ratification for breach of duty

The shareholders can, by ordinary resolution, subject to anything in the company's articles
requiring a higher majority or unanimity, under s 239(2) CA 2006, ratify (ie approve after the
breach) the following conduct of directors:
• negligence;
• default;
• breach of duty; and
• breach of trust.

If a director holds shares in the company, then any votes to ratify their breach which attach to
shares held by them or any person connected with them (eg their spouse, children, parents or a
company which they control – see ss 252 and 253 CA 2006) will be disregarded under s 239(4)
CA 2006.

Unlawful acts can never be ratified (eg declaring a dividend when no distributable profits are
available) and shareholders cannot ratify a director’s breach of fiduciary duty in insolvency
situations since directors owe their duties to creditors, not shareholders, once the company is
insolvent.

Summary
• Section 175 is the duty to avoid conflicts of interest. However, this does not apply where
the conflict arises in relation to a transaction with the company (s 175(3)).
• Section 177 CA 2006 relates to the duty on directors to declare a direct or indirect
interest in a proposed transaction. The duty to avoid a conflict of interests does not
apply to interests in proposed transactions (s 175(3)).
• Section 177 CA 2006 will likely trigger the effects of MA14, unless a company has
disapplied it or another exception applies.
• There are consequences, as set out under the common law, for breaches of duty.
• Shareholders can, in certain circumstances, approve in advance or ratify the conduct of
directors.
Directors’ long term service contracts

Introduction: Transactions with Directors

On this module you will learn about three types of transaction between the company and its
directors (or people connected to them) which are regulated by CA 2006 and which require the
approval of the company's shareholders, in order for the transaction to be valid. The particular
types of transaction are:
• Directors' long-term service contracts (ss 188 – 189 CA 2006)
• Substantial property transactions (ss 190 – 196 CA 2006)
• Loans, quasi-loans and credit transactions (ss 197 – 214 CA 2006)

In these transactions there is a real risk of conflict between the interests of the directors and
the shareholders. If the directors proceeded with any of these transactions without obtaining
shareholder approval, then they would be in breach of their general duties under s 171 – 177
CA 2006, as well as in breach of the requirements above.

Directors' long-term service contracts (s 188 CA 2006)

Under s 188(2)(a) CA 2006 (combined with s 281(3) CA 2006)), shareholder approval
by ordinary resolution is required for any director’s service contract which is, or may be, for
a guaranteed period in excess of two years (referred to as the ‘guaranteed term’).
The guaranteed term applies to either:
• a period during which the contract is to continue other than at the instance of the
company (ie a contractual term of more than two years or where the director is in
control of how long the contract continues) (s 188(3)(a)(i) CA 2006), and
• during this time the company either cannot terminate the contract or can only
terminate in specific circumstances (s 188(3)(a)(ii) CA 2006).
• OR the period of notice to be given by the company (s 188(3)(b) CA 2006).
• It will also apply to an aggregate of any periods covered by either s 188(3)(a) or (b).
• Note that s 188(2)(b) CA 2006 also makes it clear that if the director is also a director of
any holding company, the shareholders of the holding company will also need to give
approval.

Consequences of non-compliance: s 189 CA 2006

If a company agrees to a provision in a service contract in contravention of s 188 CA 2006, the
consequences are as follows:
• the provision will be void to the extent of the contravention under s 189 CA 2006, and
• the contract will be deemed to contain a term entitling the company to terminate it at
any time by the giving of reasonable notice.

Section 188(3) CA 2006 example

If a company is unable to terminate a director’s service contract for the first 18 months of the
term and thereafter has to give a minimum of nine months’ notice to terminate, this contract
will fall within s 188(3) because the aggregate period of the two provisions is in excess of two
years.
Such a contract will need to be approved by an ordinary resolution.

Exception: Section 188(6)(b) CA 2006 example

Under s 188(6)(b) CA 2006 approval is not required by the members of any company which is
a wholly owned subsidiary of another company.

HoldCo Plc owns 100% of the shares in Subsidiary Ltd.

Subsidiary Ltd has a proposed new service contract with guaranteed term of more than 2 years
with one of its directors.

In this example, even though it appears from s 188(2)(a) CA 2006 that Subsidiary Limited would
need to obtain approval from the shareholders (ie the single SH, being HoldCo Plc) for the
proposed new service contract for the director of Subsidiary Limited because it has a
guaranteed term of more than 2 years, the fact that Subsidiary Limited is a wholly-owned
subsidiary means that the approval is not required.

Section 188 CA 2006 and Disclosures

Disclosure of Interest – s 177 CA 2006

Under s 177(6)(c) CA 2006, a director is not required to disclose their interest in the service
contract. However, it is likely to remain the practice that directors will continue to make the
declaration of interest under s 177(1) CA 2006 so that it is documented in the board minutes.

In addition, the director will not be permitted to vote or count in the quorum on any board
resolution relating to the contract (MA 14(1)).

Members’ inspection rights of all directors’ service contracts - s 228 CA 2006

A company must keep a copy of all directors' service contracts (or, where the contracts are not
in writing, memoranda of their terms) at the company's registered office or a place specified in
regulations made under s 1136 CA 2006 for a period of at least one year from the date of
termination or expiry of the contract for members to inspect. This obligation applies regardless
of the length of any service contract and whether or not it is terminable within 12 months.

Under s 229 CA 2006 members have the right to inspect without charge or to request a copy on
payment of a fee.

Section 188 CA 2006: Procedural Issues

Where the ordinary resolution is to be passed at a General Meeting, s188(5)(b) CA 2006 sets
out that a memorandum setting out the proposed contract must be made available for
inspection by members of the company both:
• at the company’s registered office for not less than 15 days ending with the date of the
meeting; and
 • at the meeting itself.

A minimum of 15 days’ notice of the GM held to approve the contract will therefore have to be
given to shareholders (even if the short notice procedure is followed) unless the written
resolution procedure is used. You can see that this will impact on the speed with which the
decision to approve the service contract or not can be made. There is no such 15-day
requirement for a written resolution.

Where the written resolution procedure is being followed pursuant to s 188(5)(a) CA 2006, the
memorandum setting out the proposed contract must be sent or submitted to every eligible
member at or before the time at which the proposed resolution is sent or submitted to the
member.

Summary
• Shareholder approval by ordinary resolution is required for any director’s service
contract which is, or may be, for a guaranteed period in excess of two years (s 188(2)(a)
CA 2006).
• The guaranteed term is the period during which the contract is to continue other than at
the instance of the company where the company either cannot terminate the contract
or can only terminate in specific circumstances (s 188(3)).
• In the absence of approval the term will be void and the contract deemed to terminate
on reasonable notice (s 189).
• Under s 188(6)(b) approval is not required by the members of any company which is a
wholly owned subsidiary of another company.
• If the director is also a director of any holding company, the shareholders of the holding
company will also need to give approval (s 188(2)(b)).

Substantial property transactions

Substantial property transactions (s 190 – 196 CA 2006)

Section 190 CA 2006 governs an acquisition or disposal by a director/holding company
director (or connected person) of a substantial non-cash asset to or from the company.
These types of transaction are permitted but again require shareholder approval by ordinary
resolution.

Shareholder approval must be given either before the transaction is entered into, or after,
provided that the transaction is made conditional on approval being obtained.

Section 190 CA 2006: Substantial Non-Cash Asset

‘Non-Cash Asset’ means any property other than cash (s 1163 CA 2006).
‘Substantial’ is defined in s 191 CA 2006 as follows:
• An asset worth £5,000 or less is not a substantial asset.
• An asset worth more than £100,000 is a substantial asset.
 • An asset worth more than £5,000, but not more than £100,000 is a substantial
asset only if it is worth more than 10% of the company’s net asset value. A company’s
net asset value is that shown in its most recent statutory accounts.

If the company is only recently incorporated and no accounts have yet been prepared, then the
net asset value is taken to be the amount of the company's called up share capital.

Connected persons – s 252 – 254 CA 2006

The definition of ‘persons connected with a director’ is set out in ss 252 – 254 CA 2006. The
definition is complex and where you suspect that a connected person may be involved, you
should always check the details of the legislation. However, in summary, the key categories of
connected persons are:
• Members of the director's family: spouse or civil partner, parents, children or step-
children (s 253(2)). Note that brothers, sisters, grandparents, grandchildren, uncles and
aunts are NOT connected persons under CA 2006.
• Companies in which the director (and others connected with them) hold 20% or more of
the shares (s 254).
• A business partner of the director or those connected with them (s 252(2)(d)).
• Trustees of a trust the beneficiaries of which include the director or those connected
with them (s 252(2)(c)).

Example

Question:
XYZ Ltd is to sell a property to C (wife of A who is a director of XYZ Ltd) for £109,000. XYZ Ltd’s
net asset value is £2 million. Is this a substantial property transaction?
Answer:
Yes. It is a transaction between the company and a person connected to its director and the
value of the property is substantial.
Even though £109,000 does not exceed 10% of the company’s net asset value, it is
automatically deemed to be substantial as the value exceeds £100,000.

Holding company

Section 190(2) CA 2006 states that if the transaction is between a company and a director of
the company’s holding company or a person connected to a director of the holding company,
the holding company will also need to approve the transaction by OR.

Exceptions
Under s 190(4)(b), approval is not required by the members of any company which is a
wholly-owned subsidiary of another company. This is exactly the same rule that you saw in
relation to a director’s long-term service contract (s 188).
In addition, there are a list of limited exceptions in s 192 CA 2006. If the arrangement falls
within the list of transactions within this section, it will not require shareholder approval. For
example, if a director who is also a shareholder sells their shares back to the company, this
transaction will not be a SPT because it falls under s 192(a) as a transaction between a company
and a person in their capacity as a shareholder.

Remedies (s 195 CA 2006)

Where a SPT is entered into without shareholder approval, under s 195(2) CA 2006 the
transaction is voidable at the instance of the company unless:
(a) restitution is no longer possible,
(b) the company has been indemnified for the loss or damage suffered by it, or
(c) rights acquired in good faith by third party would be affected by the avoidance.

The directors involved (and those so connected under s 195(4) CA 2006) are liable to account
to the company for any profits made and to indemnify the company for any loss incurred s
195(3) CA 2006.

Section 196 CA 2006 allows for the arrangement to be affirmed by the shareholders of the
company and the holding company (where relevant) by ordinary resolution within a reasonable
period. If the transaction is affirmed, the arrangement may no longer be avoided under s 195
CA 2006.

Defences (s 195 CA 2006)

If the SPT is between a company and a person connected with a director, and the director
concerned shows that they took all reasonable steps to ensure the company’s compliance with
s 190 CA 2006, the director will not be liable under s 195(6) CA 2006.

There is also a defence under s 195(7) CA 2006 for any connected person (if relevant) and any
director who authorised the transaction who can show they had no knowledge of the
circumstances constituting the contravention.

Sections 190 & 177 CA 2006

Under s 177(1) CA 2006, a director would need to disclose the nature and extent of their
interest to the board.

Under the exception in s177(6)(b) CA 2006, it is arguable that an interested director need not
formally declare an interest if the other directors are already aware of it. However, it is likely to
remain the practice that directors will continue to make the declaration so that it is
documented in the board minutes.

Under MA 14(1), any interested directors will not be permitted to vote on the board resolutions
to approve the contract and authorise a signatory. They cannot count in the quorum for board
resolutions regarding the contract either.
Summary
• Shareholder approval by ordinary resolution is required where there is an acquisition or
disposal by a director/holding company director (or connected person) of a substantial
non-cash asset to or from the company.
• Shareholder approval must be given either before the transaction is entered into, or
after, provided that the transaction is made conditional on approval being obtained.
• ‘Substantial non-cash asset’ means an asset other than cash where the value is either:
over £5,000 and 10% of the company’s net asset value; or over £100,000.
• If the transaction is between a company and a director of the company’s holding
company or a person connected to a director of the holding company, the holding
company will also need to approve the transaction by OR (s 190(2)).
• Approval is not required by the members of any company which is a wholly-owned
subsidiary of another company (s 190(4)(b)).

Loans and related transactions with directors

Introduction: Loans to directors (s 197 – 214 CA 2006)

Company loans to directors, holding company directors and connected persons, although
permitted, may also be subject to the requirement of shareholder approval by ordinary
resolution.

The restrictions set out in this part of CA 2006 apply to four different types of transactions:
• Loans – where the company lends money to a director (197 CA 2006);
• Quasi-loans – as defined in s 199 CA 2006. An example of a quasi-loan would be where a
company agreed to pay off an outstanding account owed by a director to a third party
on the understanding that the director would later reimburse the company;
• Credit Transactions – as defined in s 202 CA 2006. A credit transaction includes any
transaction entered into between the company and the director where the company
provides goods or services on a credit basis which will be paid for at a later date. Only
the company and the director will be parties to this arrangement; and
• Guarantees or the provision of security for any of the above – eg where a director
obtains a loan from a bank and their company stands as guarantor for the repayment of
the loan or the company provides the bank with security over its assets.

Which companies are restricted?

For these restrictions, it is important to distinguish between private companies on the one
hand, and public companies and private companies that are associated with public
companies on the other. Under s 256 CA 2006, companies are associated if one is a subsidiary
of the other or both are subsidiaries of the same body corporate.
So, for example, a private company that is a subsidiary of a public company will be associated
with the public company for these purposes.

You will see that private companies (not associated with a Plc) are subject to much less
regulation than Plcs (or companies associated with Plcs).

All companies (s 197): Loans, guarantees or security for directors

No company may make loans to its directors or to directors of its holding company or
give guarantees or enter into security in connection with loans to such directors, without the
transaction first being approved by the shareholders by ordinary resolution. If the company in
question is a private company that is not associated with a public company, these are the only
transactions for which shareholder approval is required under the CA 2006 loan provisions.

Public companies and private companies associated with public companies (s 198 – 202):

Quasi loans, credit transactions and connected persons

These companies also require shareholder approval for:
• Loans to a person connected to a director of the company or a director of its holding
company (s 200);
• Quasi-loans (s 198) to, or credit transactions (s 201) with their directors and directors of
a holding company or persons connected with such directors; and
• Guarantees or security in respect of any such loans, quasi-loans or credit transactions
with their directors and directors of a holding company or persons connected with such
directors (s 197, 198, 200, 201).

Examples:

ALL COMPANIES

• Loans (s 197)
A loan is a straightforward lending of money. For example, a company wishes to lend
one of its directors £50,000 to assist with the costs of training.

• Guarantees or security (s 197)

A guarantee or security is where the company provides a guarantee or gives security in
relation to a loan provided to one of its directors by a third party eg a bank. For
example, a director wishes to borrow £100,000 from a bank and the bank requests the
company to guarantee the loan.

COMPANIES ASSOCIATED WITH A PLC ONLY Quasi loans (s 198)

A quasi-loan is a transaction under which the company agrees to pay a sum to a third party on
behalf of the director on terms that the director will reimburse the company. For example, a
company wishes to pay a third party for the cost of building work on the home of one of its
directors, on the basis that the director will repay the money at a later date or in instalments.

• Credit transactions (s 201)

A credit transaction is where the company provides goods or services in the normal
course of its business to one of its directors on the basis that the director will pay for the
goods and services at a later date or in instalments. For example, a building company
builds an extension for one of its directors on credit terms.

Exceptions (s 204 – 209 CA 2006)

There are a number of exceptions to the requirement for shareholder approval, the details of
which are set out in s 204 – 209 CA 2006. These are as follows:
• Section 204: Expenditure on company business (up to a maximum of £50,000);
• Section 205: Loans for defending proceedings brought against a director;
• Section 206: Loans for defending regulatory actions or investigations;
• Section 207: Minor and business transactions – loans or quasi-loans of up to £10,000
and credit transactions up to £15,000 do not require shareholder approval;
• Section 208: Intra group transactions, and
• Section 209: Money lending companies (where the loan is made in the ordinary course
of the business of the company).

Remedies (s 213 CA 2006)

If shareholder approval is not obtained and no exceptions apply, the consequences are set out
in s 213 CA 2006. These are very similar to the consequences for breach of s 190 CA 2006, set
out earlier. In relation to the transaction, the consequences are set out in s 213(2) CA 2006:
the arrangement is voidable at the instance of the company unless:
(a) restitution is no longer possible,
(b) the company has been indemnified for the loss or damage suffered by it, or
(c) rights acquired in good faith by a third party would be affected by the avoidance.

The directors involved (and those so connected under s 213(4) CA 2006) are liable to account
to the company for any profits made and to indemnify the company for any loss incurred (s
213(3) CA 2006).

Section 214 CA 2006 allows for the arrangement to be affirmed by the shareholders of the
company and the holding company (where relevant) by ordinary resolution within a reasonable
period. If it is affirmed, the arrangement may no longer be avoided under s 213 CA 2006.

Defences?
If a transaction contravenes ss 200, 201 or 203 CA 2006 and is entered into with a person
connected with a director, that director will not be liable if they took all reasonable steps to
ensure the company complied with those sections (s 213(6) CA 2006).
There is also a defence under s 213(7) CA 2006 for any connected person (if relevant) and any
director that authorised the transaction who can show they had no knowledge of the
circumstances constituting the contravention.

Holding Company
As with s 190 CA 2006, if the transaction is between a company and a director of the
company’s holding company or a person connected to a director of the holding company, the
holding company will also need to approve the transaction by OR.

Wholly-owned subsidiary Exemption

As with both ss 188 and 190 CA 2006 approval is not required by the members of any
company which is a wholly-owned subsidiary of another company.

Disclosures under s 177 CA 2006

Again, under s 177(1) a director would need to disclose the nature and extent of their interest
to the board if they were interested in any of the transactions caught by ss 197-202 CA 2006.

Pursuant to s 177(6)(b) CA 2006, it is arguable that an interested director need not formally
declare an interest if the other directors are already aware of it. However, it is likely to remain
the practice that directors will continue to make the declaration so that it is documented in the
board minutes. In addition, it will not always be obvious to the rest of the Board if the director
has an indirect interest in a transaction, so directors should be advised to act cautiously.

Under MA14(1), any interested directors will not permitted to vote on the board resolutions to
approve the transaction and authorise a signatory because it is “a... transaction…with the
company in which [they] are interested”. They cannot count in the quorum for board
resolutions regarding the contract either.

Sections 197 - 201: Procedural issues

Where the ordinary resolution is to be passed at a General Meeting, a memorandum setting
out the proposed transaction must be made available for inspection by members of the
company both:
a) at the company’s registered office for not less than 15 days ending with the date of
the meeting; and
b) at the meeting itself.

A minimum of 15 days’ notice of the general meeting held to approve the transaction will
therefore have to be given to shareholders (even if the short notice procedure is followed)
unless the written resolution procedure is used. You can see that this will impact on the speed
with which the decision to approve the transaction or not can be made.

Where the written resolution procedure is being followed, a memorandum setting out the
proposed transaction must be sent or submitted to every eligible member at or before the time
at which the proposed resolution is sent or submitted to the member.
You will find these rules within the relevant statutory authority for each transaction.

Summary of transactions between companies and their directors

CA 2006 regulates various transactions between companies and directors, eg:
• Directors' long-term service contracts (ss 188 – 189)
• Substantial property transactions (ss 190 – 196)
• Loans, quasi-loans and credit transactions (ss 197 – 214)
All of these transactions require the approval of shareholders by way of ordinary
resolution unless any of the exceptions apply.

Note that if a company is a wholly-owned subsidiary of another company, it is exempt from the
requirement to obtain shareholder approval.

The remedies for breach of the requirements of shareholder approval differ depending on
which transaction is involved. Details are found in the relevant statutory sections.

If a company wishes to seek approval for one of these transactions, it will need to follow the
procedural requirements.

Summary
• For private limited companies which are not associated with a Plc, the only relevant
provision is s 197 which provides that an ordinary resolution is required to approve
loans to its directors or to directors of its holding company or give guarantees or enter
into security in connection with loans to such directors.
• Plcs and private limited companies which are associated with PLCs are subject to further
restrictions relating to loans to a person connected to a director of the company /
holding company; quasi-loans to, or credit transactions with, their directors/directors of
a holding company / connected persons and guarantees or security in respect of any of
these transactions (s 198 – 202).
• Where the transaction is with a director of the holding company or a person connected
to a director of the holding company, the holding company will also need to approve the
transaction by OR.
• Approval is not required by the members of any company which is a wholly-owned
subsidiary of another company.
• Where an ordinary resolution is required to approve a loan / quasi-loan / credit
transaction/guarantee or security, a memorandum setting out the proposed contract
must be made available for inspection by members of the company at the company’s
registered office for not less than 15 days ending with the date of the meeting and at
the meeting itself.
• Where a written resolution is used, the memorandum must be annexed to the written
resolution and sent to all eligible members.
Business Law and Practice - Workshop 4
Shareholders’ Rights and Remedies
Over this part of the module you will:
1. Analyse the procedure for removal of a director under the Companies Act 2006;
2. Understand minority shareholder protection, including derivative claims and unfair
prejudice, and
3. Apply the skill of case and matter analysis in the context of advising the client on the
removal of a director.

The Rights and Remedies of Shareholders

This element considers the rights of shareholders under the Articles and the use of Shareholder
Agreements, as well as providing a summary of the rights of shareholders with different
percentage shareholdings. The rights of shareholders to remove a director is covered in the
next element.

Introduction
As you have seen, the day to day running of a company is carried out by the directors with
certain important decisions being reserved to the shareholders. You also know that
the decisions reserved to the shareholders are taken following the principle of “majority
rule”: a requisite majority of the shareholders must vote in favour of the proposed resolution in
order for it to be passed. Bearing this principle in mind there is often little that a minority
shareholder can do to influence whether or not a resolution will be carried, unless they can join
forces with other shareholders in order to make up or block the majority required. In most
cases, therefore, the minority shareholder must simply live with decisions made by the
majority.

There are various protections or remedies open to all shareholders including minority
shareholders, but these can be costly and uncertain. This is why shareholders may choose to
enter a shareholders' agreement which aims to minimise the effect of the principle of majority
rule by setting out how the company is to be run as between the shareholders and how the
shareholders will vote on certain matters. So, for example, the shareholders might sign up to an
agreement requiring the unanimous consent of all shareholders before certain matters can
occur (eg removal of a director).
In this element you will consider the following remedies or protections available to a
shareholder (including minority shareholders):
• Membership rights – enforcement under s33 CA 2006
• Shareholders’ agreements
• Shareholders’ rights under CA 2006

In the next elements you will consider the following remedies:

• The removal of directors under s 168 CA 2006
• Derivative actions under s260 CA 2006
• Unfair prejudice actions under s994 CA 2006
• Just and equitable winding up under s122 Insolvency Act 1986 (‘IA 1986’)
• Membership rights under the Articles: s 33 CA 2006

The Articles of a company regulate the relationship between the members and each other
and between the members and the company. They act as a contract. This is enshrined in s 33
CA 2006, which provides as follows:

The provisions of a company’s constitution bind the company and its members to the same
extent as if there were covenants on the part of the company and of each member to observe
those provisions.

The effect of this provision is that members can sue under s 33 CA 2006 if their membership
rights are infringed. The usual remedy for breach of s 33 CA 2006 is damages.

The meaning of membership rights is far from clear. It is necessary to look to decided case law
to establish the rights that have been considered to be membership rights in the past.

Examples of membership rights that have been enforced under s33 CA 2006 (or the
corresponding section of CA 1985):
• right to a dividend once it has been lawfully declared;
• right to share in surplus capital on a winding up;
• right to vote at meetings; and
• right to receive notice of GMs and AGMs.

Rights of members which are not membership rights are not enforceable under s 33. For
example, in Eley v Positive Government Security Life Assurance Co Limited the company’s
articles contained a provision that the plaintiff would be appointed as the company’s solicitor.
He was never appointed as such although he did become a member. The court held that the
plaintiff could not sue under the equivalent of s 33 CA 2006 as the right to be appointed as the
company’s solicitor was not a membership right.

Note that a company’s Articles are deemed to be a complete contract and the court will not
imply any terms into them whether to create business efficacy or otherwise. In order to protect
members, it is important, therefore, that any of their rights which are not membership rights
are set out in a separate contract (such as a shareholders’ agreement) and not in the Articles.
Shareholders Agreements

While the parties could rely solely on the Articles to govern how the company is run, in most
companies owned by more than one person a Shareholders’ Agreement will usually be
entered into. The Shareholders’ Agreement acts as a kind of extension to the Articles in terms
of governing how the company is run and can contain provisions that the law does not permit
the Articles to contain.

The specific provisions in the Shareholders’ Agreement will depend upon the reason why the
parties are entering into the business venture but are likely to include provisions relating to:
• Unanimous voting over certain matters eg removing a director;
• Quorum for GMs;
• Dividend policy;
• Allotment of new shares, and
• New and departing shareholders.

Shareholders Agreements vs Articles

A Shareholders’ Agreement is a contract between some or all of the shareholders, in which
they can agree between themselves how to regulate the affairs of their company.
They can, for instance, agree not to change the Articles of the company and not to exercise
their power under s 168 CA 2006 to remove any director of the company unless they are all in
agreement.

Such provisions in a Shareholders’ Agreement will constitute personal rights and obligations on
the shareholders, including how they will exercise their voting rights on certain decisions.
Another key reason why Shareholders’ Agreements exist is because they can be kept private
(unless they are explicitly referred to in the Articles).

The Articles are treated as a contract between the company and its shareholders in their
capacity as shareholders pursuant to s 33 CA 2006, and do not therefore deal with
shareholders’ personal rights and obligations.
The provisions of the Articles are subject to CA 2006, whereas a Shareholders’ Agreement is an
arrangement arrived at between the shareholders in their personal capacities.

Where the shareholders agree between themselves in a Shareholders’ Agreement as to how to

regulate the affairs of the company, the company should not be a party to any terms which
restrict its statutory powers. This does not mean, however, that the company should never be a
party to a Shareholders’ Agreement: only that it should not be a party to those provisions that
restrict it from exercising its statutory powers.

The use of Shareholders’ Agreements in protecting minorities

You learnt in the previous element about the use of Shareholders’ Agreements when removing
a director. We review below certain other aspects of these agreements which are particularly
relevant to minority shareholders.

Right of action/enforceability
A Shareholders’ Agreement provides a right of action which enables one member to enforce
the provisions of the Shareholders’ Agreement directly against another, whereas under the
Articles this right of action may not arise. Because of the difficulties shareholders can encounter
in enforcing the provisions of the articles under s 33 CA 2006, a Shareholders’ Agreement can
be used in order to ensure the enforceability of provisions that would not be regarded as
membership rights.

If a term of a Shareholders’ Agreement is breached it can be enforced in the usual way under
general contract law principles. A shareholder will be able to claim for breach of contract, or
alternatively could apply to the court for an injunction to prevent a breach of the terms of the
agreement. A Shareholders’ Agreement can also prevent the need for s 994 petitions (unfair
prejudice), although it obviously cannot stop a disgruntled shareholder from bringing such a
petition.

Reserved matters in shareholders’ agreements

Certain matters can be reserved in a Shareholders’ Agreement as matters requiring the consent
of all shareholders or certain individual shareholders and this protects minority shareholders.
For example, a Shareholders’ Agreement may provide that the unanimous consent of all
shareholders is required to pass a resolution to remove a director. This does not remove the
right of the shareholders to remove a director under s 168 CA 2006, as a company is bound to
accept the vote of a shareholder even if this is in breach of the provisions of the Shareholders’
Agreement.
Where a removal resolution is passed without the required unanimity, provided a simple
majority voted in favour (in accordance with CA 2006), the resolution would still be valid, and
the director would be removed from office. The director would then have a claim against the
other shareholders for breach of the Shareholders’ Agreement. The threat of a breach of
contract claim effectively means that the minority shareholder is able to influence whether or
not the resolution is passed.

Amendments to shareholders’ agreements

A further reason why parties may enter into Shareholders’ Agreements is that amendments to
a company’s articles of association can be made by passing a special resolution requiring 75%
approval. Changes to a Shareholders’ Agreement in contrast will require the unanimous
approval of all parties to the agreement. This would consequently give a minority party a right
of veto to any proposed changes.

Summary of shareholders’ rights under CA 2006

The table below summarises the rights of shareholders with different shareholdings under CA
2006:
Any shareholder
• Receive notice of a GM (s 307)
• Appoint a proxy to attend a GM in their place (s 324)
• Vote at a GM (provided they hold voting shares) (s 284)
• Receive a dividend (if declared)
• Receive a copy of the company’s accounts (s 423)
• Inspect minutes and company registers (s 116)
• Ask the court to prevent a breach of directors’ duties
• Commence a derivative claim (s 260 - see later)
• Bring a petition for unfair prejudice (s 994 - see later)
• Bring a petition for just and equitable winding up (s 122 Insolvency Act 1986 - see later)

5% or more
• Require directors to call a General Meeting (s 303)
• Require the circulation of written statements regarding proposed resolutions to be
considered at a GM (s 314)
• Circulate a written resolution (s 292)

10% or more
• Demand a poll vote (MA 44)
 Over 25%
• Block a special resolution (s 283) (note that a special resolution is passed by 75% or
more of the votes)

Over 50%
• Pass or block an ordinary resolution (s 282) (note that an ordinary resolution requires
over 50% of the votes to pass, therefore a shareholder with exactly 50% of the shares
can block an ordinary resolution but cannot pass the ordinary resolution alone)

75%
• Pass a special resolution (s 283) (note that a special resolution is passed by 75% or more
of the votes)
Summary
• Shareholder decisions are taken by majority rule ie ordinary resolutions will pass when
they have the support of a simple majority and special resolutions will pass when they
have the support of 75% of the shareholders. This may cause problems for minority
shareholders.
• The Articles act as a contract between the members (in their capacity as members) and
the company.
• Section 33 CA 2006 means that shareholders can sue if their membership rights are
infringed. The usual remedy for breach of s 33 CA 2006 is damages.
• CA 2006 does provide some statutory protection for minority shareholders, eg 5% of
shareholders can request that the board call a GM under s 303 CA 2006.
• Shareholders’ Agreements often provide a simpler and more effective way of protecting
minority shareholders’ interests.

The Removal of Directors

This element covers how a director may be removed by the shareholders.

Introduction – Removal of a director by the shareholders

Under s 168(1) CA 2006, a company (ie the shareholders) may by ordinary resolution remove
a director before the expiration of their period of office.
The ability to remove a director from office is the ultimate sanction that shareholders have
against a director. It is not possible for the Board to remove a director (unless the articles
specifically provide for this).
Directors who are also shareholders are allowed to vote in their capacity as a shareholder on
the ordinary resolution to remove them. You will consider in this element the different ways in
which a director who is also a shareholder may protect themselves when it comes to a
shareholders’ vote on a resolution to remove them.
For the purpose of this topic, we refer to a resolution to remove a director under s 168(1) CA
2006 as a “removal resolution”. Under s 168(2) CA 2006 special notice (28 days) is required of
a removal resolution.

Note that it is not possible for a company to use a written resolution to remove a director (s
288(2)(a)).

What is special notice?

Shareholders proposing a removal resolution must give notice of that proposed removal
resolution to the company (ie to the board of directors) at least 28 clear days before the
General Meeting (‘GM’) at which the removal resolution will be voted on by shareholders (ss
312(1) and 360(1) and (2) CA 2006).
It is the board that usually decides what matters will be considered at a GM. Therefore, when
the board receives notice of the proposed removal resolution, two courses of action are open
to it:
• Option 1
o The board may place the removal resolution on the agenda of a GM
• Option 2
o The board may decide NOT to place the removal resolution on the agenda of a
GM

Option 1: Board places the removal resolution on the agenda of a GM

If the board does decide to place the removal resolution on the agenda of a general meeting, it
should give the shareholders notice of that removal resolution at the same time and in the
same manner as it gives notice of the general meeting (s 312(2) CA 2006). This means that the
board will need to give shareholders at least 14 clear days’ notice of the removal resolution
under ss 307(1) and 360(1) and (2) CA 2006.

If that is not practical (eg because notice of the general meeting has already been sent out),
notice of the removal resolution may be given either by advertisement in a newspaper or any
other mode allowed by the company’s Articles at least 14 clear days before the GM(ss 312(3)
and 360(1) and (2) CA 2006).
Why does the board need to give shareholders notice of the removal resolution when it was
the shareholders who sent the removal resolution to the board in the first place?
Only some of the shareholders (the ‘unhappy shareholders’) will have sent the proposed
removal resolution to the board. The company’s other shareholders may have no knowledge of
the fact that the unhappy shareholders have proposed a removal resolution. Therefore, if the
board decides to put the removal resolution on the agenda of a general meeting, it needs to
give notice to all shareholders (including the unhappy shareholders) of the fact that a general
meeting will be held and that, at that general meeting, all shareholders will have the
opportunity to vote on a removal resolution.

Option 2: Board does NOT place the removal resolution on the agenda of a GM
Alternatively, the board may decide not to place the removal resolution on the agenda of a
general meeting. Directors are not bound to place the removal resolution on the agenda for
consideration at a forthcoming general meeting (Pedley v Inland Waterways Association Ltd). In
practice, this creates a problem for shareholders as directors may choose simply to ignore the
proposed removal resolution.
If the removal resolution is not placed on the agenda, it will not be considered at the general
meeting. In this case, the shareholders may need to force the directors to call a general meeting
in accordance with s 303 CA 2006.

Shareholders’ power to require calling of general meeting

What happens if the board tries to frustrate an attempt to remove a director by refusing to call
a general meeting? (ie on receipt of the special notice, the board refuses to call a GM or decides
not to place the removal resolution on the agenda of a GM).

In this situation, the unhappy shareholders may have the ability to require the directors to
call a GM and, if the directors refuse to do this, the unhappy shareholders may be able to call
the GM themselves. Under s 303(1) CA 2006, shareholders together holding not less than 5%
of the paid up voting share capital of the company can serve a request on the company ie the
board. The request will require the board to call a GM (a “s 303 request”).

A section 303 request must state the general nature of the business which the shareholders
wish to be dealt with at the GM and may include the text of the resolution they want proposed
at the GM (here, to consider a removal resolution pursuant to s 168 CA 2006).
Note that the power of shareholders to require the board to call a GM is a general power: it is
not limited to circumstances in which they wish to consider a removal resolution.

What are directors’ obligations on receipt of a s 303 request?

Under s 304(1) CA 2006, when the directors receive a s 303 request, they must call the GM:
a) within 21 days from the date on which they become subject to the s 303 request to
call the GM; and
b) to be held on a date not more than 28 days after the date of the notice convening (ie
calling) the GM.

If the directors fail to call a GM under s 304(1) CA 2006, all of the shareholders who submitted
the s 303 request or any of them representing more than one half of the voting rights of those
who submitted that s 303 request, can call a GM themselves pursuant to s 305 CA 2006.

If the shareholders call the GM themselves then that GM must be called on no fewer than 14
clear days’ notice (s 305(4) CA 2006) and held within 3 months of the date that the directors
received the s 303 request (s 305(3) CA 2006). These timings are summarised in the diagram
below. Note that under s 305(6) CA 2006, if the shareholders are forced to call the GM
themselves, they can recover their reasonable expenses for doing so from the company.

Effect of s 303 notice

Unhappy shareholders give special notice to the Board AND serve notice under s 303
Board has 21 days to decide whether to call a GM.

If the board decides to call a GM, it has to be held within 28 days from date of calling it

If the board decides not to call GM: Shareholders can call GM on normal notice. GM must be
held within 3 months of s 303 request

Practical points to note

In order for the unhappy shareholders to ensure the resolution to remove a director is heard as
soon as possible, they will submit a s 303 request requiring the directors to call a GM at the
same time as sending their s 312 CA 2006 special notice to the board.

By sending these two notices to the board at the same time, shareholders will comply with s
312 CA 2006 (which is a standalone requirement that needs to be satisfied) and also ensure
that:
• the directors either call a GM with an agenda which includes the resolution to remove
the director under s 303 CA 2006; or
• the shareholders can step in and call the GM under s 305 CA 2006 themselves.
Timeline where the Board does co-operate with s 303 Notice
• DAY 1
o Unhappy shareholders serve notice under s 303
o NB – assuming they have already served special notice
• DAY 22 (latest)
o Board has 21 days to decide whether to call a GM
• DAY 50 (latest)
o If the board decides to call a GM, it has to be held within 28 days from date of
calling it
Timeline where the Board does NOT co-operate with s 303 Notice
• DAY 1
o Unhappy shareholders serve notice under s 303
o NB – assuming they have already served special notice
• DAY 22 (latest)
o Board has 21 days to decide whether to call a GM
o Board loses control of the process on Day 23.
• DAY 38
o If the board decides not to call GM: from DAY 23 the unhappy shareholders can
call GM on normal notice (14 clear days).
o [GM must be held within 3 months of s 303 request]

Director’s rights to protest removal

If a company receives notice that one or more members intends to propose a removal
resolution, the company must immediately send a copy of the notice to the director
concerned (s 169(1) CA 2006). Note that even if the Board decides not to put the removal
resolution on the agenda of a GM, it is obliged to send the special notice to the director
concerned.

The director then has the right to make representations in writing provided those
representations are of a reasonable length (s 169(3) CA 2006). These representations will, for
example, set out the reasons why the director feels they should not be removed. These
representations should, unless they are received too late for the company to do so,
be circulated to the members of the company. If the representations are not circulated, they
should be read out at the GM (s 169(4) CA 2006).

In any event, the director concerned has a right to be heard ie to speak in their defence at the
GM, whether or not they are a shareholder (s 169(2) CA).
What if the director is also a shareholder?
1. Bushell v Faith clauses

Always check the articles to see if there is a Bushell v Faith clause.

A Bushell v Faith clause in the articles of association may give a director, who is also a
shareholder, weighted voting rights at a GM at which a s 168 CA 2006 resolution is
proposed. This is likely to mean that shareholders are unable to pass an ordinary resolution to
remove the director concerned.

This type of clause is often found in the articles of association of smaller companies where the
directors have played a key role in setting up the company and have an expectation that they
will be able to continue to be involved in the running of the business. Any shareholders’
agreement should also be checked for similar provisions.

The articles should also be checked in order to determine whether there are any transfer
provisions which may govern the transfer of the outgoing director’s shareholding in the
company. If a director is to be removed, the company and the shareholders are unlikely to want
them to retain their shareholding, so transfer provisions are usually found in a company’s
articles of association and/or in any shareholders’ agreement. These transfer provisions would,
for example, require the director to transfer their shares to the other shareholders if they are
removed as a director.

Example
ABC Ltd: A, B and C are all directors and own shares as follows:
A 60
B 20
C 20

How many votes per share will B need to stop A and C removing him as a director?

B will need 4 votes per share. B's shares will then carry 80 votes and A and C will have votes
carrying, in aggregate, 80 votes. A and C will lack the necessary majority of over 50% to pass
an ordinary resolution.

The existence of a Bushell v Faith clause may appear to be contrary to s 168 CA 2006 because it
makes it harder to remove a director beyond the simple majority vote (ordinary resolution)
required. However, such weighted voting clauses are allowed because the requirement for an
ordinary resolution is not being changed, but rather it is the way votes are amassed which is
altered, making it easier for the imperilled director to survive. This is a matter of internal
management and private contractual agreement and is not something the court will intervene
in.

What if the director is also a shareholder?

2. Shareholders’ Agreements
A shareholders’ agreement may provide that the unanimous consent of all shareholders is
required in order for a resolution to remove a director to be passed. If a director is also a
shareholder in a company where there is a shareholders’ agreement with such a provision, this
is an important right for the director/shareholder.

It is important to note that such a provision does not remove the statutory right of the
majority shareholders to remove a director under s 168 CA 2006, as a company is bound to
accept the vote of the shareholders even if this is in breach of the provisions of the
shareholders’ agreement.

In a situation where a resolution is passed under s 168 CA 2006, (ie by a simple majority), but
without the required unanimity and therefore contrary to the terms of a shareholders’
agreement, the resolution would still be valid, and the director would be removed from
office. But the director would have a claim against the other shareholders for breach of the
shareholders’ agreement (ie a claim for breach of contract under usual contract law principles)
or alternatively could apply to the court for an injunction to prevent a breach of the terms of
the agreement.

Will the director be entitled to any compensation for loss of office?

Any such payment by a company to a director of its holding company must also be approved by
that company. However, no approval is required under s 217 CA 2006 from the shareholders of
a wholly-owned subsidiary (s 217(4) CA 2006).

Directors cannot avoid these provisions by the payment being made to a third party rather than
directly to the director themselves - under s 215(3) CA 2006 payments made to a person
connected to a director, or made to any person at their direction, or for the benefit of, a
director or a connected person, will be treated as a payment to the director and will also
require shareholder approval.
A memorandum setting out particulars of the payment must be made available to
shareholders for 15 days before the ordinary resolution is passed, ending with the date of the
general meeting (s 217(3) CA 2006).
The legislation also includes provisions requiring shareholder approval for:
• any payment for loss of office made by any person to a director in connection with the
transfer of the whole or part of the undertaking or property of a company (for example,
on a share or business sale of the company) (s 218 CA 2006); and
• any payment for loss of office made by any person to a director in connection with a
transfer of shares in the company, or one of its subsidiaries, resulting from a takeover
bid (s 219 CA 2006).

Summary
• A director’s appointment may be terminated by ordinary resolution of the shareholders
under s 168 CA 2006.
• Shareholders wishing to remove a director will need to give 28 clear days’ notice of the
resolution to remove the director to the board.
• The board is not obliged to put the resolution on the agenda of a GM.
• Shareholders can serve a notice on the board under s 303 CA 2006 to require it to call a
GM at which the resolution to remove a director will be heard. If the board fails to call a
GM within 21 days, the shareholders may call it themselves on normal notice.
• Directors who are also shareholders may protect themselves by inserting Bushell v
Faith clauses into the articles or entering into a shareholders’ agreement.
• A company may pay compensation to a director who leaves office. This will require
shareholder approval under s 217 unless one of the exceptions apply.

Derivative claims

This element introduces you to another potential remedy for minority shareholders: derivative
claims (s 260 CA 2006).
The two final minority shareholder remedies of unfair prejudice under s 994 CA 2006 and just
and equitable winding up are covered in the next element.
Introduction to derivative claims
A derivative claim is one where the shareholder’s right of action is not one which is personal
to that shareholder but instead it is one which is derived from the company’s right of action,
which the company has not exercised.
Before the enactment of CA 2006, this claim was a common law remedy established under the
exceptions to the rule in the case of Foss v Harbottle, which established the important principle
that in situations where a wrong has been done to a company, the company is the proper
claimant (acting through the board or in some circumstances the majority shareholder(s)).
Limited exceptions to this rule developed under the common law, where the court recognised
that shareholders should be allowed to bring a claim on the company’s behalf.

The rule in Foss v Harbottle: a minority shareholder is not allowed to sue for a wrong
committed against a company of which they are a member, even if the company is refusing to
take action.

The procedure for bringing a derivative claim is now set out under s 260 CA 2006.

Derivative claims under s260 CA 2006: what are they?

Section 260 CA 2006 allows shareholders to bring a derivative claim where directors have
breached their statutory duties.
Section 260 CA 2006 was a new provision introduced by CA 2006. It provides an express right to
bring a derivative claim in certain circumstances. It is therefore a statutory exception to the rule
in Foss v Harbottle.
Section 260 provides a wider range of circumstances in which a derivative claim may be
brought by a shareholder compared with the previous common law rules.
The statutory right to bring a derivative claim supports enforcement of the directors’ wider
duties. Note that any remedy granted is granted to the company itself and not to the
shareholder bringing the claim.
Section 260(1) CA 2006 defines a derivative claim brought under s 260 CA 2006 as one initiated
by a member of a company, rather than by the company itself:
a) in respect of a cause of action vested in the company; and
b) seeking relief on behalf of the company.

When can a derivative claim be brought?

Section 260(3) provides that a claim:
“… may be brought only in respect of a cause of action arising from an actual or proposed act or
omission involving negligence, default, breach of duty or breach of trust by a director of the
company.”
Note that a ‘breach of duty’ will also encompass breaches of common law duties not falling
within CA 2006.
Importantly, there is no requirement that the director has to have benefited personally from
the breach before a derivative claim can be brought.
For the purposes of s 260 CA 2006, ‘director’ includes shadow directors as well as former
directors. Note that s 260(3) CA 2006 extends to all statutory duties of directors under ss 170-
177 CA 2006 (including, for example, the s 174 CA 2006 duty to exercise reasonable care, skill
and diligence).

Against whom can the derivative claim be brought?

Under s260(3) the cause of action may be brought against ‘the director or another person (or
both)’. However a cause of action will only arise in respect of the actions or omissions of a
director.
Therefore, provided the cause of action is in respect of a relevant breach by a director
(including shadow directors), third parties may be defendants to the derivative claim, either in
lieu of the director or in addition to the director.
According to the Explanatory Notes to CA 2006, derivative claims against third parties are only
to be permitted in very narrow circumstances, for example against a third party to a contract
entered into in breach of the director’s duties, where that third party knew about the breach.
The cause of action against a third party is not set out in CA 2006, but derives from the common
law rules relating to the concept of ‘knowing assistance’ in respect of a breach of duty by a
director.

Who may bring a derivative claim?

Derivative claims brought under s 260 CA 2006 must be brought by a member. However,
pursuant to s 260(4) CA 2006 it is immaterial whether the cause of action arose before or after
the person bringing the claim became a member of the company.
A member may, therefore, bring a claim in respect of events that occurred before they became
a member of the company. This underlines the fact that the cause of action is vested in the
company, rather than the member.
By contrast, a former member cannot bring a claim even in relation to events which occurred
when they were a member.

Requirement for court approval – Stage 1

There are two stages to bringing a derivative claim.
At the first stage,the member must obtain the permission of the court to continue a derivative
claim (ie once the claim form has been issued) – s 261(1) CA 2006. The onus is on the member
to make out a prima facie case in order to obtain permission.
There are certain circumstances set out in s 263(2) CA 2006 where permission to continue the
claim must be refused by the court. These include where the court is satisfied that a person
acting in accordance with s 172 CA 2006 (the duty to promote the success of the company)
would not seek to continue the claim.
If the circumstances are not such as to be an absolute bar to the continuation of the derivative
claim, the court must then take in to account the factors listed in s 263(3) in determining
whether to allow the claim to continue. These include whether the member is acting in good
faith and whether the act or omission which gave rise to the cause of action would be likely to
be ratified by the company.

Requirement for court approval – Stage 2

If the application is not dismissed at the first stage then the court will consider the claim at the
second stage, when it must consider particular criteria. The court must have “particular regard”
to any evidence it has before it as to the views of the members who have no “personal interest,
direct or indirect, in the matter” – s 263(4) CA 2006. This provision was introduced to make it
harder for a single member to bring proceedings against the wishes of the general body of
shareholders and is considered to be an important safeguard against the bringing of tactical
litigation by disgruntled shareholders.
The requirement to obtain court permission to continue a derivative claim and the safeguards
built into s 263 CA 2006 were designed as a counterbalance to the extension of the rights to
make a derivative claim under s260 CA 2006. It was thought that the new statutory provisions
would be easier to use than the exceptions to the rule in Foss v Harbottle and thus lead to more
tactical action by minority shareholders. However, the anticipated increase in successful
derivative claims has not materialised. The courts have generally adopted a restrictive approach
in denying permission to continue derivative claims in a large number of cases.

Summary of the Two-Stage Process

STAGE 1:
• Court decides if there exists a prima facie case
• No prima facie case:
• Dismiss claim: either absolute grounds (s 263(2)) or factors in s 263(3) – SH to consider
other options…
 • A prima facie case exists:
• Allows case to proceed to STAGE 2
STAGE 2
• Detailed consideration of criteria, including evidence from other members. Case then
proceeds to trial.

Summary
• Any member has the statutory right to bring a derivative claim under s 260 CA 2006 on behalf
of the company against directors (and third parties) who have breached their duties.
• A derivative claim may be brought by a shareholder on behalf of the company in respect of a
cause of action arising from an actual or proposed act or omission involving negligence, default,
breach of duty or breach of trust by a director of the company.
• Claims may be brought against a director and/or a third party.
• Any remedy granted is to the company, not to the shareholder bringing the claim.
• There is a two-stage process for a derivative claim under s 260 CA 2006 to avoid an abuse of
this right.
• Derivative claims are rare in practice.

Unfair prejudice and just and equitable winding up

This element introduces you to:

• unfair prejudice under s 994 CA 2006, and
• just and equitable winding up under s 122 Insolvency Act 1986.

Introduction
In this element you will consider the following remedies:
• Unfair prejudice actions under s994 CA 2006
• Just and equitable winding up under s122 Insolvency Act 1986 (‘IA 1986’)

These remedies are not used very frequently in practice but their existence and the threat of
claims being brought will be ever-present in the directors’ minds and may have an impact on
their conduct.
Unfair prejudice – s 994 CA 2006
Section 994 CA 2006 allows a member to bring an action on the grounds that the company is
being run in such a way that they have suffered unfair prejudice.
This is a long-established provision which is preserved under CA 2006. Examples of conduct that
may be held to be unfairly prejudicial to the interests of members include:
• the granting of excessive remuneration to directors;
• directors’ dealing with associated persons; and
• non-payment of dividends.
Note that under s 994 CA 2006 the shareholder sues for themselves, whereas unders 260 CA
2006 (derivative actions) the shareholder sues on behalf of the company in respect of the
company’s loss.
Section 994(1) CA 2006 provides that:
A member of a company may apply to the court by petition for an order….on the ground:
(a) that the company’s affairs are being or have been conducted in a manner that is
unfairly prejudicial to the interests of members generally or of some part of its members
(including at least that shareholder), or
(b) that an actual or proposed act or omission of the company (including an act or
omission on its behalf) is or would be so prejudicial.
If the shareholder can show that the company’s affairs are being conducted in a manner
unfairly prejudicial to their interests, or that some act or omission of the company has unfairly
prejudiced them, in terms of the reasonable bystander (objective) test – (Re Guidezone
Limited), the court will decide what remedy is appropriate in the circumstances.

Unfair prejudice – s994 CA 2006

Key principles
The meaning of unfairly prejudicial conduct has been developed through case law and you
should note the following principles:
• Negligent or inept management of a company – this will not amount to unfairly
prejudicial conduct unless that conduct amounts to serious and/or repeated
mismanagement which puts at risk the value of the minority shareholder’s interest;
• Disagreements as to company policy - such as a change in direction of the business, will
also not afford grounds for a petition under s 994 CA 2006;
• Bad faith – there is no need to show either bad faith or conscious intent for the conduct
to be unfair;
 • Breaches of the articles of association – see Lord Hoffmann in O’Neill v Philips:“a
member of a company will not ordinarily be entitled to complain of unfairness unless
there has been some breach of the terms on which he agreed that the affairs of the
company should be conducted… [However,] there will be cases in which equitable
considerations make it unfair for those conducting the affairs to rely upon their strict
legal powers”;
• Claimant’s conduct – although the conduct of the claimant may be relevant in deciding
whether the prejudice was unfair, there is no overriding requirement that the claimant
come to court with “clean hands;
• Excessive remuneration –the courts will take a wide view of the prejudice that may be
suffered by a minority shareholder;
• Legitimate expectation – in terms of certain small private companies (which are often
referred to as quasi-partnerships, case law has established that shareholders may have
a legitimate expectation that they be involved in the management of the company, and
the prevention of such involvement may equate to unfairly prejudicial conduct.

Unfair Prejudice - Remedies

Under s 996(1) CA 2006 the court has the power to grant such order as it thinks fit to provide
relief.
Section 996(2) CA 2005sets out a list of particular types of order that may be made. These
include orders regulating the future conduct of the company’s affairs and requiring the
company to do or refrain from doing certain acts.
The most commonly made order is to provide for the purchase of the petitioner’s shares by the
wrongdoer(s) (only rarely does this result in an order entitling the minority shareholder(s) to
purchase the shares of the majority shareholder(s)).
The value at which such shares are to be purchased is a fundamental issue and usually a matter
which is argued.

Valuation Principles
The court has a wide discretion in relation to valuation matters and its aim is to set a fair price.
The following principles apply to valuations generally, although the court will look at all the
circumstances of the case:
• Shareholders should first attempt to use a valuation mechanism set out in the articles (if
any) provided that it is fair. However, if there is no fair method then a court valuation
will be necessary.
 • The courts will generally not impose a discount on the value of a minority shareholding
in a private company, on the basis that the minority shareholder is being forced to sell
their shares because of the unfairly prejudicial conduct of the majority shareholder. This
is particularly the case where the company has been controlled and operated by all the
shareholders playing major roles (a quasi-partnership). However, the court may order a
discount to be applied if the shareholding is viewed as an investment or the company is
operated along more commercial lines.
• As a general rule the valuation date is that on which the court order was made.
• The behaviour of the claimant may be relevant eg if they previously rejected a
reasonable offer.

Unfair prejudice – s994 CA 2006 Commercial Points

In practice, where one side is willing to buy out the shares held by the other and the dispute
centres around the valuation of those shares, the court will encourage the parties to settle out
of court by means of a binding third-party valuation of the shares. If the petitioner objects to
such an out of court settlement, the court will usually require them to give reasons for their
objection.
Therefore, if a shareholder wants to avoid the situation where the court makes an order for the
purchase of their shares, a petition under s 994 CA 2006 may not be a suitable course of action.
Section 994 petitions are likely to be expensive, time-consuming and complicated to bring.
Since the court has discretion to make such order as it thinks fit, such petitions also bring with
them a great deal of uncertainty for the petitioner.
Generally, a negotiated settlement will, therefore, be the preferred option.
Just and equitable winding up Section 122 Insolvency Act 1986
The final, and most drastic, remedy available to any shareholder is the right to bring a
petition to the court for the company to be wound up (liquidated) on the grounds that it is
just and equitable to do so.
The right for a disgruntled shareholder to apply for the company to be wound up on the
grounds that it is just and equitable to do so arises under s 122(1)(g) Insolvency Act 1986.
When a company is wound up its life is effectively brought to an end. This is therefore a rather
drastic solution for a disgruntled shareholder. In such cases the court has discretion to decide
whether it is just and equitable for winding up to take place.
As there is a degree of overlap between the sections, it is common for a s 122 IA 1986 and a s
994 CA 2006 petition to be made at the same time.
Summary
• Any shareholder can bring an unfair prejudice claim under s 994 CA 2006 on the grounds
that the running of the company has unfairly prejudiced them.
• A claim under s 994 CA 2006 is a personal action brought by the shareholder against the
company.
• The various orders for relief are set out in s 996 CA 2006 and the most common order
would be that the other shareholders or the company buy the claimant shareholders'
shares from them.
• It is possible, but rare for a minority shareholder to apply to bring a petition to the court
for the company to be wound up because it is “just and equitable” to do so.

Professional Skills – Case and Matter analysis

Suggested methodology (part 1)

Suggested methodology (part 2)
Suggested methodology (part 3)
Business Law & Practice - Workshop 5
Equity finance

Introduction to shares

What is capital?
The general term ‘capital’ is used to refer to the funds available to run the business of a
company. In company law, the term ‘share capital’ relates to the money raised by the issue of
shares. The share capital is contributed by investors in the company and is represented by
shares that are issued to such investors.

Why does a company need funds?

When a company is set up, funds are needed to get the business started, eg to buy stock and
machinery. Funds are also needed to keep the business going, commonly known as ‘working
capital’. Funds are also needed for expansion and growth, eg by taking on new premises or
buying other businesses.

How does a company fund its business?

There are various ways in which a company can raise funds, including by issuing shares, (ie
‘equity finance’); borrowing (ie ‘debt finance’); and/or retaining its profits for use in the
business (rather than paying the profits to the shareholders).

Equity finance: what are shares?

A share is often described as a ‘bundle of rights’.

By investing in the share capital of any company, the investor becomes a part owner of the
company and will often have voting rights in shareholder meetings. In the case of a private
company, most investors make a long-term investment and will only usually get their
investment back on a sale of their stake, a sale of the company itself, on a flotation, or when
the company is wound up (provided sufficient funds are available).

The incentives for investing would be the receipt of income (by way of dividend) and a capital
gain (by way of the growth in the value of the company, and therefore the individual shares),
although neither are guaranteed.
Different classes of shares may carry different rights and entitlements. All rights and
entitlements in relationto shares of all classes are set out in the Articles. It is imperative to
check these.

Share capital structure

Nominal or par value

Section 542(1) CA 2006 provides that the shares in a limited company having a share capital
must have a fixed nominal value. Section 542(2) CA 2006 provides that any allotment of a share
that does not have a fixed nominal value is void. The nominal or par value of a share is the
minimum subscription price for that share.

It represents a unit of ownership rather than the actual value of the share. Common nominal
values for ordinary shares are 1p, 5p or £1.
Section 580 CA 2006provides that a share may not be allotted/issued by a company at a
discount to its nominal value.

Premium
However, a share may be allotted/issued for more than its nominal value, and the excess over
nominal value is known as the ‘premium’. The market value will often be much higher than the
nominal value of the share.

Share Terminology
Issued Shares
The amount of shares in issue at any time is known as the issued share capital (‘ISC’). This is the
amount of share capital that will be shown in the company’s balance sheet in its accounts. This
was the same under CA 1985. A company’s ISC is made up of:
• shares purchased by the first members of the company, known as the ‘subscriber
shares’; and
• further sharesissuedafter the company has been incorporated, to new or existing
shareholders. New shares can be issued at any time provided that the correct
procedures are followed.

Allotted Shares
‘Allotment’ is defined in s 558 CA 2006. Shares are said to be allotted when a person acquires
the unconditional right to be included in the company’s register of members in respect of those
shares. This term is often used interchangeably with the issue of shares but the terms have
different meanings. There is no statutory definition of ‘issue’, but it has been held that shares
are only issued and form part of a company’s issued share capital once the shareholder has
actually been registered as such in the company’s register of members, and their title has
become complete. Section 112(2) CA 2006 confirms that full legal title to shares is only
achieved once a person’s name is entered in the company’s register of members.

Called-up/Paid-up Shares
It is not necessary for shareholders to pay the full amount due on their shares immediately. The
amount of nominal capital paid is known as the ‘paid-up share capital’. The amount
outstanding can be demanded by the company at any time. Once demanded, the payment has
been ‘called’. It is increasingly rare for shareholders not to pay the full nominal value of their
shares on issue.

The definition of ‘called-up share capital’ in s 547 CA 2006 is the aggregate amount of the calls
made on a company’s shares and the existing paid-up share capital. Given that shares are rarely
not fully paid up, this term is not regularly used.

Treasury shares
These are shares that have been bought back by the company itself and are held by the
company ‘in treasury’. Treasury shares are issued shares being held by the company in its own
name, and the company can subsequently sell those shares out of treasury.

Note that although such a sale of shares is a transfer, not an issue, of shares, s 561 CA 2006 pre-
emption rights (see s 560(3) CA 2006) and s 573 CA 2006 disapplication of pre-emption rights
will apply.

The company can also choose to cancel treasury shares at any time or transfer them to an
employee share scheme.

Classes of shares
A company may have different classes of shares. Some common types of share are listed below.
The differing rights usually relate to entitlements to vote, entitlements to dividends and to the
return of capital when a company is wound up. There is nothing in CA 2006 which defines
classes of shares or class rights and the label attached to a share is not determinative.

The rights attached to a class of shares are determined in the company’s Articles.
• Ordinary shares
• Redeemable shares
• Preference shares
 • Non-voting shares
• Employees' shares
• Cumulative shares
• Convertible shares
• Deferred shares

Ordinary shares
Ordinary shares the most common form of share and are the default position: if a company's
shares are issued without differentiation, they will be ordinary shares.

Ordinary shares carry a right to vote in general meetings, a right to a dividend if one is declared
and a right to a portion of any surplus assets of the company on a winding-up. A company may
have more than one class of ordinary share, with differing rights, and perhaps differing nominal
values.

Ordinary shares are defined in s 560(1) CA 2006 as "shares other than shares that as respects
dividends and capital carry a right to participate only up to a specified amount in a
distribution". This negative definition illustrates the point that ordinary shares are the default
position and are shares that have an unlimited right to participate in dividends and in surplus
capital when a company is wound up. These shareholders receive a fraction of the dividend and
capital in accordance with their shareholding.

Although ordinary shareholders receive dividends after preference shareholders, one

advantage of ordinary shares is that the entitlement of ordinary shareholders to a dividend is
unrestricted.

Preference shares
A preference share may give the holder a ‘preference’ as to payment of dividend or to return of
capital on a winding up of the company, or both. This means the payment will rank as higher
priority than any equivalent payment to ordinary shareholders.

If there is a preference as to dividend, this will be paid before the other shareholders receive
anything.

The amount of preferred dividend is usually expressed as a percentage of the par (nominal)
value of the share eg 5% £1 preference shares – these shares give an entitlement to 5% of £1
per share (which equates to 5p per share) by way of dividend each year provided a dividend is
declared.
If the preference shares have been issued at a premium to their par value and it is intended
that a fixed dividend will be paid based on the amount subscribed for the share (ie par plus
premium), the share rights must expressly state that the dividend is to be calculated as a
percentage of the total subscription price per preference share.

Preference shares are normally non-voting although it is important to check the rights set out in
the Articles since it is possible to issue preference shares with voting rights.

Cumulative preference shares

It is presumed that a preference share is ‘cumulative’ unless otherwise stated. This means that
if a dividend is not declared for a particular year, the right to the preferred amount on the share
is carried forward and will be paid, together with other dividends due, when there are available
profits. If this accumulation is not desired, then the share must be expressed to be non-
cumulative.

Participating preference shares

‘Participating’ preference shareholders may participate, together with the holders of ordinary
shares, (1) in surplus profits available for distribution after they have received their own fixed
preferred dividend; and/or (2) in surplus assets of the company on a winding up. As with
preference shares, participating preference shares are almost always issued with a fixed
dividend and can be cumulative if stated as such in the articles of association. Participating
preference shares with these characteristics are generally called ‘fixed rate participating
cumulative preference shares’.

Example

Company A has participating preference shares in issue which carry a right to receive a fixed
preferential dividend of 5% of the par value of the shares per annum. The shares have a par
value of £1 each.

Assuming that a dividend has been declared, the preference shareholders would be entitled to
receive a dividend of 5p per share per annum before the ordinary shareholders receive any
dividend. They would then also be entitled to a fraction of the remaining general dividend
alongside the ordinary shareholders.

Company B has non-participating preference shares in issue which carry a right to receive a
fixed preferential dividend of 5% of the total subscription price per share per annum. The
shares have a par value of £1 each but were subscribed for at a price of £2 per share.
Assuming that a dividend has been declared, the preference shareholders would be entitled to
receive a dividend of 10p per share per annum before the ordinary shareholders receive any
dividend. They would not be entitled to any further dividend.

Deferred, redeemable and convertible shares

Deferred shares
These carry no voting rights and no ordinary dividend but are sometimes entitled to a share of
surplus profits after other dividends have been paid (presuming there is a surplus); more
usually ‘deferred’ shares carry no rights at all and are used in specific circumstances where
‘worthless’ shares are required.

Redeemable shares
Redeemable shares are shares which are issued with the intention that the company will, or
may wish to, at some time in the future, buy them back and cancel them.

Convertible shares
Such shares will usually carry an option to ‘convert’ into a different class of share according to
stipulated criteria.

Variation of class rights

A company may issue different classes of share, as seen above. The rights attaching to each
class are usually set out in the company’s Articles. In relation to any type of share, you should
always refer to the Articles to find the relevant rights attaching to a share, since there are no
formal, universal definitions of different types of share.

If an attempt is made to alter the Articles of a company such that existing class rights are
varied, the resolution in question will not be effective unless varied in accordance with
provisions in the company’s Articles for the variation of those rights or, where Articles don’t
contain such provisions, by consent in writing of holders of at least 75% of the issued shares of
that class or by means of a special resolution passed at a separate general meeting of holders of
that class (s 630 CA 2006).

Shareholders holding 15% of the relevant shares may (provided they did not vote in favour of
the variation) apply to court within 21 days of the resolution to have a variation cancelled (s
633(2) CA 2006). Following such application, the variation will not take effect unless and until it
is confirmed by the court. The court will not confirm the variation if it feels that the variation
unfairly prejudices the shareholders of the class in question.
Dividends
The main reason for shareholders to invest in shares in a company is generally to make money.
Shareholders may receive a return on their investment in two ways:
• By receipt of dividends (income receipts), and
• An increase in the capital value of the shares.
Dividends are only payable by a company if it has sufficient distributable profits (s 830(1) CA
2006).

'Distributable profits' means the company's accumulated realised profits less its accumulated
realised losses (s 830(2)).

There are two types of dividend:

1. Final dividends – Final dividends are declared by the directors and approved by an
ordinary resolution of the shareholders following the financial year end.
2. Interim dividends - The articles of a company normally give the directors the power to
decide to pay interim dividends if the company has sufficient distributable profits (MA
30 allows this). Interim dividends can be paid without the need for an ordinary
resolution of the shareholders. Interim dividends are often paid where the company has
realised an investment.

Summary
• The term 'capital' refers to all of the company’s assets, of whatever nature. The term
‘legal capital’ refers to the company's share capital.
• A share is a ‘bundle of rights’ in a company that often provide voting rights. Shares (and
the rights attaching to them) can broadly be categorised into six groups:
• ordinary shares;
• preference shares;
• participating preference shares;
• deferred shares;
• redeemable shares; and
• convertible shares.
• There are no statutory definitions of different types of shares. The rights attaching to
shares are set out in the company’s Articles.
Allotment, transfer and transmission of shares

Allotment, transfer and transmission of shares

This element considers some important restrictions on allotment and sets out the process by
which a company may transfer shares. Transmission of shares on death or bankruptcy is also
covered.

The procedure for issuing new shares is covered in the next element.

What is the difference between allotting and transferring shares?

An allotment of shares is a contract between the company and a new/existing shareholder
under which the company agrees to issue new sharesin return for the purchaser paying the
subscription price.

A transfer is a contract to sell existing shares in the company between an existing shareholder
and the purchaser.The company is not a party to the contract on a transfer of shares (with the
exception of a sale out of treasury of treasury shares).

Considerations on allotment
The s 755 restriction on private companies offering shares to the public
Under s 755 CA 2006 a private company limited by shares is prohibited from offering its shares
to the public. As a result, private companies are essentially restricted to offering their shares to
targeted investors only and not to the public indiscriminately.

The expression ‘offer to the public’ (as defined in s 756 CA 2006) covers offers to ‘any section of
the public’ but excludes offers which are intended only for the person receiving them and offers
which are a ‘private concern’ of the persons making and receiving them. This latter exclusion
covers offers made to existing shareholders, employees of the company and certain family
members of those persons, and offers of shares to be held under an employee’s share scheme.

These excluded offers will not fall foul of the s 755 restriction. This restriction must be
considered carefully when a private company is proposing to allot shares.

The requirement for a prospectus

Every time that a company offers shares you will need to consider whether it is required to
publish a prospectus to would-be investors. A prospectus is an explanatory circular giving
investors details about the company and about the investment itself on which to base their
investment decision. A prospectus should contain all the information necessary to enable
investors to make an informed assessment of the financial status of the company and the rights
attaching to the shares (s 87A(2) FSMA), and preparing a prospectus is therefore an expensive
and time-consuming process.
In an offer of shares by a private company, it will usually be the case that a prospectus will
not be required. However, you will need to consider the rules each time.

Financial Promotions
Under s 21 FSMA a financial promotion is any invitation or inducement (in the course of
business) to engage in investment activity (which includes buying shares). Financial promotions
are prohibited (for all companies) unless certain requirements set out in FSMA are fulfilled.
Clearly this is potentially relevant when a company is considering issuing shares to investors.
Communications made by a company when issuing its shares must, either be within an
exemption from the s 21 FSMA prohibition or be issued or approved by an authorised person.

Transfer and transmission of shares

Transmission of shares is an automatic process in the event of death or bankruptcy of a
shareholder as follows:
• If a shareholder dies, their shares will automatically pass to their personal representatives.
• If a shareholder is made bankrupt, their shares automatically vest in their trustee in
bankruptcy.

Transfer
Shares may be transferred from an existing shareholder to a new shareholder by way of sale or
gift.

Shareholders are free to transfer their shares subject to any restrictions in the Articles (s 544(1)
CA 2006).

It is therefore important to check the Articles for any restrictions on transfer.

Some common restrictions are set out below.

Restrictions on transfer
The two most common forms of restriction are:
1. Directors’ power to refuse to register
a. Article 26(5) MA states: “The directors may refuse to register the transfer of a
share, and if they do so, the instrument of transfer must be returned to the
transferee with the notice of refusal unless they suspect that the proposed
transfer may be fraudulent”.
b. Under s 771 CA 2006, a company must give reasons if it refuses to register a
transfer.
1. Pre-emption clauses (rights of first refusal)
a. Here we are looking at pre-emption rights on a transfer of shares (which should
not be confused with pre-emption rights on allotmentunder s 561 CA 2006).
Such rights are usually set out in the articles. CA 2006 and MA do not contain any
pre-emption rights on transfer, so they must be specially inserted into the
Articles of any company wishing to establish them. Pre-emption rights on
transfer will often require that a shareholder wishing to sell shares must offer
 them to the other existing shareholders before being able to offer them to an
outsider.

Method of transfer

Instrument of transfer
A transfer of shares is made by way of a stock transfer form, which has to be signed by the
transferor and submitted, with the share certificate, to the new shareholder (s770 CA 2006).

Legal and equitable ownership

Beneficial title to the shares passes on the execution of the stock transfer form. Legal title
passes on the registration of the member as the owner of those shares in the register of
members by the company (s 112 CA 2006). The company will also send the shareholder a new
share certificate in this name within two months (s 776 CA 2006).

Stamp duty
The stock transfer form must be stamped before the new owner can be registered as the holder
of those shares. Stamp duty is currently payable at 0.5% of the consideration rounded up to the
nearest £5. No stamp duty is payable where the consideration is £1000 or less; but where the
consideration is more than £1000, a minimum fee of £5 is payable.

Summary
• It is possible for a company to allot new shares or for existing shares to be transferred
between shareholders by way of sale or gift.
• Private limited companies are prohibited from offering shares to the public.
• When a shareholder is seeking to transfer shares, the Articles must always be checked
to ensure there are no restrictions on transfer or pre-emption rights.
• Transfer of shares is effected by the transferor signing a stock transfer form and giving
this to the transferee together with the share certificate.
• Stamp duty is payable on transfer of shares at 0.5% (subject to a minimum payment of
£5) where the sale price exceeds £1,000.
• Transmission of shares is an automatic process in the event of death or bankruptcy of a
shareholder.

The procedure for allotment of shares

Introduction
Remember, in company law, the term ‘share capital’ relates to the money raised by the issue
of shares. The share capital is contributed by investors in the company and is represented by
shares that are issued to such investors.
Many companies will be incorporated with just one single share. As a way of raising finance, the
company may choose to issue more shares.

In the context of issuing shares, it is important that you appreciate whether the company you
are instructed by has been incorporated under the CA 2006 or the CA 1985 as there are
differences between the way in which these companies will issue shares.

In this element, you will consider the five-step process which a company needs to go through
to issue shares. It could be that no action is needed at one or more of the stages. However,
working through the five stages in each case will aid your understanding and ensure that you
identify all the steps required in each particular case.

STEP 1: Any cap on the number of shares that may be issued?

Before issuing new shares, you must check the company’s Articles for any cap or limit on the
number of shares that may be issued. If this is to be exceeded, the cap must be removed, or the
limit increased.

A company incorporated under CA 1985 will originally have had an authorised share capital
(‘ASC’), which acted as a ceiling on the number of shares it could issue. These companies (since
1 October 2009) will continue to have a deemed ceiling on the number of shares that can be
issued, in their articles, unless such cap is removed from their Articles.

The requirement for a company to have an ASC no longer exists under CA 2006. Companies
incorporated under CA 2006 will not have an authorised share capital and shareholders wishing
to impose a cap to restrict the number of shares which such a company can issue will need to
amend the Articles (by special resolution) to include suitable provisions.

How can the cap be removed?

For companies incorporated under CA 1985, shareholders wishing to remove or amend the
deemed restriction in a company’s Articles may do so by ordinary resolution. This is despite the
fact that removing such a deemed restriction involves changing the Articles, which would
normally require a special resolution under s 21(1) CA 2006.

Any such deemed restriction will also fall away as a consequence of the company adopting,
wholesale, new Articles (such as MA) which do not include provision for any cap (applying s
21(1) CA 2006).

Companies incorporated under CA 2006 will not have an authorised share capital. For such
companies, therefore, there will be no bar to issuing shares under step 1.
The only exception would be if the company has placed a provision in its Articles limiting the
number of shares that may be issued. If such a restriction exists, it can be removed, or the limit
increased, by special resolution under s 21(1) CA 2006.
Under s 617(2)(a) CA 2006, each time a company issues shares, its share capital increases
automatically.

Step 1: Summary
For step 1, you must therefore check:
• whether any resolutions to remove, impose or change any cap, or increase the share
capital, have been passed, and ensure that you have up-to-date information
(particularly checking the company’s Articles); and
• whether any shares have been issued by checking the register of members or the most
recent confirmation statement*filed at Companies House and any subsequent forms
filed on allotments of shares (using Form SH01 under s 555 CA 2006).
• If the company does not have a limit on its share capital or if there are sufficient
unissued shares available within any cap for a proposed new issue, the company can
proceed to step 2.

*Companies are required to file an annual confirmation statement. This confirmation statement
states (‘confirms’) that the company has filed all necessary returns in the previous 12-month
period (eg changes to registered address, changes to directors or company secretary etc). It
also sets out any changes to share capital.

STEP 2: Do the company’s directors need authority to allot?

Directors are responsible for the actual allotment of shares to a shareholder and they must
resolve by board resolution to make an allotment. However, they may need to have the prior
authority of the shareholders to be able to do this.

Section 549 CA 2006 provides that the directors of a company must not exercise any power of
the company to allot shares in the company except in accordance with:
• s 550 CA 2006: for private companies with only one class of shares in existence, the
directors will have automatic authority to allot new shares of the same class, or
• s 551 CA 2006: for all other companies, the directors will need to be granted authority
to allot the new shares by the shareholders by way of ordinary resolution.
• Section 550 – Private companies with only one class of share
In private companies with only one class ofshare, s 550 CA 2006 provides that directors have
the automatic power to allot shares of that same class, unless they are prohibited from doing
so by the company’s Articles.

This helps many smaller companies to simplify the process of issuing shares, since no
shareholder resolution is required to grant authority to directors to allot the new shares.

Note that for companies incorporated under CA 1985, an ordinary resolution is required to
authorise the directors to rely on s 550 CA 2006.
All other cases: Section 551 CA 2006
If s 550 CA 2006 cannot be relied upon, directors require authority under s 551(1) CA 2006,
which provides that authority may be given by a provision in the company’s Articles or by
shareholder resolution. Under s 281(3), this means an ordinary resolution unless the Articles
require a higher majority. You would therefore need to check the latest version of the
company’s Articles and any resolutions that have been passed giving the directors authority, in
order to establish whether further authority is required.

Authority to allot under s 551(1) CA 2006 can only be given subject to limits in terms of both
time and number of shares (s 551(3) CA 2006). This means that if the company has already
granted its directors a s 551(1) CA 2006 authority, it must be checked to ensure it is still valid.

STEP 3: Must pre-emption rights be disapplied on allotment?

What does a ‘pre-emption right’ mean?

It means the ‘right of first refusal’. New shares should be offered pro rata to existing
shareholders before any new investor.

This is because, when a company allots shares to new shareholders, there is an effect on the
proportionate ownership of the company held by the existing shareholders. Their ownership
is diluted, and therefore their entitlement to dividends and voting power is also diluted.

Due to the potential dilution, s 561 CA 2006 contains pre-emption rights, which give protection
to existing shareholders.

Where pre-emption rights apply, the most usual approach is for the company to request the
existing shareholders to disapply these pre-emption rights by special resolution.

Consider the following example:

XYZ Ltd has issued share capital of 100 ordinary shares of £1 each. The shares are held as
follows:
A 20 shares 20%
B 80 shares 80%
100 shares 100%
B, on a poll vote, has the power to pass ordinary and special resolutions without A’s support.
This means, for example, that B, acting alone, can change the constitution of XYZ Ltd by altering
its Articles, and has control of the board of directors as they have the power to appoint and
remove directors. In addition, B is entitled to larger dividends than A.
If XYZ Ltd now issues a further 100 ordinary shares of £1 each to a new shareholder, C, the
position is:
A 20 shares 10%
B 80 shares 40%
C 100 shares 50%
200 shares 100%
On a poll vote, each of the shareholders now needs the support of at least one other
shareholder to be able to pass an ordinary or special resolution. The only control that any of
them has is that B is able to block special resolutions and C is able to block both ordinary and
special resolutions. In addition, both B and A are now entitled to lower levels of dividends.

To what type of shares are pre-emption rights relevant?

Section 561 CA 2006 states as follows:

”(1) A company must not allot equity securities to a person on any terms unless
(a) it has made an offer to each person who holds ordinary shares in the company to allot to
him on the same or more favourable terms a proportion of those securities that is as nearly as
practicable equal to the proportion in nominal value held by him of the ordinary share capital of
the company …”

As a result, any new ‘equity securities’ (defined ins 560 CA 2006) must be offered to the
existing shareholders of a company (holding ordinary shares), in proportion to their existing
shareholdings, before they can be offered to anyone outside the company.
Under s 560(1) CA 2006, ‘equity securities’ are (i) ‘ordinary shares’ or (ii) rights to subscribe for,
or convert securities into, ordinary shares.

However, under s 560(1) there is a special statutory definition of ‘ordinary shares’, the
meaning of which is wider than we are accustomed to in everyday parlance.
‘Ordinary shares’ are shares ‘other than shares that as respects dividends and capital carry a
right to participate only up to a specified amount’ for this purpose.

This means that if a class of shares carries a right to receive dividends and, on a winding up,
capital payments, and these rights are both capped, the shares will not fall within the
definition of ‘equity securities’ and will not need to be offered pre-emptively.
In every other case, the shares will fall within the definition of ‘equity securities’ and be subject
to pre-emption rights under s 561 CA 2006.

Example:
XYZ Ltd has a class of shares in issue which carry a right to receive a fixed preferential dividend
of 5% of the nominal amount of the shares with no other right to any dividend. In addition, the
shares carry a right to share pari passu with the ordinary shareholders in any surplus assets on a
winding up.

These shares are equity securities for the purpose of s 560(1) CA 2006 because even though the
right to receive dividends on the shares is capped (at 5%) they carry an uncapped right to
participate in capital payments on a winding up.
Can a company disapply pre-emption rights?
Yes. The procedure for giving effect to pre-emption rights (which can be found in s 562 CA
2006) can be lengthy and, especially for companies with numerous shareholders, complicated
to carry out.

On many occasions it will not be appropriate or desirable to follow the pre-emption rights
procedure set out in CA 2006: for example, where all shareholders agree that the company
ought to bring in a new shareholder. In such a case, the company would want to disapply or
excludethe pre-emption rights. This is permitted in CA 2006, with the permission of the
company’s existing shareholders.

In practice, companies usually use one of these two methods to disapply pre-emption rights,
depending on the source of the directors’ authority to allot the shares.

1. General disapplication of pre-emption rights

A company may disapply pre-emption rights where the directors are generally authorised
for the purposes of s 551 CA 2006 by passing a special resolution or by including the
disapplication in its articles, both under s 570(1) CA 2006. This is not a permanent
disapplication, but attaches to a particular, pre-existing s 551 authority. In practice, this is
the most common means by which companies dispense with pre-emption rights on
allotment.

2. Private companies with one class of share – disapplication by special resolution

Section 569 CA 2006 provides for disapplication of pre-emption rights for private
companies with only one class of share by special resolution. Such a disapplication
presupposes the directors’ authority to allot the shares derives froms 550 CA 2006 and
therefore can apply for so long as the company has in issue, and allots, shares of only one
class.

3. There are other ways to disapply pre-emption rights:

• Specific disapplication of pre-emption rights: It is possible, although uncommon, for a
company to disapply pre-emption rights in relation to a specific allotment of shares (eg
in relation to shares being issued to a particular person or as consideration for a
specific purpose) by passing a special resolution under s 571 CA 2006 (rather than s
570 CA 2006). The procedure for specific disapplication is more cumbersome than that
for a general disapplication. Directors will need to provide the company’s shareholders
with a written statement explaining (i) the reasons for the specific disapplication, and (ii)
the amount to be paid to the company pursuant to the allotment along with justification
for the amount, under s 571(6) CA 2006. A specific disapplication under s 571 attaches
to a particular, pre-existing s 551 authority.
• Private companies – exclusion of pre-emption rights in Articles (s 567 CA 2006): Private
companies can exclude statutory pre-emption rights permanently, by way of a provision
in their Articles. However, companies rarely exclude pre-emption rights on a permanent
basis because this would give existing shareholders no protection from dilution (there is
 no such provision in MA). In practice, only subsidiary companies commonly exclude
statutory pre-emption provisions in their Articles.
• Private companies with one class of share – disapplication in Articles (s 569 CA
2006): provides for disapplication of pre-emption rights for private companies with only
one class of shareunder the Articles. This is also unusual in practice because it leaves
existing shareholdings no protection from dilution.

STEP 4: Must new class rights be created for the shares?

When issuing new shares, a company may also wish to create a new class of shares, such as
preference shares.

You considered some examples of rights typically attached to different classes of shares in
element 1.

In order to create a new class of shares, it is necessary for the company, in addition to taking
some or all of the steps set out previously, to insert new provisions in its Articles dealing with
the rights attached to those new shares.

An alteration to the Articles, you will recall, requires a special resolution of the shareholders
under s 21 CA 2006 (except if removing a cap transferred from a company’s authorised share
capital in its memorandum).

STEP 5: Directors must pass a board resolution to allot the shares

The directors will resolve by board resolution to allot new shares on behalf of the company. Any
requirements for shareholder resolutions must be dealt with in a general meeting before the
board meeting is held at which the new shares are allotted. A general meeting will not be
needed in advance of the board meeting if:
• has no limit in its constitution on the number of shares which can be issued by the
company; and
• does not require directors’ authorisation because the company is a private company
with only one class of shares and there is no restriction in the company’s Articles – s 550
CA 2006) or has already given the directors authority to allot shares; and
• is issuing the shares to existing shareholders in proportion to their existing
shareholdings and follows the procedure in s 562 CA 2006 or has already disapplied s
561 CA 2006 or is a private company and has taken advantage of s 567 CA 2006; and
• has the relevant class rights in its Articles.

Administrative requirements on allotment

Copies of resolutions to be sent to Companies House within 15 days (s 29, s 30(1), s 26(1))
• All special resolutions
• Any s 551 ordinary resolution granting directors authority to allot
• CA 1985 companies: also need to file any ordinary resolution removing the cap on
authorised share capital and any ordinary resolution allowing the company to use s 550
CA 2006
 • Amended Articles must also be sent to Companies House if a new class of shares has
been created and the Articles amended
Company forms to be sent to Companies House
• Return of allotment (Form SH01) and statement of capital within one month
• If the persons with significant control have changed as a result of allotment, the relevant
forms (PSC01, PSC02, PSC04, PSC07)

Updating company registers

• Update register of members within two months
• Update PSC register if necessary

Share certificates
Share certificates must be prepared and sent to new shareholders within two months

Summary
• When issuing shares, a company needs to follow a 5-step procedure.
• Step 1 – check whether there is a cap on the amount of shares that can be issued by the
company.
• Step 2 – check whether company directors need authority to allot the shares.
• Step 3 – are the shares equity securities? You will be able to work this out by looking at
the dividend and capital payout on the shares. If both are capped, the share is not an
equity security and therefore pre-emption rights are not relevant. If the shares are
equity securities, consider whether the company needs to disapply pre-emption rights.
• Step 4 – is the company creating a new class of share? If so, the Articles will need to be
amended to incorporate the new class rights.
• Step 5 – Board will resolve to allot the shares. This step will always be required,
regardless of the other steps.
• Finally, there will be administrative matters to attend to.

Financial assistance

When shares are being acquired in a company, there are statutory rules prohibiting certain
companies involved in the acquisition from giving assistance for the purpose of the
acquisition. Very broadly speaking, the statutory rules are relevant to public companies and
private companies in groups which contain public companies.

Example:
An individual wishes to purchase shares in a public company but is having trouble raising
finance. The company whose shares are to be purchased may consider making a loan to that
individual to enable them to proceed with the share purchase. However, the directors need to
be aware that the proposed loan may constitute financial assistance in accordance with CA
2006 and thus be illegal.
The statutory provisions on financial assistance are derived from the doctrine of maintenance
of capital and the legislation is designed to protect public companies’ assets representing share
capital.

To which transactions are the rules on financial assistance applicable?

Acquisition or sale of shares

Financial assistance is relevant when there is an acquisition (or proposed acquisition) of
shares.

A share sale involves an acquisition by way of a share transfer. When a share sale is
contemplated, therefore, the funding arrangements should be examined carefully to see if they
fall foul of the financial assistance prohibitions.

Issue of shares
Financial assistance is also relevant on an issue of shares by a company to an investor, since
that equally amounts to an acquisition of shares by the investor.

Which companies are prohibited from giving financial assistance?

Sections 678(1), 678(3), 679(1) and 679(3) CA 2006 set out the basic prohibitions on the giving
of financial assistance. It is important to analyse the wording of ss 678 and 679 CA 2006 very
carefully to determine which companies are caught by these prohibitions.

It is first necessary to establish the identity of the company in which shares are being
acquired.
• On a share sale this will be the company which is the subject of the acquisition.
• On an issue of shares this will be the company doing the issuing.

The company whose shares are being acquired (whether by transfer or issue) will be referred
to as the target company.

It is then necessary to consider whether the target company is a public company, in which case
the relevant section to consider is s 678 CA 2006, or a private company, in which case the
relevant section to consider is s 679 CA 2006.

If the target company is a public company, under s 678(1) and (3) CA 2006 the prohibition on
giving financial assistance applies to:
• The target company itself; and
• any subsidiary of the target company, whether private or public

Example (Share Sale):

A Ltd is selling the shares in its subsidiary B Plc. B Plc in turn has a subsidiary, C Limited. In this
case the target company, B Plc, is a public company, so the prohibition on giving financial
assistance would apply to both B Plc and its subsidiary, C Ltd (s 678(1) and (3) CA 2006).
If the target company is a private company, under s 679(1) and (3) CA 2006 the prohibition on
giving financial assistance applies to any public company subsidiary of the target company.
Example (Share Issue)

E Ltd is proposing to issue shares to an investor, Mr D. E Ltd has a subsidiary, F Plc. In this case
the target company, E Ltd, is a private company, so the prohibition on giving financial assistance
would only apply to E Ltd’s public company subsidiary, F Plc (s 679(1) and (3) CA 2006),
and not to E Ltd itself.

What does giving financial assistance mean?

Financial assistance is very broadly defined in s 677 CA 2006. Section 677 sets out a number of
different types of transaction that may amount to financial assistance:
• Financial assistance given by way of gift (s 677(1)(a) CA 2006).
• Financial assistance given by way of guarantee, security or indemnity, release or
waiver (s 677(1)(b) CA 2006).
• Financial assistance given by way of loan or similar agreement (s 677(1)(c) CA 2006).
• Any other financial assistance given by a company where the net assets of the company
are reduced to a material extent by the giving of the financial assistance or the company
has no net assets (s 677(1)(d) CA 2006).
Note that the last of these provides a “catch-all” for any type of transaction not expressly listed
in the preceding sub-sections, if it materially reduces a company’s net assets or if the company
has no net assets.

Note also that, because of the wording of s 677 CA 2006 (“financial assistance means… financial
assistance given by way of…”), it is not enough that a transaction is of the type listed above – it
must also actually constitute financial assistance. In other words:
• assistance must be being given; and
• the assistance must be financial in nature.
It has been held that these terms should be given their ordinary meaning, bearing in mind the
commercial realities of the transaction eg actions which merely "smooth the path to the
acquisition“ (such as the payment, by a subsidiary of the target, of due diligence fees incurred
by the buyer) have been held to amount to financial assistance.

Financial assistance is covered by the rules whether it is direct (eg a loan given to the buyer of
shares) orindirect (eg a guarantee given to a bank in relation to a loan made by the bank to a
buyer of shares).

Financial assistance is also covered by the rules whether it is given before or at the same
time as the acquisition (s 678(1) and s 679(1) CA 2006), or after the acquisition (s 678(3) and s
679(3) CA 2006).

Finally, to fall within the statutory provisions, the financial assistance must be being given for
the purpose of the acquisition (or, if given after the acquisition, for the purpose of reducing or
discharging a liability incurred for the purpose of the acquisition), ie the company giving the
assistance must have intended to facilitate the acquisition.

Example

Financial Assistance Question (Share Sale)

Question: Would a loan given by I Plc to J Ltd to enable J Ltd to fund the purchase of shares in
H Ltd (a subsidiary of G Ltd) amount to prohibited financial assistance?
Answer: A loan given by I Plc to J Ltd to enable J Ltd to fund the purchase of shares in H
Ltd would amount to prohibited financial assistance under s 679(1) CA 2006 for the following
reasons:
• There is an acquisition of shares, in H Ltd, by way of a share sale (transfer).
• The target company’s subsidiary, I Plc, is subject to the prohibition in s 679 CA 2006
since it is a public company subsidiary of a private company target.
• A loan is a specified type of transaction under s 677(1)(c)(i) CA 2006.
• The transaction does constitute actual financial assistance since the loan is clearly
enabling J Ltd to pay for the shares and a loan is financial in nature.
• The loan is an example of direct financial assistance since it is given directly to the
buyer, J Ltd.
• The loan will be given before or at the same time as the acquisition (to allow the buyer
to use the loan money to fund the acquisition).
• The purpose of the loan is clearly to allow the buyer to go ahead with the acquisition.

Are there any exceptions to the prohibition?

The “purpose” exceptions

Sections 678(2), 678(4), 679(2) and s 679(4) CA 2006 set out “purpose” exceptions in relation to
ss 678(1), 678(3), 679(1) and s 679(3) CA 2006 respectively.

Essentially, the purpose exception states that the giving of financial assistance will not be
unlawful if the principal purpose in giving it is not for the purpose of the acquisition or if that
purpose (the acquisition) is only an incidental part of some larger purpose.

It should be noted however that because of its narrow application as stated in case law and
because of the very serious consequences of giving unlawful financial assistance, this
exemption is not normally relied upon.

The unconditional exceptions

Section 681 CA 2006 lists a number of specific types of transaction which will be exempt from
the ss 678 and 679 CA 2006 prohibitions, eg dividend payments (s 681(2)(a) CA 2006).

The conditional exceptions

Section 682lists a number of specific types of transaction which will be exempt from the ss 678
and 679CA 2006 prohibitions provided certain conditions are met.
These transactions include, for example:
• Money lending in the ordinary course of business (s 682(2)(a) CA 2006).
• Assistance in respect of employee share schemes (s 682(2)(b) CA 2006).

The conditions are that (i)the company giving the assistance is a private company or (ii) the
company giving the assistance is a public company and the net assets of that company are not
reduced by the giving of the assistance or to the extent that they are reduced the assistance is
provided out of distributable profits (s 682(1) CA 2006).

It is important to note that, to fall within the s 682 CA 2006 exception, a transaction must be of
a type listed in s 682(2) CA 2006 and fulfill the conditions contained in s682(1) CA 2006.

What are the consequences of carrying out prohibited financial assistance?

Under s 680 CA 2006, breach of s 678 or s 679 CA 2006is an offence whichcan lead to penalties
for:
• the company (a fine) and
• the officers of the company (fine/imprisonment).

In addition to the criminal penalties, under case law the transaction amounting to prohibited
financial assistance (eg the loan made the buyer) would be void and the wider transaction (eg
the share acquisition itself) may be void as well.

Summary
• The term "financial assistance" is extremely broad and captures many different types of
assistance (see s 677 CA 2006).
• The prohibitions on a company providing financial assistance for the purchase of its own
shares apply only to public companies (and private companies offering assistance for the
purchase of shares in a public holding company) - ss 678 - 679.
• There are conditional and unconditional exceptions set out in ss 681 and 682.
• There are also principal purpose and incidental part of a larger purpose defences set out
in s 678(2) and (3) and s 679 (2) and (3) but these will be extremely narrowly construed
by the courts.
• Financial assistance is a criminal offence and the company and defaulting officers are
liable to a fine and/or up to 2 years' imprisonment.

Buyback of shares

Maintenance of share capital

Once a shareholder has decided to invest in shares in a company, that investment cannot
normally be returned to the shareholder. In other words, a company is not usually permitted
to return capital to its shareholders – all payments by a company to its shareholders should be
made out of distributable profits.
The shareholders’ investment in a company is recorded in the accounts in the bottom half of
the balance sheet. Generally speaking, a company cannot release the sums represented in the
equity account and the share premium account to return value to shareholders. The money
represented in these accounts may be used to carry on the business of the company as working
capital but generally it cannot be returned to the shareholders while the company is a going
concern. This is known as the doctrine of maintenance of share capital.

This is primarily for the benefit of the company’s creditors. It is a fundamental and long-
established concept of company law that the share capital of a company is seen as a
permanent fund available to its creditors. In practice, many private companies have only a
small issued share capital, so this capital maintenance regime is of little relevance.

Consequences of the principle of maintenance of share capital

The principle of maintenance of share capital has a number of important consequences, in
particular:
• Dividends may only be paid out of distributable profits, not capital (s 830(1)), and
• Companies generally must not purchase their own shares.
• However, there are some exceptions to these rules. For example:
• A company may buyback its own shares (or redeem redeemable shares) provided it
follows the procedures set out in CA 2006, and
• A company may purchase its own shares where a court order is made for this following
a successful shareholder petition for unfair prejudice.
This element reviews in detail the procedure for buyback of shares. We do not consider the
procedure for redemption of redeemable shares in detail.

Redemption and buyback of shares

There are two types of situation when a company can effectively buy its own shares:
• redemption of redeemable shares; and
• purchase of own shares (‘buyback’).
One reason a company may wish to do this is that (in a private company) a shareholder may
want to leave and cannot find a buyer for their shares. Shareholders in private companies are
prohibited from offering their shares to the public.

In order to prevent a shareholder being locked into the company with no way to sell their
shares, the company can purchase or redeem the shares. However, because of the principle of
the maintenance of share capital, there are very strict controls on the purchase or
redemption of a company’s shares.

Both private and public companies may buyback their own shares or redeem redeemable
shares provided they comply with the provisions of CA 2006.
Buyback of shares

A buyback of shares takes place when a company purchases its own shares from an existing
shareholder.

A company may decide to purchase shares from a shareholder when there is no other buyer
available.

Generally, the kind of companies that you are looking at on this module will be making ‘off-
market’ purchases of own shares ie the purchase of own shares will take place otherwise than
on a ‘recognised investment exchange’. In this case, the company will need a contract setting
out the terms of the purchase and this contract will need to be approved by the shareholders
by an ordinary resolution.

Where a company uses capital to fund the buyback there is a lot more regulation and
procedure.

In this element we look in detail at the procedure by which a company may buyback its shares.

Buyback of shares: funding

There are three ways in which a company may fund a buyback of its own shares. The company
may use:
Distributable profits; Proceeds of a fresh issue of shares made for the purpose of financing the
buyback; or Capital.
However, the use of capital to fund a buyback is strictly regulated. You should note that:
• The option to use capital is only available to private companies. A public company can
never use capital to purchase its own shares;
• Any redemption or purchase out of capital must comply with the restrictions in ss 709 -
723 CA 2006 inclusive; and
• Companies must first use any money available either in the form of profits or the
proceeds of a fresh issue of shares to fund the purchase before using capital.

Buyback of shares out of profits / proceeds of a fresh issue

A company may purchase its shares out of distributable profits or the proceeds of a fresh issue
of shares for the purpose of the purchase provided:

The purchase of own shares is not restricted or prohibited in the company’s Articles (s
690(1)(b));The shares being purchased by the company are fully paid up (s 691(1));
andFollowing the purchase, the company must continue to have issued shares other than
redeemable and treasury shares.

Section 694 sets out the procedure:

A contract to purchase own shares is required (s 694(1)); andthe terms of the contract need to
be approved by ordinary resolution (s 694(2)).
The contract must be available for inspection at the company’s registered office for a period of
15 days before the GM and also at the GM. If a written resolution is used, a copy of the contract
must be sent together with the copy of any written resolution (s 696(2)).

Procedure for the buyback of shares out of profits / proceeds of a fresh issue

Initial steps
• Check there is no limit in Articles on s 690 power to buyback shares
• Prepare accounts to check there are sufficient distributable profits
• Confirm shares are fully paid
Board Meeting
• BR to approve the draft contract
• BR to call a GM / propose a WR
• Contract to be made available to shareholders:
- If GM: contract must be available for inspection at the company’s registered
office for at least 15 days prior to and at GM
- If WR: circulate contract with WR
GM / WR
• Shareholders pass OR to approve contract.
• Holders of shares being bought are not eligible to vote.

Board Meeting
• BR to enter into the contract
• BR to appoint a director(s) to sign the contract

Post meeting matters

• File return, notice of cancellation & statement of capital within 28 days
• Keep copy of contract for 10 years
• Cancel shares, update register of members (and PSC register if applicable)

Buyback of shares out of capital

Remember, only private companies are permitted to fund a purchase of their own shares out of
capital. The following conditions apply in addition to those set out above in relation to the
buyback of shares out of profits or the proceeds of a fresh issue:

The purchase of own shares out of capital is not restricted or prohibited in the company’s
Articles; Check that the accounts were prepared no more than three months before the
directors’ statement; Check if the company has any distributable profits available. If so, those
profits (or funds from a fresh issue of shares for the purpose) must be used to fund the buyback
before capital can be used (s 710);A directors’ statement of solvency must be prepared
together with an auditors’ report (s 714);A special resolution to approve payment out of
capital must be passed within a week after the directors sign the written statement of solvency
(s 716).
Buyback out of capital - directors’ statement of solvency and auditors’ report

The directors’ statement of solvency must be made no earlier than one week before the GM.
The statement confirms that the company is solvent and able to pay its debts as they fall due
and that it will remain solvent for a period of 12 months after the buyback (s 714).
The directors need to be careful when making this statement, since if the company does
become insolvent and is wound up within one year, they may be required to contribute to the
assets of the company and may face criminal sanctions if they had no reasonable grounds for
making the statement of solvency.

An auditors’ report must be annexed to the written statement of solvency confirming that the
auditors are not aware of anything to indicate that the directors’ opinion is not reasonable (s
714).
A copy of the directors’ statement and auditors’ report must be made available to members
(sent with the written resolution or available for inspection at the GM).

Buyback out of capital – notification requirements

Within seven days of the passing of the special resolution approving the payment out of capital,
under s 719 CA 2006 the company must give notice to its creditors by:
Publishing a notice in the Gazette. The notice must state:
• that the company has approved a payment out of capital for the purpose of purchasing
its own shares;
• where the directors' statement and auditors’ report are available for inspection; and
• that any creditor of the company may, at any time within the five weeks immediately
following the date of the resolution, apply to the court under s 721 CA 2006 for an order
preventing the payment.

Publishing a notice in the same form as the Gazette notice in an appropriate national
newspaper, or give notice in writing to each of its creditors, andFiling copies of the directors’
statement and auditors’ report at Companies House. This is so that any interested creditor
may inspect these.

Buyback out of capital - timing

The share purchase can take place no earlier than five weeks, and no later than seven weeks,
after the date of the special resolution (s 723 CA 2006).

This period cannot be reduced even if the special resolution is passed unanimously – the five
week delay is designed to enable shareholders and/or creditors of the company to object to the
payment out of capital by lodging an application at court for cancellation of the resolution (s
721 CA 2006).

The seven week longstop period is intended to ensure that the view formed by the directors in
their statutory declaration as to the solvency of the company is still likely to be accurate at the
time the share purchase is made.
Within 28 days of the date on which the shares that are bought back are delivered to the
company, the company must send a return to Companies House under s 707(1) CA 2006 and a
notice of cancellation under s 708(1) CA 2006, together with a statement of capital (s 708(2) CA
2006).

Procedure for the buyback of shares out of capital

Initial steps
• Check there is no limit in Articles on s 690 power to buyback shares or s 709 power to
use capital to fund the buyback
• No earlier than three months before the directors prepare the statement of solvency,
prepare accounts to ascertain available profits
• Confirm shares are fully paid

Board Meeting
• BR to approve the directors’ statement of solvency (‘DSS’) and the auditors’ report (‘AR’)
• BR to approve the draft contract
• BR to call a GM / propose a WR
• Contract to be made available to shareholders:
- If GM: contract must be available for inspection at company’s registered office
for at least 15 days prior to and at GM
- If WR: circulate contract with WR
• DSS and AR must be signed no earlier than one week before the GM or the passing of
the WR

WR
• Circulate WR with contract, DSS and AR.
• SR to approve payment out of capital and OR to approve contract.
• Holders of shares being bought back are not eligible to vote.

ALTERNATIVELY GM
• Shareholders pass OR to approve contract.
• Shareholders pass SR to approve payment out of capital.
• Holders of shares being bought are not eligible to vote.
• Contract, DSS and AR must be available at the meeting.

Following GM / WR
• Within 7 days: place notices in Gazette and national newspaper and file DSS and AR at
Companies House.
• Within 15 days: file SR at Companies House.
• For five weeks after date of SR: creditors and shareholders have right to object. Copies of DSS
and AR must be available for inspection at company’s registered office.
Board Meeting
• BR to enter into the contract.
• BR to appoint a director(s) to sign the contract.
• Payment out of capital must take place between 5-7 weeks after SR passed.

Post meeting matters

• File return, notice of cancellation & statement of capital within 28 days.
• Keep copy of contract for 10 years.
• Cancel shares, update register of members (and PSC register if applicable).

Summary of procedure for buyback of shares using profits / proceeds / capital

Buyback out of profits and/or proceeds of a fresh issue of shares
• Check Articles for any prohibition on buyback
• Verify distributable profits
• Terms of buyback must be set out in a contract - must be available for inspection at
least 15 days before GM and at GM itself (or circulated with written resolution)
• Shareholders must approve the contract by OR

Buyback out of capital (PRIVATE companies only)

• Check Articles for any prohibition on buyback and on use of capital
• Terms of buyback must be set out in a contract (15 day display)
• DSS and AR; accounts (<3 mths old)
• Shareholders must approve the contract by OR
• Shareholders must approve the payment out of capital by SR
• Detailed notification requirements for creditors

Redemption of redeemable shares

Redeemable shares are shares which are issued as redeemable shares.
Redeemable shares effectively give the holder temporary membership in the company. They
are issued to be redeemed on the occurrence of certain circumstances (for example by
providing for redemption on a fixed date and at a fixed price) or may be redeemed at the
option of the issuing company or the shareholder.
All details of the redemption, including date of redemption and the price to be paid at that
date, will either be in the Articles or determined by the directors.

As a result, a contract is not required to redeem shares, irrespective of the source of funding
used. This is because the terms of the redemption have already been set out in the company’s
Articles (or determined by the directors) prior to the shares being allotted.
Where a company uses capital to fund the redemption there is a lot more regulation and
procedure. The procedure is very similar to the buyback of shares out of capital.

Summary
• It is a fundamental and long-established concept of company law that the share capital
of a company is seen as a permanent fund available to its creditors.
 • However, companies may buyback their own shares (or redeem redeemable shares)
provided they meet the conditions in CA 2006.
• A buyback of shares may be funded out of distributable profits, the proceeds of a fresh
issue of shares or (for private companies only and only to the extent that there are no
profits / proceeds of a fresh issue available), out of capital.
• Where a buyback is funded out of profits / proceeds of a fresh issue, a contract is
required which must be approved by an OR of the shareholders.
• Where capital is used there are further procedural requirements: a DSS and an AR are
required, a SR is needed to approve payment out of capital and there are detailed
requirements to notify creditors. The buyback must take place within five to seven
weeks following the passing of the SR.

Introduction to financial services regulation

Introduction
This element will give you an overview of how the conduct of financial services is regulated in
the UK and how the regulatory framework applies, with particular reference to work done by
solicitors in the corporate sector. It is essential that you, as a solicitor, are aware of the scope of
financial services regulation in the UK.

What are ‘financial services’?

There is a huge variety of investments available in the market today. The term ‘investment’ can
be used to refer to a wide variety of products including bank deposits, pensions, endowment
policies, shares, unit trusts, bonds and many others.
For your purposes, the term ‘financial services’ refers (in the most part) to services such as:
• advising on investment products on behalf of clients
• dealing in investment products on behalf of clients
• arranging investment products on behalf of clients

Why are financial services regulated?

When an individual decides to invest money in an investment, they have a number of difficult
decisions to make. For example:
• What type of investment should they invest in?
• What level of risk are they willing to take (as one type of investment may be riskier than
another)?
• What is the return from the investment – does the investor want regular income
payments or do they want the long-term capital value of the underlying investment to
increase?
• Are there tax advantages to be gained from investing in one type of investment or
another?
As there are so many different products available on the market, individuals increasingly look to
professional advisers to help them decide which investment to make.
The provision of financial services is heavily regulated in the UK to ensure that those
providing such services are approved and authorised and that consumers are adequately
protected from negligent advisers.

How is the provision of financial services regulated in the UK?

The key statute governing the provision of financial services is the Financial Services and
Markets Act 2000 (‘FSMA’) together with several statutory instruments, one of which is the
Financial Services and Markets 2000 (Regulated Activities) Order 2001 (SI 2001/544), as
amended, is known as the Regulated Activities Order (‘RAO’) and establishes the activities to
be regulated by FSMA if they are carried on in the UK by an entity by way of business.

FSMA and the statutory instruments arising out of FSMA are important not just from the
perspective of a solicitor having to ensure that in the course of their practice the solicitor does
not commit an offence, but also in terms of being aware of the statutory constraints which
might be placed on a client in terms of the deal being proposed.

There are two regulators: the Prudential Regulation Authority (‘PRA’) and the Financial Conduct
Authority (‘FCA’). Few law firms have obtained direct FCA authorisation because the stringent
level of regulation imposed by the FCA, coupled with the relatively small proportion of work for
clients which would require direct FCA authorisation, compared to a firm’s overall workload,
means it is not cost efficient.

The general prohibition under s 19(1) FSMA

s 19(1) FSMA states:
"No person may carry on a regulated activity in the United Kingdom…unless he is –
(a) an authorised person; or
(b) an exempt person."

It is a criminal offence to breach s 19(1) FSMA. In order to avoid criminal liability a solicitor must
always assess whether or not the activity they are proposing to carry out for a client is
governed by s 19(1) FSMA.
s 22(1) FSMA states: "An activity is a regulated activity for the purposes of this Act if it is
an activity of a specified kind which is carried on by way of business and…relates to
an investment of a specified kind; …"
ie Regulated Activity = Specified Investment + Specified Activity

Summary of steps to consider

1) Is the investment ‘specified’ under FSMA? (see Part III RAO)? If yes
2) Is the activity a ‘specified activity’ under FSMA? (See Part II RAO) If yes
3) Is the activity excluded under FSMA? (See Part II RAO)? If no
4) Does the activity fulfil the basic conditions in s. 327 of FSMA and SRA Scope Rule
2? If yes, exemption is possible; if no, authorisation is required.

Step 1: Is the investment ‘specified’ under FSMA?

The first thing a solicitor must therefore decide is whether they (or the client) are carrying out
an activity in relation to a ‘specified investment’.

The term ‘specified investment’ is not defined within FSMA itself. The list of specified
investments is to be found in in Part III of the RAO. The investments which are regulated are
specified in Part III of the RAO and include:
• shares (Article 76)
• instruments creating or acknowledging indebtedness (Article 77) including bonds (for
example an interest-bearing debt instrument issued by a company) and certain other
instruments where the investor is lending money to a third party.
• regulated mortgage contracts (Article 88)**as defined in in Article 61(3) RAO.
• These are the specified investments that you will focus on in this module.
Step 2: Is the activity a ‘specified activity’ under FSMA?
A person will not require authorisation however, unless they are carrying out a ‘specified
activity’ by way of business in relation to the ‘specified investment’. Part II of the RAO lists the
specified activities. Activities listed include:
• dealing in investments as principal (Article 14) or as agent (Article 21). This includes
buying, selling, subscribing for or underwritingsecurities or contractually based
investments.
• arranging deals in investments (Article 25);
• managing investments (Article 37) (ie exercising discretion in relation to investments
which are securities or contractually based investments); and
• advising on [the merits of] investments (Article 53(1)).
Again, these are the most likely specified activities that arise for a corporate lawyer, especially
advising on the merits of investments.

Advising on [the merits of] investments (Article 53(1) RAO)

Often corporate solicitors will be giving advice; after all, a solicitor’s job is to advise.
Giving generic advice (eg to invest in China, as opposed to Europe) is not a specified activity,
nor, generally, is giving information as opposed to advice, although the context may affect the
character of the information. Only advice which is given to someone who holds or is a
prospective investor in a security or relevant instrument relating to the merits of buying, selling,
subscribing for, exchanging, redeeming, holding or underwriting such investments will fall
within Article 53(1). To be caught, the advice requires an element of opinion on the part of
the solicitor and a recommendation as to a course of action.
A solicitor giving generic advice relating to investments (for example, explaining the legal
rights attaching to two different classes of shares) will not require FCA authorisation.

However, the advice would be regulated if the solicitor recommended to their client to
purchase ABC plc shares, or to take out an endowment mortgage with XYZ Building Society.

Step 3: Is the activity excluded under FSMA?

Excluded activities can be carried on without the need for further authorisation.
Specific Exclusions
Each specified activity in the RAO has a Chapter devoted to it and any exclusions which are
specific to that specified activity are included in the relevant Chapter.
Eg For example, Chapter V of the RAO covers ‘Dealing in Investments as Agent’. Article 21 sets
out what it means to be ‘dealing in investments as agent’ and Article 22 contains the exclusion
of ‘deals with or through authorised persons’, ie such activity can usually be referred to an
authorised person

General Exclusions (articles 66-72 RAO)

Some exclusions apply to more than one activity.In the context of the corporate lawyer, two of
these may assist you.
• Regulated activities that are a necessary part of other services carried on in the course
of a profession or non-investment business (Article 67 RAO)
• Regulated activities in connection with the sale of a body corporate (Article 70 RAO)

Regulated activities that are a necessary part of other services carried on in the course of a
profession or non-investment business (Article 67 RAO)
Among other things, a solicitor will generally not be ‘dealing as an agent’ (Art 21 RAO) or
‘arranging deals’ (Art 25 RAO) or ‘advising [on the merits]’ (Art 53(1) RAO) in relation to
investments for the purposes of FSMA and therefore will not be carrying on a specified activity,
provided that these activities are:
• carried on in the course of carrying on any profession or business which does not
otherwise consist of the carrying on of regulated activities in the UK; and
• the activities can reasonably be regarded as a necessary part of other services
provided in the course of that profession or business.

This exclusion will not apply if the specified activity is remunerated separately from the other
services.

What constitutes a ‘necessary part’ of other services is not specified in the RAO. The FCA’s view
is that it must not be possible for the other services to be provided unless the dealing /
arranging / advising is also provided.

Example: when a client is selling a leasehold flat, the transaction might also involve the transfer
of a share in a management company or the company that owns the freehold for the block of
flats. Although shares are specified investments, arranging their sale would be a necessary part
of the other property work the solicitor is carrying out.

Regulated activities in connection with the sale of a body corporate (Art 70 RAO)
A solicitor will not be ‘dealing as principal’ (Art 14 RAO), ‘dealing as an agent’ (Art 21 RAO),
‘arranging’ (Art 25 RAO) or ‘advising [on the merits]’ (Art 53(1) RAO) if such activity is carried
out in connection with the purchase or sale of shares in a company (if the transaction to buy or
sell the shares is entered into for the purposes of buying or selling the shares), PROVIDED
THAT: the shares consist of or include 50% or more of the voting shares in the company AND
the acquisition or disposal is between parties each of whom is a body corporate, partnership,
single individual or a group of connected individuals; orthe shares, together with any shares
already held by the purchaser, consist of or include 50% or more of the voting shares in the
company AND the acquisition or disposal is between parties each of whom is a body corporate,
partnership, single individual or a group of connected individuals; orthe object of the
transaction may reasonably be regarded as being the acquisition of day-to-day control of the
affairs of the body corporate.

Note: the two entities do not each have to have the same legal status to fall within paragraphs
i) or ii) eg a company can sell its shares to an LLP; a company can sell its shares to an individual
and still fall within i) or ii) above.

If FSMA applies, what should a solicitor do?

If a solicitor’s work involves carrying out a ‘regulated activity’ (i.e. a ‘specified activity’ in
relation to a ‘specified investment’) and the activity is not excluded from regulation under
FSMA by the RAO, the statutory regime set down by FSMA will apply.

The solicitor will either need to be:

• Directly authorised – iewhere the firm is authorised by the FCA directly; or
• Supervised by a Designated Professional Body - The Law Society is a law firm’s ‘DPB’
but responsibility for regulation rests with the SRA as the profession’s independent
regulator. To rely on this exemption, s 327 FSMA must be satisfied and the firm must
comply with the SRA Scope Rules.

Under FSMA, the Law Society, as a DPB, is required to make rules governing the carrying on of
regulated activities by firms of solicitors. FSMA enables firms authorised and regulated by the
SRA to carry on exempt regulated activities provided the firms can comply with the SRA
Financial Services (Scope) Rules 2019 (the ‘Scope Rules’). The Scope Rules set out the scope of
the regulated financial services activities that may be undertaken by firms authorised by the
SRA (but not the FCA).

Step 4: Basic conditions specified by s 327 FSMA

In order for the regulated activities to be exempt regulated activities all the conditions set out
in s 327(2) – (7) FSMA must be satisfied. The key conditions we focus on in in this module are:
the person carrying on the regulated activities must be a member of a profession (such as
practising as a solicitor – see s 325(2) FSMA);that person must not receive a commission from a
third party in respect of the regulated activities, unless he accounts to his client for the
commission; The SRA guidance states that you must hold the commission to the client’s order
and may only keep it if the clientgives you informed consent to do so. the specified activity
must be provided in a way that is incidental to the provision of professional services (see the
next slide); andthe person must only carry out regulated activities which he is permitted to
carry out as a result of s 332(3) FSMA (i.e. he has to comply with the rules set by his relevant
designated professional body - for the SRA, the Scope Rules).

When is the activity ‘incidental’?

The FCA considers that to satisfy the incidental requirement, the regulated activities cannot be
a major part of the practice of the firm. The FCA also considers the following factors are
relevant:
• what is the scale of the activity in proportion to the other professional services provided
by the firm?
• to what extent are these services held out by the firm to be separate services to the
other professional (legal) services it offers to clients?
• what impression does the firm give of how it provides regulated activities e.g. through
its advertising or other promotion of its services?

In the FCA’s opinion, the firm will not be providing incidental regulated activities if they amount
to a separate business conducted in isolation from the provision of the professional services
provided by the firm. However, the FCA has confirmed this does not stop the firm from
operating its business in a way which involves separate departments, one of which handles the
regulated activities.

To work out whether or not the activity in question is incidental you need to look at the
overall work the firm does - is the specified activity the solicitor is being asked to do a small
part of what the firm does for clients overall? If so, it will be incidental.

Step 4: Basic conditions specified by Rule 2 of the Scope Rules

The further condition contained in Scope Rule 2 of the Scope Rules is that a firm must ensure
that: the activity arises out of OR is complementary to the provision of a particular
professional service to a particular client (Scope Rule 2.1(b)).

To work out whether or not the activity arises out of the (non-regulated) work the solicitor is
doing for the client you need to ask what has happened to prompt the activity in question. If,
for example, you are acting for a client on the sale of a company and the client asks for advice
as to how best to invest in a personal pension, the advice would not arise out of the work being
done for the client because it is completely unrelated to the non-regulated work.
To work out whether or not the activity is complementary you need to ask yourself if the
specified activity arises naturally out of the work the solicitor is doing for the client - if it does
not then the work is not complementary.
Eg giving legal or tax advice, drafting documents to effect the sale of shares or other (specified)
investments.

Conclusion
Can you satisfy all the requirements under s 327 FSMA AND Scope Rule 2?
IF YES:
the activity is an exempt regulated activity. In order to be able to carry out an exempt
regulated activity, the law firm must 1) ensure it complies with the Scope Rules; and2)
be authorised by the SRA in relation to this activity_and_ must comply with any relevant SRA
Financial Services (Conduct of Business) Rules 2019.

IF NO:
The firm must be authorised by the PRA or FCA and must comply with the PRA or FCA
Handbook in relation to this activity OR refuse to carry out the activity.
If the firm is not PRA or FCA authorised, and carries out the activity, the person carrying out the
activity is likely to have breached s 19(1) FSMA which is a criminal offence.

Summary
• Financial services are heavily regulated in the UK to protect consumers from negligent
advice.
• There is a General Prohibition under s 19 FSMA from Solicitors carrying out Regulated
Activities.
• Regulated Activities means you are carrying out ‘specified activities’ (eg advising on the
merits) in relation to ‘specified investments’ (eg shares).
• If you are carrying out a Regulated Activity, you need to check if there are any specific or
general exclusions.
• If there are no exclusions, you need to satisfy s 327 FSMA and Scope Rule 2.
• If you can satisfy s 327 FSMA and SR 2, you are carrying out an exempt activity. If not,
you need to be regulated or refrain from carrying out the activity.
• There are criminal sanctions for breaching the s 19 FSMA General Prohibition.
Business Law and Practice – Workshop 6
Taxation of individuals

Introduction to taxation - general principles

Introduction
The taxes covered on the BLP module are:
• Income Tax;
• Capital Gains Tax (‘CGT’);
• Value Added Tax (‘VAT’); and
• Corporation Tax.
Of these, income tax, CGT, and corporation tax are examples of direct taxes whilst VAT is an
example of an indirect tax.

Direct taxes are imposed by reference to a taxpayer’s circumstances. For example, CGT is
assessed by reference to an individual’s chargeable gains calculated on the basis of that
individual’s circumstances. By contrast, indirect taxes are imposed by reference to transactions
eg VAT is chargeable by reference to the value of supplies.

Inheritance Tax is only covered to a limited amount and Stamp Duty Land Tax is not covered in
this module as you will learn more about these taxes in other modules.

The distinction between income and capital

Whilst the difference between a receipt and an expense appears obvious, the distinction can be
confusing in practice especially when dealing with the various types of each. A receipt is money
(of whatever nature) that is paid TO the business and is often referred to as income. Contrast
that to an expense which is money the business pays OUT.

It is necessary to distinguish income receipts from capital receipts and income expenditure
from capital expenditure. The reason for this is that, in general, income expenditure can only
be deducted from income receipts and capital expenditure can only be deducted from capital
receipts to reduce the overall tax bill (but see the corporation tax element regarding capital
allowances).

There is no statutory definition of income or capital, but a series of general guidelines have
been established by case law, which are summarised in this element. In practice, it can
sometimes be difficult to distinguish between income and capital and you may come across
scenarios where it is not clear into which category a particular receipt or expense falls.

It is important to be able to distinguish between income and capital to ensure that the
correct tax treatment is applied. This will be explained in more detail later in the element.
Receipts
Income receipts
Money received on a regular basis will be classified as an income receipt. For example:
• the trading profits of any business/profession will be income (this is synonymous to the
salary received by an individual employee);
• interest the bank pays in relation to savings held in an account is an income receipt for
the individual/business, and
• rent received by a landlord is an income receipt of the landlord.

Capital receipts
If a receipt is from a transaction that is not a part of such regular activity this is likely to be
classified as a capital receipt. Think of capital transactions as ‘one-off’ transactions.

Therefore, if a newsagent’s business owned the premises from which the business operates
then any gain on the sale of those premises would be a capital receipt.

Expenditure
Having determined whether receipts are of an income or capital nature, it is also necessary to
decide whether expenditure is of an income or capital nature.

Income expenditure
Money spent as part of day-to-day trading, is 'income' expenditure.

Bills for heating and lighting, rent, marketing and stationery expenses, staff wages and other
fees in the general running of a business will be income expenses. General repairs will also
amount to income expenses. Interest payable on loans is also expenditure of an income nature
as it will be paid to the lender on a regular basis (whether that is monthly or quarterly) over a
period of time.

Capital expenditure
If money is expended to purchase a capital asset as part of the infrastructure of the business or
as an enduring benefit for the business, it is ‘capital’ expenditure.

As with capital receipts, capital expenditure can be seen as a ‘one-off’ transaction. Expenditure
on large items of equipment and machinery or property will be capital expenditure.

Equally expenditure on enhancing a capital asset (other than routine maintenance) will be
capital expenditure. Even though these assets are used by a business to trade, they are one-off
purchases.

It is necessary to make the distinction between income and capital expenditure because
certain INCOME expenditure can be set off against INCOME receipts in a business context to
reduce the overall tax bill.
INCOME RECEIPTS – LESS – INCOME EXPENDITURE = TRADING PROFITS

Example: deduction of INCOME expenditure from income receipts

A man runs an antique shop. He calculates all his income receipts from his trading activities so
that he can then set off against (ie deduct from) these income receipts the income expenses he
has incurred in the course of trading. Examples of such deductible income expenses are the
cost of buying his stock and the lighting, heating and insurance for his shop. Accordingly, his tax
bill is reduced because his income receipts (ie the amount in respect of which he is taxed) are
reduced by his income expenditure.

In general, relief for CAPITAL expenditure can only be deducted for tax purposes from the
proceeds realised when a CAPITAL asset is disposed of.

Example: deduction of CAPITAL expenditure from CAPITAL receipts

The initial cost of an individual’s capital assets, for instance the cost of buying a shop and the
van used to collect and deliver stock, cannot be set off against income receipts in order to
reduce the individual’s tax bill. If, however, the shop or van was subsequently sold at a
gain/profit (a capital receipt), for tax purposes it would be possible to reduce the gain/profit
made on the sale of the asset by deducting the original cost of the asset (capital expenditure).
NB. a proportion of the cost of some capital assets (capital expenditure) can be set off against
the trading profits (income receipts) of the business each year during the life of the asset
concerned.

This is done through the system of capital allowances.

Capital Allowances
Tax relief (deductions from the tax bill) for capital expenditure is usually only given at the time
when the capital asset is sold or otherwise disposed of (eg by way of gift).

Most of us are familiar with the concept of depreciation. We know the new car we buy (a
capital asset) will depreciate in value over time. Depreciation is an accounting concept,
whereby the cost of an asset is deducted in the accounts over a period of time. Depreciation is
used here simply to illustrate the concept of capital allowances used in tax calculations as
the tax equivalent of depreciation is capital allowances.

Capital allowances spread the cost of capital expenditure on certain capital items over a
period of time. This is achieved by a proportion of the capital expenditure being deducted from
income receipts over a period of time. Note that as an exception to the general rule you read
about above (capital receipts less capital expenditure), capital allowances enable certain
types of capital expenditure to be deducted from income receipts.
You will learn more about these in the Corporation Tax element. The relevant allowances are
deducted when calculating trading profits (ie income) for tax purposes.

Assessment of tax
In general, there is a separate system for the administration of each particular tax which will be
addressed in the relevant section of this topic.

It is important to note that the tax year (for individuals) and the financial year (for companies)
are different to the calendar year.
HMRC collects tax from individuals and businesses (including sole traders, partnerships and
companies) via the self-assessment system.

Companies pay corporation tax on all income profits and chargeable gains that arise in each
accounting period (this will be explained further in the corporation tax element).

Individuals are assessed to income tax and capital gains tax on the basis of a tax year which
runs from 6 April in one calendar year to 5 April in the next.

Companies are assessed to corporation tax on the basis of a financial year which runs from 1
April in one calendar year to 31 March in the next.

PAYE System
It is also important for you to be aware that in some cases income tax is deducted at
source. This is the system whereby the payer of a sum that is taxable in the hands of the
recipient deducts the tax due in respect of the sum and accounts for it to HMRC on the
recipient’s behalf.

The recipient of the taxable sum therefore receives the sum net of tax (ie after tax has been
deducted).

One example of a sum where tax is deducted at source by the payer is the Pay As You Earn
(PAYE) system. The employer deducts the income tax payable by the employee from the
employee’s wage or salary, and accounts for this tax to HMRC. The employee receives the wage
or salary net of income tax.

In calculating tax liabilities, it is important to note where tax has been deducted at source
because it is the the gross amount of the receipt that must be included in the calculation
(rather than the net amount).

Glossary
You will come across the following terminology in this topic:

Annual exemption: For CGT: A tax allowance for individuals only.

Annual investment allowance: A special type of capital allowance.

Available tax reliefs: Certain payments which reduce an individual taxpayer’s Total Income eg
interest on certain loans and pension contributions (relevant for income tax only).

Business Asset Disposal Relief: A tax relief available to individuals in certain circumstances to
reduce their chargeable gains. It was formally known as “Entrepreneurs’ Relief” or “ER”.

Capital allowances: Tax allowances (ie deductions) for capital expenditure available to
businesses (whether run by individuals or companies).

Capital gains tax (CGT): A tax paid by individuals on their taxable chargeable gains.

Corporation tax: A tax paid by companies on their TTP.

Current year basis: Income tax is charged on the current year basis. This means that income
earned in this current year (from 6 April 2020 to 5 April 2021) will be taxed in, and according to,
the rates applicable to the tax year 2020/21. (See definition of ‘Tax year’ below.)

Deduction of tax at source: In some circumstances the payer of certain sums is obliged to
deduct tax when making a payment eg deductions of income tax by employers (the PAYE
system).

Dividend allowance: A band of tax free dividend income available to individuals for income tax
purposes.

Financial year: Companies are assessed to corporation tax by reference to financial years
(rather than calendar years). The financial year begins on 1 April in one calendar year and ends
on 31 March in the next calendar year. A company’s accounting period can differ from the
financial year.

Gross sums and net sums: A gross sum is the total sum before tax is levied. A net sum is the
amount left after tax has been paid/deducted.

HMRC: HM Revenue & Customs, the body responsible for collection of all UK taxes covered in
this Topic.

Income tax: A tax paid by individuals on their Taxable Income.

Indexation allowance: A tax allowance (ie deduction) for indexation available to companies in
calculating their chargeable (ie capital) gains. This allowance takes into account inflation based
on the Retail Price Index ("RPI"), so that a company is not taxed on chargeable gains arising
solely because of inflation. Indexation allowance was frozen on 31 December 2017 and cannot
be claimed for any period commencing on or after 1 January 2018.
Investors' Relief (IR): A tax relief available to individuals in certain circumstances to reduce
their chargeable gains.

Net Income: Total Income less available tax relief.

Non-savings income: Income which is not savings or dividend income such as salary (relevant
for income tax only).

Pay As You Earn (PAYE): The system under which income tax and employees' national
insurance contributions are deducted at source (ie by the employer) from payments of salary
and other employment income to employees.

Personal allowance: A band of tax-free income for individuals (relevant for income tax only).

Personal savings allowance: A band of savings income available for basic and higher rate
taxpayers which is taxed at the savings nil rate (relevant for income tax only).

Savings income: Income from savings, such as interest (relevant for income tax only).

Taxable income: Net Income less the personal allowance (relevant for income tax only).

Tax year: Individuals are assessed to tax by reference to tax years rather than calendar years.
The tax year begins on 6 April in one year and ends on 5 April in the next year.

Total Income: A taxpayer's gross income from all sources before any deductions (relevant for
income tax only).

TTP: Taxable total profits, chargeable to corporation tax. The total of a company’s taxable
income profits and chargeable gains.

Value Added Tax (VAT): A tax collected by registered businesses chargeable on supplies of
goods and services.

Summary
• Income vs capital: it is important to distinguish between income receipts and expenses
and capital receipts and expenses so that the correct tax treatment can be applied and
the correct amount of tax paid.
• Capital allowances: a regime that allows certain types of capital expenditure to be
deducted when calculating income receipts, thereby reducing the taxpayer’s tax bill.
• Assessment of tax:
• individuals are assessed to tax by reference to the tax year; and
 • companies are assessed to tax by reference to the financial year (companies can choose
an accounting period that does not match the financial year but will still have to
calculate tax due for each financial year).
• Deduction of tax at source: certain payments require the payer to deduct the tax (which
would ordinarily be payable by the recipient) from the payment and account for the tax
to HMRC on behalf of the recipient.

Income Tax

1. Self-Assessment
This means it is up to the individual to calculate the tax bill and not HMRC. Not all individuals
are required to complete a self-assessment tax return. For example, employed individuals with
uncomplicated tax affairs are not required to complete a self-assessment tax return because
their tax is collected via the PAYE (Pay As You Earn) system. Directors, high and additional rate
tax payers and self-employed people are examples of individuals who are always required to
complete a self-assessment tax return.

2. Deduction at source
This system is used where the payer of a taxable sum is obliged to deduct tax and account for it
to HMRC. The recipient of the taxable sum receives it 'net of tax'. One example is the PAYE
system.

The personal tax computation

You will now work through a simple personal tax computation for an individual taxpayer in a
non-business context. In order to do this, there are three terms that you will need to become
familiar with. These are:

Total Income:
A taxpayer’s gross income from all sources

Net Income:
Total Income less available tax reliefs

Taxable Income:
Net Income less the personal allowance

It is important when calculating income tax that the steps are undertaken in order so that the
correct amount of tax is applied to the correct elements of a person’s income.

Step 1: Calculating Total Income

Total Income is a taxpayer's total gross income from all sources.

This means that we need to add together all the receipts from all the sources of income of that
particular individual.
Where income has been received by a taxpayer after deduction of tax at source (ie 'net of tax'),
you will need to include the grossamount in the calculation of Total Income. The calculation for
this is known as “grossing up” (you are not expected to do this on this module).

You have already seen that tax is deducted at source from earnings through the PAYE system.

Savings income and dividend income are received gross (ie with no deduction at source). There
are some special rules and allowances which apply to these particular types of income, as
follows.

1. Savings
Interest received by the individual on savings is subject to income tax but some taxpayers will
have the benefit of a personal savings allowance. Basic rate taxpayers are entitled to their
first £1,000, and higher rate taxpayers are entitled to their first £500 of interest received on
savings at the savings nil rate. This means that the first £1,000, or £500 respectively of interest
received on savings is taxed at 0%. Additional rate taxpayers do not get the benefit of a
personal savings allowance. Examples of how savings income is taxed are set out later in this
element.

2. Dividends
Companies pay dividends to shareholders out of profits that have already been charged to
corporation tax. To take account of this (in part at least), a dividend allowance was
introduced. The effect of this allowance is that no individual pays any tax on the first £2,000
of dividend income they receive. The allowance is the same for all taxpayers, no matter how
much non-dividend income they receive.

As we will see when we apply the rates of tax, the tax rates for dividends are different to
those applicable to other forms of income. There is a useful summary table of the tax rates in
Step 4 below. Examples of how dividends are taxed are set out below in this topic.

3. Benefits in kind
Many employees receive benefits in kind in addition to the salary they are paid in respect of
their employment. Benefits in kind include health insurance, company cars and gym
membership.

Cash payments of salary (including bonuses) are subject to deduction of tax under PAYE.
Benefits in kind are subject to income tax but are NOT subject to deduction of tax under
PAYE. Instead, the employer must report the amount of the benefit to HMRC as well as to the
employee. The employee then includes the benefit sums on their tax
return if they complete one. Such benefits must be included in the individual’s Total Income.
Note: There are some minor exemptions to the rules on benefits in kind and there are also
specific types of income which are exempt, but the detail of this is beyond the scope of this
topic.

Step 2: Calculating Net Income

Once Total Income has been calculated the next stage of the income tax computation is to
deduct available tax reliefs in order to establish the taxpayer’s Net Income. The only tax
reliefs we look at in this topic are interest PAID on qualifying loans and pension scheme
contributions.

1. Interest paid on qualifying loans

This type of interest is not to be confused with interest received by the individual from a bank
on savings held at the bank (considered previously under total income). This interest is the
interest an individual must pay TO the bank as the cost of receiving certain qualifying loans
from the bank.

Interest on qualifying loans is a form of tax relief because it can be deducted from Total Income
to reduce the amount of income subject to tax thereby reducing the tax bill.

The amount of the interest paid on these loans must be deducted from the taxpayer’s Total
Income in order to determine the taxpayer’s Net Income.

Qualifying loans include:

• loans to buy an interest in a partnership;
• loans to contribute capital or make a loan to a partnership;
• loans to buy shares in (or make a loan to) a 'close' company (you will learn about these
in more detail later); and
• loans to buy shares in an employee-controlled company or invest in a co-operative.

2. Pension scheme contributions

Many individuals pay contributions into a pension scheme, either a scheme set up by their
employer (an occupational pension scheme) or a personal pension scheme. Such contributions
have the benefit of relief from income tax, subject to certain limits.

Relief on pension contributions is given as follows: An amount equivalent to the pension

scheme contributions made by a taxpayer during the tax year are deducted from their Total
Income for that year (ie at the same time as interest on qualifying loans).

Note: There are limits to the amount an individual can pay into their pension scheme each year
but this is beyond the scope of this topic. Most contributions made by an employer to an
employee’s pension scheme will be exempt from income tax.

Certain charitable donations are also eligible for tax relief.

Example
A woman bought an interest in a catering business which is run as a partnership with two
others. In order to do so, she took out a bank loan on which the annual interest payments are
£3,000. The woman also paid £2,500 into her personal pension scheme. The woman’s annual
income from the partnership for the 2022/23 tax year is £56,000.

The woman’s Net Income would be calculated as follows:

Total income £56,000 (annual income)

Less Tax reliefs:

£3,000 (interest paid on bank loan – this is a "qualifying loan")
£2,500 (pension contributions)
Net Income: £50,500

Step 3: Calculating Taxable Income

Once Net Income has been calculated, the next stage of the income tax computation is to
deduct the taxpayer's Personal Allowance in order to ascertain the taxpayer’s Taxable
Income.

The personal allowance for the tax year 2022/23 is £12,570. The amount of this allowance is
reduced by £1 for every £2 of Net Income above £100,000.
Going back to the woman in the example above, the next stage in her income tax computation
would be:
· Net Income £50,500
· Less Personal Allowance (£12,570)
· Taxable Income £37,930

The personal allowance of £12,570 is reduced by £1 for every £2 of Net Income above
£100,000. This means that individuals with Net Income of £125,140 and above will lose the
benefit of the personal allowance completely. To work out the reduced allowance for
individuals with Net Income between £100,001 and £125,000, follow this formula:
£12,570 – [(Net Income - £100,000) / 2] = reduced allowance

Example: application of personal allowance on earnings up to £100,000 but below £125,140:

Net Income £110,000
Less Personal Allowance Calculated by:
£12,570 – [(£110,000 - £100,000) / 2]
i.e. £12,570 – 5,000
= £7,570 (amount of reduced allowance)
Taxable Income = £110,000 - £7,570 = £102,430

Example: application of personal allowance on earnings above £125,140

Net Income £130,000
Less Personal Allowance (0)*
Taxable Income £130,000
*****£12,570 – [(£130,000 - £100,000) / 2] = a negative figure.
In this scenario none of the personal allowance would be left so there is no deduction from Net
Income.

Step 4: Applying the Tax rates

It is CRITICAL that the different types of income (non-savings, savings and dividend) income
are separated at this point as they MUST be taxed in the order of non-savings, then savings,
and then dividend income as different tax rates apply to each type of income. It may be
useful to remember a mnemonic in order to recall which order the incomes are taxed
(examples include: “never squash donuts” or “never say die”).
In order to calculate non-savings income, simply deduct the savings and dividend income
figures from the taxable income.
Taxable Income LESS Savings Income LESS Dividend Income = Non-Savings Income
Worked examples appear under the tax rate summary table.

Tax Rate Summary Table 2022/23

Tax band > taxable income > Non-savings > Savings > Dividends

Basic → 0 – 37,700 > 20% > 20% > 7.5%

Higher → 37,701- 150,000 > 40% > 40% > 32.5%
Additional → +150,001 > 45% > 45% > 38.1%

Taxable Income Non-savings Savings Dividends

Basic 0 – 37,700 20% 20% 8.5%
Higher 37,701- 150,000 40% 40% 33.75%
Additional +150,000 45% 45% 39.35%

*NB these savings rates are applied AFTER the personal savings allowance has been applied
(see below).
** NB these dividend rates are applied AFTER the nil rate has been applied to the first £2,000 of
dividend income. The nil rate applies to ALL individuals irrespective of the level of their taxable
income.

The Personal Savings Allowance:

Savings income is taxed at 0% (the savings nil rate)for the first £1,000 (if the taxpayer’s entire
taxable income is within the basic rate band) or the first £500 (if the taxpayer’s entire taxable
income exceeds the basic rate band but does not exceed the higher rate band, ie is not over
£150,000). There is no savings nil rate for taxpayers whose taxable income exceeds the higher
rate band (over £150,000).
Example 1
If we continue with the example of the woman above, since all of her £37,930 Taxable Income
is non-savings income, the next stage of her income tax computation would be as follows:
Taxable Income £37,930

Charge tax as follows:

20% on first £37,700 = £7,540
40% on balance of £230 = £92
Total tax payable =£7,632

You will see from the above example that the woman’s non-savings income crossed over /
straddled the basic and higher rate bands. The non-savings income therefore had to be
apportioned to the correct band. You ALWAYS use up the lower bands first, just as we did in
the above example.

Let us look now at an example where the taxpayer has a more complicated calculation involving
all types of income. The step by step approach detailed above will be followed.

Example 2: Factual Scenario

A man receives a salary of £75,000, plus benefits in kind to a value of £450. He pays pension
contributions of £3,000, and receives interest of £2,000 on his savings, and earns £2,500 by way
of dividends on the shares he holds.
STEP 1: Calculate Total Income
· Salary: £75,000
· Benefits: £450
· Interest: £2,000
· Dividends: £2,500
£79,950
STEP 2: CalculateNet Income
£79,950 (total income) LESS £3,000 (pension contributions)= £76,950

There are no other tax reliefs to be deducted.

STEP 3: Calculate Taxable Income

£76,950 (net income) - £12,570 (personal allowance) = £64,380

STEP 4:Applying the tax rates

First, separate the types of income:

£64,380 (taxable income) LESS £2,500 (dividend income) LESS £2,000 (savings income) =
£59,880 non-savings income.
Second, apply the tax rates to the types of income in the order of non-savings, then savings,
then dividend income:
· Non-savings income (£59,880):

Basic rate band:

0 to 37,700 @ 20% = £7,540

Higher rate band:

The balance of £22,180 (i.e. 59,880 – 37,700) will all be taxed at 40% as it all falls within the
higher rate band
37,701 to 59,880 (i.e. £22,180) @ 40% = £8,872
Total tax on non-savings income = £16,412.
· Savings income (£2,000)
Apply any personal savings allowance.
As this man is a higher rate taxpayer, he is entitled to the first £500 of his savings at 0%.
Balance of £1,500 @ 40% (as all falling within the remainder of the higher rate band) = £600
***
Total tax on savings income = £600
***NB: As non-savings income used up all of the basic rate band and there is sufficient capacity
in the higher rate band for all of the savings income, savings income is taxed at the higher
rate. IF there had been insufficient capacity in the higher rate band, the part of savings income
that crossed the band into the additional rate would be taxed at the additional rate. This
concept is explained in greater detail below (see the cake method).
· Dividend income (£2,500)

Apply the nil rate band to the first £2,000 as this is available to all taxpayers.
The balance of £500 will be taxed at 32.5% as there is sufficient capacity within the higher rate
band (see tax summary table above for the applicable rates to be applied).
£500 @ 32.5% = £162
Total tax on dividend income = £162
Lastly, add the tax payable on the three types of income to obtain the taxpayer’s total tax
liability.
£16,412 (non-savings) + £600 (savings) + £162 (dividend) = £17,174 Total Tax Payable

The ‘cake’ method

Another way to look at applying the different tax rates to the different bands of income in
calculating income tax is to think about it in terms of baking a cake. You may wish to use this
device to remember how to carry out the calculation.

Think of each type of income as being a different layer of the cake - ie:
1. non-savings income is the base layer;
2. savings income is the cream filling; and
3. dividend income is the top layer.
Think of the tax bands as measurements on a ruler sitting vertically next to the cake. The total
taxable income will be the height that the overall cake will rise to. Each layer of the cake will
rise according to how much tax the taxpayer must pay on each type of income.

Each type of income sits on top of the one before (like the layers in a cake), with the effect that
each tax bracket is used up in turn and no bracket is used until the one before it has been
exhausted.

If a layer of the cake/type of income rises through a tax band, then the tax rate to be applied
will have to be apportioned accordingly (as we saw with the non-savings income in Example 2
above). Example 2 is illustrated using the cake method below.
Inco****me tax due for the year

At the end of the personal tax computation, we establish the total amount of tax that the
individual taxpayer should pay for the year. If the taxpayer is in employment with little other
income during the relevant tax year, then much of this tax will have been paid already
through the PAYE system.

The income tax that remains to be paid must be settled in each year by a final payment to
HMRC. Alternatively, if the amount still outstanding and due to HMRC is fairly small, it may be
recovered by HMRC through an adjustment to the individual’s PAYE tax code for the following
tax year. If it transpires that the taxpayer has overpaid tax during the year the taxpayer will
receive a tax refund from HMRC.

Individuals also pay National Insurance Contributions (‘NICs’) out of employment income via the
PAYE system. NICs do not affect the individual’s personal income tax computation in any way
and will not be considered any further.

STEP 2: CalculateNet Income£79,950 (total income) LESS £3,000 (pension contributions)=

£76,950
Second, apply the tax rates to the types of income in the order of non-savings, then savings,
then dividend income:
· Non-savings income (£59,880):
Basic rate band:
0 to 37,700 @ 20% = £7,540
Higher rate band:
The balance of £22,180 (i.e. 59,880 – 37,700) will all be taxed at 40% as it all falls within the
higher rate band
37,701 to 59,880 (i.e. £22,180) @ 40% = £8,872
Total tax on non-savings income = £16,412.
of the cake will rise according to how much tax the taxpayer must pay on each type of income.
Each type of income sits on top of the one before (like the layers in a cake), with the effect that
each tax bracket is used up in turn and no bracket is used until the one before it has been
exhausted.

If a layer of the cake/type of income rises through a tax band, then the tax rate to be applied
will have to be apportioned accordingly (as we saw with the non-savings income in Example 2
above). Example 2 is illustrated using the cake method below.

Income tax due for the year

At the end of the personal tax computation, we establish the total amount of tax that the
individual taxpayer should pay for the year. If the taxpayer is in employment with little other
income during the relevant tax year, then much of this tax will have been paid already
through the PAYE system.

The income tax that remains to be paid must be settled in each year by a final payment to
HMRC. Alternatively, if the amount still outstanding and due to HMRC is fairly small, it may be
recovered by HMRC through an adjustment to the individual’s PAYE tax code for the following
tax year. If it transpires that the taxpayer has overpaid tax during the year the taxpayer will
receive a tax refund from HMRC.

Individuals also pay National Insurance Contributions (‘NICs’) out of employment income via the
PAYE system. NICs do not affect the individual’s personal income tax computation in any way
and will not be considered any further.

Example 3: income tax due for the year (higher rate taxpayer)
NB. Steps 1, 2 and 3 have already been calculated so we pick this calculation up at Step 4.
A man has the following income:
Taxable Income £44,700
Made up as follows:
Non-savings income £39,600
Savings income £5,000
Dividend income £100
As the man is a higher rate taxpayer, he will be entitled to a personal savings allowance of £500
of savings income at the savings nil rate.

Charge tax as follows:

Tax non-savings income first
20% on first £37,700 - Tax Due = £7,540
40% on (39,600-37,700) £1,900 - Tax Due - £760
Then tax the savings income
0% on first £500 - Tax Due - £0
40% on (£5,000 - £500) £4,500 - Tax Due - £1,800
Then tax the dividend income (covered by the dividend allowance)
0% on £100 - Tax Due - £0
Total tax liability £10,100 (£7540 + £760 +£1,800)
If the man’s payslips show that £9,000 of income tax has been deducted from his salary under
PAYE in this year, then his income tax due for the year is (10,100-9,000) £1,100.

Summary of Income Tax Calculation

In order to calculate an individual’s income tax liability correctly, the following formula should
be followed:
Step 1 Calculate Total Income
Step 2 Deduct available tax reliefs (interest on qualifying loans and pension contributions) = Net
Income
Step 3 Deduct Personal Allowance**(**reduced by £1 for every £2 of net income above
£100,000) = Taxable Income
Step 4 Split the Taxable Income into non-savings, savings and dividend income
NB. Taxable Income less (savings income and dividend income) = non-savings income
Step 5 Calculate any personal savings allowance that is available (ie looking at the Taxable
Income figure to see which income tax band it ends in)
Step 6 Apply relevant tax rates
Step 7 Add together the amounts of tax calculated at Step 6 = Total tax liability

Anti-avoidance legislation
A certain amount of tax legislation has been developed by successive governments in order to
put a stop to loopholes which have been exploited by taxpayers seeking to
reduce or eliminate their tax liabilities. HMRC and the courts are increasingly hostile towards
tax avoidance schemes.

In relation to income tax ,you should be aware that a taxpayer cannot reduce their income tax
liability by making gifts of certain income-producing items eg shares (which give rise to
dividends) or a lump sum (which gives rise to interest) to their children. Instead, under special
legislation often referred to as the ‘settlements’ legislation the income is treated as remaining
with the taxpayer who made the gift.

Summary
• Income tax is charged at different tax rates. The rate to be applied will depend upon (i)
the type of income and (ii) which band the income falls into (basic, higher or additional
rate bands).
• Individuals pay income tax on their salaries via the PAYE.
• Any tax deducted at source (such as PAYE) has effectively already been paid and must
be deducted from the tax liability before payment of the tax is made to HMRC.
• Each individual is entitled to an annual Personal Allowance. The personal allowance is
reduced by £1 for every £2 of net income above £100,000. If Net Income is £125,140 or
above, none of the PA is available.
• Some individuals have the benefit of the Personal Savings Allowance. For basic rate
taxpayers, the first £1,000 of savings income is taxed at the savings nil rate and for
 higher rate taxpayers, the first £500 is taxed at the savings nil rate of 0% (in each case
after the starting rate for savings has been applied, if applicable).
• The first £2,000 of dividend income for all taxpayers is taxed at the dividend nil rate of
0%.

Capital Gains Tax

Introduction

The idea behind Capital Gains Tax (‘CGT’) is to tax the profit that a person might make from
disposing of a capital asset which has appreciated (increased) in value during their period of
ownership.

CGT is charged where there is:

• a Chargeable Disposal
• of a Chargeable Asset
• by a Chargeable Person
• whichgives rise to aChargeable Gain.
CGT is charged on all gains made in therelevant tax year (i.e. 6 April to 5 April).

The tax is payable on or before 31 January following the tax year in which the disposal occurs.

This is the same date as for the final payment (or refund) of income tax for the year.

Chargeable Disposal
The two main instances of disposal are as follows:
1. the sale of an asset; and
2. the gift of an asset during the tax payer’s lifetime.
There is no chargeable disposal on death. The personal representatives of the deceased’s
estate are deemed to acquire the estate at its then market value. This is commonly known as ‘a
free uplift on death’.

Chargeable Asset
All forms of property are included in the definition of asset unless they are specifically
excluded. The main types of asset excluded from CGT are:
1. Principal private residence (‘PPR’):an individual can claim the benefit of this exemption
from CGT if they have occupied the PPR as their only or main residence during the
whole period of ownership, though the individual also has a valuable exemption in
respect of the last 18 months of ownership even if they were not in actual occupation.
In cases where an individual owns more than one home it is a question of fact as to
which of the residences is the PPR. A married couple can only have one PPR between
them: they cannot each have a different principal place of residence (unless separated);
2. Motor cars for private use, including vintage cars;
 3. Certain investments, such as government securities, National Savings certificates,
shares and securities held in Individual Savings Accounts (ISAs) and life assurance
policies; and
4. UK sterling and any foreign currency held for your own or your family’s personal use.

Chargeable Gain
A gain needs to have been made when disposing of the asset and in calculating the chargeable
gain, the starting point is always the consideration received (or deemed to have been
received). The appropriate rate of CGT (either 20% or 10% unless it is an upper rate gain - see
further below) is then applied to the chargeable gain.

Disposals to charities are treated as made on a no gain/no loss basis. Gains made by charities
are exempt provided that the gain is applied for charitable purposes.

Disposals between spouses

When one spouse disposes of an asset to the other, legislation deems that neither a gain nor a
loss has occurred, so no CGT is payable. In effect, the spouse receiving the asset takes over the
base cost (ie the original cost of the asset to the transferring spouse) of the spouse who
disposed of it.
This is the case for spouses or civil partners notwithstanding disposals between connected
persons (see later).

Example
A husband bought shares in a company for £4,000 in May 2018 and three years later gave the
shares to his wife. For CGT purposes, there is no capital gain (or loss) on this ‘disposal’ by the
husband: the wife in effect acquires the shares at a value of £4,000 with an acquisition date of
May 2022.

Consideration received
1. Disposals at arm’s length
a. Where there is a sale ‘at arm’s length’, the consideration received will be the
price paid by the buyer when the asset is sold.
2. Disposals between connected persons
a. If the parties are connected persons, HMRC will deem the seller to have received
market value irrespective of the actual sale proceeds.

Example
A woman bought some shares in a computer company in 2003 for £5,000. She sells them to her
daughter in April 2022 for the same price that she paid for them, £5,000. The market value of
the shares at the time she sells them was £40,000.
For CGT purposes, the woman is deemed to have disposed of the shares for £40,000 and will be
liable to CGT accordingly. Her daughter is deemed to have acquired the shares in April 2022 for
£40,000.
‘Connected Persons’ include:
• The individual’s relatives and spouses of their relatives. Relatives are direct ancestors
(parents and grandparents), lineal descendants and brothers and sisters but not ‘lateral’
relatives, eg uncles, aunts, nephews, nieces.
• Companies, if they are under common control.
• Partners in business.
Remember that this does not include a disposal to an individual’s own spouse.

3. Disposals at an undervalue
a. If the transaction is between unconnected persons and at an undervalue, then
for CGT purposes, the sale is deemed to be at the market value at the date of
disposal. Note, however, HMRC will not substitute market value if the seller has
simply made a bad bargain.
4. Gifts
a. Where a gift is made, the donor will be deemed to have received the market
value of the asset at the date of the gift.

Basic calculation of the gain

In order to calculate the chargeable gain made by the seller the following basic calculation must
be followed:
Consideration Received - Sale proceeds (or market value) = X
Less: Allowable Expenditure (eg original purchase cost) – (X)
= Gain

Example
A man purchased a sailing boat to use on his holidays on the Isle of Wight for £100,000 in May
2017.
He found that he did not enjoy sailing as much as he expected to and in May 2022 sold the boat
for £130,000
The man’s gain on the sale is £30,000:
Sale proceeds £130,000
Less: original purchase price (100,000)
Gain: 30,000

Allowable expenditure
There are three types of expenditure which can be deducted from the consideration (or
deemed consideration) received. These deductions enable the taxpayer to minimise the gain
made and therefore the tax payable. The categories of expenditure are as follows:

Initial Expenditure
1. The cost price of the asset (the ‘base cost’); and
2. The incidental costs of acquisition (eg surveyors’ fees/lawyers’ fees).
Subsequent expenditure
1. Subsequent expenditure on the asset which enhances its value; and
2. Expenditure incurred in establishing, preserving or defending title to the asset.

Disposal expenditure
Incidental costs of disposal (eg agents’ commission).

Calculation of the gain to include all forms of allowable expenditure

In order to calculate the chargeable gain made by the seller all of the allowable expenditure
needs to be included in the calculation as follows:
Sale proceeds (or market value)
Less disposal expenditure
= Net sale proceeds
Less initial expenditure
Less subsequent expenditure
= Chargeable gain

Using capital losses

Instead of a capital gain, a loss may result from a disposal. Capital losses are created when the
cost of an asset is greater than the consideration received for it on disposal (although a gift
cannot be used to create a capital loss for these purposes).

Since CGT is only charged on overall gains made by an individual in a tax year, any capital losses
that an individual has made in the same tax year can be carried across and deducted from any
gains made in that tax year. Such losses must be set off against other capital gains made in the
same tax year first.

If there are insufficient gains against which to offset the losses in the same tax year that they
are incurred, any unrelieved losses are set against gains in future tax years I.e. carried forward
(in so far as the gains in those years are not covered by the annual exemption; see below) until
used up. There is no time limit on taking a loss forward but it must be used against the first
available gains.

Note that there are limits as to how much an individual may claim in loss relief in certain
circumstances (we will not explore this further).
Annual Exemption (‘AE’)
Every individual is entitled to an annual exemption.
The annual exemption for the tax year 2022/23 is £12,300.

This means that all individuals are entitled to make up to £12,300 of gains tax free in this tax
year.
Companies do not have the benefit of any AE.

Tax payable on the gain

When the Total Chargeable Gain (i.e. after deductions and the annual exemption) has been
calculated, losses can then be taken into account and all gains are added together to find
the Total Taxable Chargeable Gains.
It is then necessary to calculate the tax payable on the total taxable chargeable gains.
In order to calculate the tax payable, the following rules apply:

1. Companies
a. All gains realised by companies will be calculated according to similar principles
as those applying to CGT (with certain exceptions eg companies qualify for
indexation allowance for inflationary gains up to December 2017 but do not have
an annual exemption). Such gains will then be taxed at corporation tax rates (see
later).
Companies do not pay CGT; they pay corporation tax. Therefore, in relation to gains made by
companies, reference should be made to ‘corporation tax on chargeable gains’ rather than CGT.
Note: charities are generally exempt from paying CGT.

2. Individuals
a. There are two rates of CGT: 10% and 20% (unless the gains are upper rate gains
(see below)).
b. Broadly, basic rate taxpayers pay 10% CGT and higher and additional rate
taxpayers pay 20% CGT. It is important to have calculated a person’s income tax
prior to their capital gains tax in order to establish this.

The details of the calculation are as follows:

• Where an individual’s Taxable Income plus total taxable chargeable gains after all
allowable deductions (including losses and the AE) is less than the basic rate tax
threshold of £37,700, the rate of CGT will be 10%.
• Where an individual’s Taxable Income exceeds the basic rate tax threshold of £37,700,
the CGT rate will be 20%.
• Where an individual’s Taxable Income is less than the basic rate tax band threshold of
£37,700 but after the gains are added, the combined total exceeds the threshold that
part of the gains within the unused part of the basic rate tax band will be charged to
CGT at 10% and any part that exceeds the threshold will be charged at 20%.
Apportioning tax in this way when bands are straddled was also seen in Example 2 of
the income tax element.

Note: Certain gains known as 'upper rate gains' are charged at 18% or 28%, for example
disposal of a property that is not a PPR. We will not consider the details of upper rate gains.

Summary of Capital Gains Tax calculation

In order to calculate an individual’s capital gains tax liability correctly the following formula
should be used:
Sale proceeds/market value: A
Less disposal expenditure: (B)
= Net Sale Proceeds: C
Less initial expenditure: (D)
Less subsequent expenditure: (E)
= Total Chargeable Gain: F
Less carried forward or carried-across losses: (G)
Less annual exemption: (12,300)
= Taxable Chargeable Gain: H
Apply CGT to the Taxable Chargeable Gain (H) at the appropriate rate (10% or 20%)

Business Asset Disposal Relief (formerly known as Entrepreneur’s Relief or ER)

Business Asset Disposal Relief reduces the higher rate of CGT from 20% to 10% for gains
arising on qualifying disposals.

The reduced 10% rate of CGT is applied to the Taxable Chargeable Gain (ie the gain after all
allowable deductions, losses and the annual exemption).
A qualifying disposal is a disposal of:
1. all or part of a trading business;
2. assets in a business that used to trade;
3. shares in a trading company; or
4. shares in a company that used to trade;
where, in each case, certain conditions are satisfied. The conditions are as follows:

1. Where someone disposes of all or part of a business:

a. the business must be a trading business; and
b. the business must have been owned for at least two years prior to the date of
disposal.
2. Where someone disposes of assets used in a business that used to trade:
a. the business must have been owned for at least two years before it ceased to
trade;
b. the assets must have been used in the business when it ceased to trade; and
c. the assets must have been disposed of within three years of the business ceasing
to trade.
3. Where someone disposes of shares in a company:
a. the company must be and have been for at least two years before to the date of
disposal, a trading company;
b. the shares must have been held for at least two years before the date of
disposal;
c. the person disposing of the shares must have been an officer or employee of the
company who holds at least 5% of the ordinary voting shares and is entitled to
 at least 5% of the profits available for distribution and 5% of the net assets on
a winding up, for at least two years before the date of disposal.
4. Where someone disposes of shares in a company that used to trade:
a. the shares must (generally) have been owned for at least two years before the
company ceased to trade;
b. the person disposing of the shares must have been an officer or employee of the
company who held at least 5% of the ordinary voting shares, and was entitled
to at least 5% of the profits available for distribution and 5% of the net assets
on a winding up, for at least two years before it ceased to trade; and
c. the shares must be disposed of within three years of the company ceasing to
trade.
d. Note that Business Asset Disposal Relief is not automatic: in order for it to apply,
the taxpayer must make a claim on or before the first anniversary of 31 January
following the tax year in which the relevant disposal is made.

Business Asset Disposal Relief – Lifetime Allowance

Business Asset Disposal Relief gives each individual a lifetime allowance, which is now set at
£1 million.

This means that the first £1 million of qualifying gains that an individual makes in his lifetime
can be charged to CGT at a reduced rate of 10%.

An individual can make as many qualifying claims as they like during their lifetime until their
cumulative gains reach the £1 million lifetime limit. Any gains beyond the £1 million lifetime
allowance will be charged to CGT at either 10% or 20% (depending on the rate at which the
individual pays CGT; see below).

Example
If the Taxable Chargeable Gain (ie the gain after all allowable deductions, losses and the annual
exemption) is £150,000 and Business Asset Disposal Relief applies, a rate of 10% CGT will be
applied to that figure. So the calculation would be:
Taxable Chargeable Gain = £150,000
CGT @ 10% = £15,000
You will see that the references throughout are to trading businesses and companies. Business
Asset Disposal Relief is not available in respect of investment businesses or companies. This
means that the disposal of a buy-to-let property investment or other non-trading business will
not qualify for Business Asset Disposal Relief.

Investors’ Relief (‘IR’)

IR was introduced to give a benefit to investors in unlisted trading companies who hold their
shares for at least three years.
IR reduces the higher rate of CGT from 20% to 10% for gains arising on disposals of qualifying
shares, subject to a lifetime limit of £10 million.
Shares will be qualifying shares if the following conditions are met:
 • The shares are fully paid ordinary shares and were issued to the individual
for cash consideration on or after 17 March 2016;
• The company is (and has been since the shares were issued) a trading company or the
holding company of a trading group;
• At the time of issue of the shares, none of the company’s shares were listed on a
recognised stock exchange;
• The shares are held by the individual for at least three years from 6 April 2016 (and
continuously since issue); and
• The individual (or any connected person) is not (nor at any time has been from the date
of issue of the shares) an officer or employee of the company (or any connected
company).
• Business Reliefs

There are two main business reliefs, which defer liability to CGT. These are:
· Replacement of business assets relief (‘Rollover Relief’)
· Gift of business assets relief (‘Hold-over relief’)

1. Replacement of business assets relief (‘Rollover Relief’)

a. To avoid having to pay CGT each time certain business assets are sold and
replaced, a taxpayer can elect to postpone the CGT liability it realises on the sale
of such an asset by ‘rolling over’ the gain into the replacement asset.
b. This applies to land and buildings, fixed plant and machinery and goodwill. The
new asset need not necessarily be of the same type as the old one. It merely
needs to be within the list of qualifying assets.
c. The effect of the relief is that any gain arising from a disposal of a qualifying
asset is carried forward and ‘rolled’ into the cost of a qualifying replacement
asset. The acquisition cost of the replacement asset is reduced by the amount of
the gain being rolled over.
d. Therefore, tax is postponed until the replacement asset is sold and no new
qualifying replacement asset is purchased.
e. It is possible to roll over gains indefinitely provided sufficient qualifying assets
are bought within the time limits.
f. The annual exemption cannot be used to reduce the gain rolled over.

2. Gift of business assets relief (‘Hold-over relief’)

a. Where an individual gives away a business asset, the donor (the person making
the gift) and donee (the person receiving the gift) can claim hold-over relief. As a
transfer at an undervalue or gift, the market value rule will apply. The donor will
have no liability to CGT but the donee’s acquisition cost for CGT purposes is
reduced by the amount of the donor’s deemed gain.
 b. In effect the CGT liability is postponed until the donee ultimately disposes of the
asset (although further hold-over relief can be claimed if the donee then gives
away the asset).
c. As in the case of roll-over relief, the whole chargeable gain must be held over if a
claim for hold-over relief is made. The donor cannot use his annual exemption to
reduce the gain held over.
d. Hold-over relief may also be claimed where an asset is sold at undervalue but
the hold-over relief will only be available on the gift element, ie the difference
between the price paid and the market value.
e. Business assets on which hold-over relief may be claimed include goodwill,
assets used in the business and shares in a trading company not quoted on a
stock market.
Summary
• CGT is charged when there is a chargeable disposal of a chargeable asset by a
chargeable person, which gives rise to a chargeable gain.
• There are two main types of disposal: a gift and a sale of an asset.
• The starting point for the CGT calculation is establishing the consideration or proceeds
received by the seller on the disposal of the asset, subject to any substitution of market
value if the transaction occurs between ‘connected persons’ or between unconnected
persons and for an undervalue.
• CGT is charged at 20% (for higher and additional rate taxpayers), 10% for basic rate
taxpayers and 10% where the individual benefits from Business Asset Disposal Relief or
Investors’ Relief.
• There are several ways to mitigate the CGT liability, eg allowable expenditure, Business
Asset Disposal Relief and Investors’ Relief (provided the conditions are fulfilled), losses;
and each individual is entitled to an annual exemption.

Inheritance tax - the Business Relief Exemption

This Element focuses on one of the exemptions: Business Property Relief.

There are three kinds of transfer (IHT trigger events) that you need to be aware of:
• Potentially exempt transfers (‘PET’) – made by a person during their life
• Lifetime Chargeable transfers (‘LCT’) – made by a person during their life
• Death

Chargeable Transfers - Revision

A PET is a transfer of value made by a person during their lifetime (inter vivos) to another
individual, eg a parent who gives their child a £10,000 contribution towards a deposit on a flat.

All inter vivos transfers of value made by a person into a trust on or after 22 March 2006 will
give rise to an LCT.

When a person dies there is a deemed transfer of all the assets that they own at the date of
their death. It is this deemed transfer that gives rise to the IHT charge on death.
For more detail about PETs, LCTs and transfers on death, including the tax treatment for them,
you should refer to the IHT Topic within Wills and Estates.

What is the value of the transfer? - Revision

PETs and LCTs

The relevant value for an inter vivos transfer is the amount by which the transferor's estate is
reduced, rather than the face value of the asset or the amount the transferee gains. For
example, if the transferor gives away one item out of a complete set, the loss to the transferor
may be more than the value of the one item given away.

Death
Property in the taxable estate is valued at the price it might reasonably be expected to fetch if
sold on the open market immediately before the death. You will consider what assets are
included in the taxable estate and special rules relating to asset valuation in the IHT Topic in
Wills and Estates.

Rates of Tax - Revision

The rates of IHT are set annually by the budget for the tax year which runs from 6 April one year
- 5 April the following year. For tax year 2022-2023 the rates are:
• £0 - £325,000 = 0% (the nil rate band (‘NRB’)) (NB. the NRB may be higher or lower in
certain situations)
• Above the NRB - 40% (death rate); or - 20% (lifetime rate - always 1/2 death rate -
applied to LCTs)
Note: There is an additional nil rate band (currently £175,000) for individuals who die on or
after 6 April 2017 if they leave their family home to lineal descendants. This is known as the
‘residence nil rate band’ (‘RNRB’))
An individual’s surviving spouse or civil partner (referred to as their ‘spouse’ for ease of
reference) can inherit the unused portion of their basic NRB and RNRB. This is known as the
‘transferable nil rate band’ (‘TNRB’).

Cumulative Total - Revision

Cumulation is used to prevent individuals reducing their IHT liability by making a series of
separate dispositions. Instead of viewing each IHT chargeable transfer (ie failed PET, LCT, death)
in isolation, HMRC also consider any other IHT transfers made in the 7 years prior to the current
transfer being taxed.

At any one point in time a person’s cumulative total can be worked out as follows:
Cumulative total = the total chargeable value of all the chargeable transfers made in the
previous 7 years.
The effect of the cumulative total is to reduce the NRB available for the current transfer. So you
must calculate the value of the cumulative total before you can work out the NRB available.
Available NRB to use for a transfer = £325,000 less the cumulative total

Exemptions and reliefs - Revision

There are a number of different exemptions and reliefs which can be used to reduce or
eliminate IHT. Exemptions and reliefs work in slightly different ways:
• Gifts to certain individuals or other entities are exempt from IHT. This means that they
can be made completely free from IHT and do not use up the NRB.
• Gifts of particular assets benefit from reliefs. This means that, where the conditions of
the relief are met, the amount of IHT payable is reduced (sometimes by 100%).
Some exemptions and reliefs only apply to PETs and LCTs. Others apply only to the death
estate. Some apply to both.

The exemptions and reliefs below apply to both lifetime transfers (failed PETs and LCTs) and the
death estate, and therefore should be considered for all chargeable transfers.

Available for both lifetime transfers and death estate

• Spouse exemption - Political party exemption
• Charity exemption - Exemptions for gifts for national purposes or to heritage
maintenance funds
• Business property relief - Exemption for gifts to EBTs
• Agricultural property relief - Exemption for gifts to housing associations

Business Property Relief (‘BPR’)

BPR is an exemption which applies to the value of qualifying business assets and is available to
LIFETIME transfers and the DEATH estate. Business property includes:
• a business or interest in a business eg business of a sole trader or partnership;
• shares in an unquoted company;
• shares in a quoted company;
• land or buildings, machinery or plant owned by transferor but used for business
purposes by either a company of which the transferor has control, or a partnership of
which the transferor was a partner.
The transferor must have owned the business assets for at least 2 years immediately prior to
the transfer. Note thatBPR is not available if the business consists wholly or mainly for making
or holding investments.
Rate of relief
• 100% relief is available in respect of transfers of a business or interest in a business or
shares in an unquoted company – eg 100% relief applies to all private company shares
irrespective of the size of the shareholding.
• 50% applies to shares in a quoted company but only if the shareholder had control of
the company (unlikely but possible) and to the land or buildings category on the
previous slide.
Note: Where a lifetime transfer qualified for BPR when made but is re-assessed following the
death of the transferor within 7 years, BPR will only be available when reassessing the transfer
if the property transferred (or replacement property) still qualifies for BPR in the transferee’s
hands when the transferor dies (or on the death of the transferee if earlier).

Calculating IHT on lifetime transfers

In order to calculate the IHT due on a failed PET or LCT the following formula should be used:
Step A – Calculate cumulative total
Step B – Identify value transferred
Step C – Apply exemptions and reliefs
Step D – Apply NRB and calculate tax
Step E - Apply taper relief
Step F –Give credit for tax paid in lifetime
Note that Steps E and F only apply when the IHT is being calculated after death.

Calculating IHT on death estate

In order to calculate the IHT due when someone dies it is necessary to follow this 7 step
process:
Step 1 - Calculate cumulative total
Step 2 - Identify assets included in the taxable estate
Step 3 - Value the taxable estate
Step 4 - Deduct debts/expenses
Step 5 - Apply exemptions & reliefs (BPR fits into IHT calculation here
Step 6 - Apply RNRB
Step 7 - Apply basic NRB and calculate tax

Summary
• Business Property Relief (‘BPR’) is an exemption for the purposes of IHT.
• It is available on both lifetime and the death estate.
• It applies on the transfer of various categories of Business Property.
• There are different rates of relief depending on the category of Business Property.
• Make sure you have read or re-visited the IHT Topic in the Wills and Estates Module.
Business Law and Practice – Workshop 7
Taxation of Companies
Introduction to Value Added Tax

Introduction
The VAT charge
VAT is charged on
• any supply of goods or services made in the UK
• where it is a taxable supply
• made by a taxable person
• in the course or furtherance of any business carried on by that person.

VAT Terminology
Supply of Goods or Services: Any supply made in the UK of goods or services done in return for
consideration.

Made in the UK: The place of supply of the relevant goods or services must be in the UK. There
are complex rules for working out the place of supply for VAT purposes in cross-border
transactions, which are outside the scope of this Workbook.

Taxable supply: Any supply made in the UK which is not an exempt supply. See below for the
various types of supply.

Taxable person: A person who is, or is required to be, registered for VAT purposes. ‘Person’
includes individuals, partners, companies and unincorporated organisations.

In the course or furtherance of any business carried on by him: ‘Business’ is a very wide term
and basically any economic activity carried on, on a regular basis. An employee’s services to an
employer are excluded. All of a person’s business activities are included in one VAT registration.

In this element we will use the phrase ‘taxable business’ to mean a person who is VAT
registered or required to be VAT registered.

Registration
A person is required to be registered:
1. at the end of any month if the value of his/her taxable supplies in the period of one year
or less has exceeded the VAT registration threshold (the person must notify HMRC
within 30 days of the end of that month and will be registered from the beginning of the
second month after the taxable supplies went over the threshold); or
 2. at any time if there are reasonable grounds for believing that the value of his/her
taxable supplies in a period of 30 days then beginning will exceed the VAT registration
threshold (the person must notify HMRC within the 30 days and will be registered from
the beginning of the 30 days).
Please note that the registration thresholds (and the deregistration threshold as referred to
later) change from time to time. The current registration threshold is £85,000.

Alternatively, a person can register voluntarily. Voluntary registration means that input VAT can
be recovered (which is helpful to a business in reducing costs). However, it also means that the
business will have to charge output VAT on supplies of goods and services to its customers
(which may make the business less attractive to customers than its unregistered competitors).

De-registration
A VAT registered person may apply to have the registration cancelled and accordingly cease to
be ‘taxable’ (even though continuing to carry on the business) where the value of his/her future
annual taxable supplies will not exceed the VAT deregistration threshold. The current
deregistration threshold is £83,000.

Output and input tax

Output tax
The VAT chargeable by a business when making a supply of goods or services is called ‘output’
tax. The VAT relates to the ‘output’ of the business.
Input tax
The VATpaidby a person on goods or services supplied to the person is called ‘input’ tax. The
VAT relates to goods and services ‘bought in’ by the person.

A VAT registered business offsets input tax it has suffered (on goods and services it has
purchased) against output tax it has charged customers or clients (on its own supplies) and
only accounts for the difference to HMRC.

The business acts as a tax collector in collecting and paying to HMRC the tax on the value added
by the business in the supply chain.

Note that where there is no output tax charged in any VAT accounting period, it is still usually
possible to reclaim any input tax incurred where it is intended output tax will be charged in the
future.

How much VAT?

The applicable rate of VAT will depend on the type of supply. The standard rate of VAT is
currently 20%.
A price is deemed to be VAT inclusive unless the contract for the supply of goods or services
states otherwise. In other words, the stated consideration paid for the supply includes any VAT
payable.

Where the standard rate of VAT applies, in order to calculate the VAT element of a VAT
inclusive price you should multiply the price by the VAT fraction, which is currently 1/6. This has
been worked out as follows:
Tax rate = 20 = 1
100 + tax rate 120 = 6

The seller must account for the VAT element amount to HMRC, so the seller won’t be allowed
to keep the full amount of the stated price. In practice, the seller can deduct any input VAT that
it has incurred so it only needs to pay HMRC the difference.

In many situations it will be appropriate for the price of goods or services to be expressed as
exclusive of VAT so that VAT is charged in addition to the stated price. Here, the seller will
account to HMRC for the VAT element and keep the (VAT-exclusive) stated price.

Example
Calculate the VAT paid to HMRC by each of the following VAT registered businesses in
connection with the supplies made. Assume that VAT is charged at 20% and that all these
individuals are registered for VAT. Note that the price charged is stated to be exclusive of VAT
in each case.
1. Arthur, a lumberjack, cuts down a tree and sells the tree to Boris for £200 +VAT;
2. Boris, a timber merchant, cuts the tree into planks and sells these to Carol for £400
+VAT;
3. Carol, a furniture manufacturer, turns the planks into desks and sells these to Desmond
for £800 +VAT;
4. Desmond, a furniture supplier, sells the desks to a Law School for £1,000 +VAT; and
5. Total sent to HMRC

Example - Answer
1. Arthur to Boris for £200 +VAT;
Input VAT suffered = £0
Output VAT charged = £40
VAT sent to HMRC = £40
2. Boris to Carol for £400 +VAT
Input VAT suffered = £40 (paid to Arthur)
Output VAT charged = £80
VAT sent to HMRC = £40
3. Carol to Desmond for £800 +VAT
Input VAT suffered = £80 (paid to Boris)
Output VAT charged = £160
VAT sent to HMRC = £80
4. Desmond to a Law School for £1,000 +VAT
Input VAT suffered = £160 (paid to Carol)
Output VAT charged = £200
VAT sent to HMRC = £40
5. Total sent to HMRC?£40 + £40 + £80 + £40 = £200

Types of Supply
A business can make four kinds of supply (or the supply can be outside the scope of VAT
altogether, such as the transfer of a business as a going concern, subject to certain conditions
being satisfied):
1. Standard Rated
2. Reduced Rated
3. Zero Rated
4. Exempt
The details of these different kinds of supply are set out below.

1. Standard Rated
Generally, the standard rate of VAT is 20%. A supply by a business will be standard rated unless
it falls within one of the other three categories.

A VAT registered business charges VAT at standard rate on its outputs and recovers any VAT
suffered on its inputs (unless it makes supplies which fall into the exempt category below).

2. Reduced Rated
A very limited number of types of supply are charged at 5%. These include supplies such as
domestic heating and power, installation of mobility aids for the elderly, smoking cessation
products and children’s car seats.

3. Zero Rated
Further supplies are zero rated for public policy reasons. Zero rated supplies include food
(within certain categories), sewerage and water, books / newspapers, talking books for the
blind, new houses and the construction of new houses, public transport and children’s clothing.

Zero rated supplies fall into the category of taxable supplies. This means that when a VAT
registered business makes zero rated supplies it charges VAT at the rate of 0% on its outputs
and it can recover any VAT suffered on its inputs. This is therefore a very favourable supply for
a business to make.

4. Exempt
Supplies that are exempt include the provision of insurance, finance, education / health
services and the sale of land and buildings (unless it comprises a new commercial building or
the supplier of a commercial building has chosen to make the supply standard rated by waiving
the exemption). When a business makes exempt supplies it does not charge VAT on its supplies
but equally it is notable to recover any VAT suffered on its inputs. This input tax is a cost to the
business.
Accounting for VAT to HMRC
Businesses with turnover above the VAT registration threshold are required to keep their VAT
records and make their VAT return online. Smaller business may choose to do so.

1. VAT Invoice
A taxable business making a standard (or reduced) rate supply of goods or services to another
taxable business must supply the customer / client with a VAT invoice within 30 days of the
supply and keep a copy. HMRC carries out regular inspections of businesses to ensure that
input and copy output invoices have been kept.

2. VAT Return
Taxable businesses must submit a VAT Return online to HMRC every three months. The due
date is within one month after the end of the VAT period.
The VAT Return must show the total output tax charged on the making of taxable supplies
during that VAT period less the total input tax attributable to the making of taxable supplies. At
the same time the business must pay to HMRC the excess of the output tax charged over the
input tax suffered.
Businesses that normally pay more than £2.3 million a year to HMRC in VAT must make
monthly payments on account and then pay the balance when submitting the quarterly VAT
return.

3. Special Schemes
There are a number of special schemes designed to simplify accounting for VAT or to reduce
VAT liability:
• Retail Schemes
o There are special schemes for use by retailers who find it difficult to issue VAT
invoices for the large number of supplies that they make direct to the public.
• Cash Accounting
o Businesses whose annual turnover is less than £1,350,000 (excluding VAT and
excluding exempt supplies) may opt to use a cash accounting scheme if they
comply with certain conditions, i.e. output tax is accounted for when the invoice
is paid rather than issued. However, input tax can only be recovered when the
business pays the supplier.
• Annual Accounting
o Businesses with an annual turnover not exceeding £1,350,000 (excluding VAT
and excluding exempt supplies) may be permitted by HMRC to make an annual
VAT Return. The VAT is paid by instalments during the year (based on the
previous year’s VAT liability) with the balance being paid when the VAT Return is
submitted.
• Flat Rate Scheme
o Where a VAT-registered business has a taxable annual turnover not exceeding
£150,000 (excluding VAT) and a total annual turnover (i.e. to include the VAT
 charged to the business, and the value of any exempt and other non-taxable
income) not exceeding £230,000 the business may elect that VAT be charged at a
flat rate on turnover rather than on every single transaction.

There is however not normally any relief for input VAT. The flat rate will depend on the type of
business and HMRC publishes a table setting out the applicable rates for the different types of
business such as hairdressers and estate agents. Since 1 April 2017, there are anti-avoidance
rules requiring ‘limited cost traders’ who use a flat rate scheme to account for VAT at a rate of
16.5%.

Summary
• VAT is charged on any supply of goods or services made in the UK where it is a taxable
supply made by a taxable person in the course or furtherance of any business carried on
by him.
• Persons are required to be registered for VAT if the value of their taxable supplies
exceeds certain thresholds. They may also register voluntarily.
• Businesses charge ‘output’ tax on the taxable supplies they make and pay ‘input’ tax on
the taxable supplies they receive.
• The rates of VAT depend on the type of supply: standard rate, reduced rate, zero rate or
exempt. Input tax attributable to standard, reduced or zero rated supplies is generally
recoverable. Input tax attributable to exempt supplies is not recoverable.
• Prices are deemed to be inclusive of VAT (if any) unless stated otherwise.

Introduction to Corporation Tax

Introduction
Corporation Tax is payable on:
• all income profits and
• chargeable gains
• of a body corporate
• that arise in its accounting period.

The sum of a company’s profits and gains is known as ‘TTP’ (taxable total profits chargeable to
corporation tax).

Companies are assessed to corporation tax by reference to the financial year (1 April – 31
March). Note that because a company can choose its accounting period, it is often different to
the financial year, which is the same for all companies.

The amount of TTP will determine the amount of corporation tax payable.

The rate of corporation tax for the tax year 2022/2023 was a flat rate of 19%. As of 1 April
2023, the main rate will increase to 25% for companies with profits greater than £250,000. A
small profits rate of 19% will be introduced on 1 April 2023 for those companies whose profits
do not exceed £50,000.

Calculation of TTP - basic proforma

Chargeable gains
Sale proceeds
[Allowable Expenditure]
[Indexation Allowance]
[Capital/Trading Losses]
= Chargeable Gain

Income profits
Income receipts
[Deductible Expenditure]
[Capital Allowances]
[Trading Losses]
= Income Profits

Chargeable gain & Income Profits → TTP

Tax treatment of income for corporation tax purposes

You have already looked at the nature of capital and income receipts. Income and capital
receipts are subject to different tax rules, so it is necessary to identify the nature of the
receipts. This is the case even though companies pay corporation tax at the same rates on
income and gains.

Remember the basic rule that income receipts and expenditure arise through everyday
trading whereas capital receipts and expenditure arise from one-off transactions.

What constitutes a company’s income?

The most common types of company income are:
• rental income;
• trading income;
• interest; and
• dividend income.

Taxable income profits

To calculate the taxable income profits, you must aggregate all chargeable income receipts and
deduct all tax-deductible expenditure.
• chargeable income receipts:Receipts of an income nature which arise from the business
or trading activity (and which are not exempt receipts).
• tax deductible expenditure: Expenditure by a company that the company is permitted
to deduct from its income receipts, thereby reducing its overall tax bill.
Deductible expenditure for income purposes
To be deductible for tax purposes the expenditure must:
• be ‘...wholly and exclusively’ incurred for the purposes of the trade – eg expenditure
which is partially by way of gift;
• not be prohibited by statute – eg business entertainment expenditure (i.e. money spent
by a company entertaining its clients) and provisions made in accounts for doubtful
debts; and
• be of an income nature – eg rent, interest paid, wages, repairs.
You will consider the particular tax treatment of dividends paid by a company and the tax
treatment of interest paid by a company later in this element.

Adjustments for capital allowances

Capital expenditure is generally only deductible from capital receipts and not usually deductible
to calculate income profits. In addition, depreciation (an accounting concept) is not an
allowable deduction for tax purposes and therefore to allow businesses to spread the cost of
certain capital assets over a period of time, ‘capital allowances’ are given as a deduction
against income receipts.

Even though capital allowances relate to capital expenditure, the allowances are treated as a
deduction for income purposes in calculating income profits. Capital allowances are available
on qualifying items of expenditure.

Qualifying expenditure includes expenditure incurred on plant and machinery. There are
other special capital allowances that apply to, for example, long life assets, research and
development expenditure and certain costs of construction and renovation of commercial
buildings but these are outside the scope of the module.

Capital allowances are available to individuals and partnerships carrying on a trade as well as to
companies.

Capital allowances on plant and machinery

Companies can deduct 18% of the value of plant and machinery (‘P&M’) from their income
receipts each year on a ‘reducing balance’ basis. This means that when a company claims
capital allowances in one year on P&M, the value of the P&M for tax purposes is reduced by
18%. This value is referred to as the ‘tax written down value’ or ‘TWDV’ of the P&M. When the
company claims capital allowances in the following year, it will claim 18% of the TWDV of the
P&M after it has been reduced by the previous year’s capital allowances claim.

Example
if the TWDV of P&M is £100,000 then the capital allowances figure will be 18% of £100,000,
which is £18,000, and the TWDV for the purposes of calculating next year’s capital allowances
will be £82,000 (£100,000 - £18,000). It follows that next year’s capital allowances figure will be
18% of £82,000, which is £14,760.
Annual Investment Allowance
Another type of capital allowance is the annual investment allowance (‘AIA’). This enables a
company to deduct 100% of expenditure on P&M up to a specified amount. This is currently
£1 million for any purchases before 31 March 2023.

The normal capital allowance of 18% can be applied to the balance of any expenditure above
that amount. Therefore, if a company has spent more than £1 million in 2022 on P&M, the
company is entitled to deduct from income profits the AIA of £1 million plus 18% of the balance
of the expenditure. After the first year, the allowance reverts back to 18% per annum on a
reducing balance basis.

Example
X Ltd spends £1,400,000 on plant and machinery in its accounting period ended 31 December
2022. It claims its full capital allowances for that year and the next year, as an income
deduction. What is the tax written down value of the plant and machinery after the second
year?

Year 1
Allowance Claimed
Annual investment allowance = £1,000,000 + 18% of reducing balance = £400,000
(18% x (£1,400,000-£1,000,000)). This comes to £72,000.
Total year 1 allowance = £1,072,000
TWDV
£328,000
(cost of £1,400,000 – Total year 1 allowance of £1,072,000)
(The company can claim (i) full AIA of £1 million plus (ii) the normal 18% allowance on the
balance of the expenditure).

Year 2
Allowance Claimed
18% of Year 1 WDV = £328,000
(18% x £328,000). This comes to £59,040.
TWDV
£268,960
(Year 1 TWDV of £328,000 – Year 2 allowance of £59,040)
The company can claim the normal 18% allowance on the tax written down value of the asset at
the end of Year 1.

Capital Allowances: Super-deduction

A new type of capital allowance was introduced in the Finance Bill 2021 which allows
companies to claim 130% first-year relief on expenditure incurred from 1 April 2021 until 31
March 2023 on qualifying plant and machinery.
The Super-deduction allowance will not apply to second-hand, used or leased assets. It will
include expenditure on assets such as fire alarm systems, security systems, bathroom
sanitaryware, carpets, computers equipment and servers, tractors, lorries and vans, ladders,
drills and cranes, office desks and furniture, refrigeration units and electric vehicle charging
points.

Unlike the AIA, there is no expenditure limit on the super-deduction allowance. We will not
consider this further in the module.

Example
B Ltd spends £2,000,000 on qualifying plant and machinery in its accounting period ended 31
March 2023. It can claim the super-deduction allowance of 130% relief on the expenditure. This
means B Ltd can deduct £2,600,000 in calculating its taxable profits in Year 1.

Assessment of tax, reliefs and exemptions for companies on disposal of capital assets

The same rules apply in relation to allowable expenditure for chargeable disposals by
companies as for individuals (ie initial expenditure, subsequent expenditure (such as costs of
defending title and enhancement expenditure) and costs of disposal can be deducted). But
note the following differences between companies and individuals:
• There is no annual exemption for companies.
• Indexation allowance continues to be available for companies but is frozen up to 31
December 2017.

The Substantial Shareholding Exemption, or SSE, is a relief that can exempt from corporation
tax the whole of a chargeable gain that arises when a company disposes of shares in a trading
company (or the holding company of a trading group) provided certain conditions are met. The
disposing company must have held at least 10% of the ordinary share capital of the
• company whose shares are being disposed of for at least 12 consecutive months in the last six
years. This relief is not available for individual sellers BUT Companies cannot reduce the tax
they pay on their chargeable gains by claiming Business Asset Disposal Relief or Investors’
Relief.

Rollover relief for replacement of business assets (‘Rollover Relief’)

This relief is a tax deferral mechanism, which can be used by individuals or companies to defer
tax that would otherwise be due in respect of a gain arising when an asset is disposed of. You
were introduced to this relief earlier.
It will potentially be available in the following situations:
• where a company disposes of a qualifying business asset and it (or a company in its
group) buys another qualifying asset (referred to as the ‘replacement asset’);
• where a sole trader or partnership disposes of a qualifying business asset and buys
another qualifying asset;
• where an individual, other than a sole trader, owns a business asset, sells that asset and
buys another qualifying asset and both assets are used by either:
 • a company which is the individual’s personal company; or
• a partnership of which the individual is a partner.
Note that although the new asset is referred to as the ‘replacement asset’, it does not have to
be the same type of asset as the asset which has been disposed of.

General effect of the relief

The gain from a disposal of a qualifying asset is carried forward and ‘rolled’ into the acquisition
cost of a qualifying replacement asset. The acquisition cost of the replacement asset is reduced
by the amount of the gain being rolled over. Therefore, tax is postponed until the replacement
asset is sold and no new qualifying replacement asset is purchased. It is possible to roll over
gains indefinitely, provided sufficient qualifying replacement assets are bought within the time
limits.

Qualifying assets
Only certain types of the following assets attract Rollover Relief, including for example:
• land and buildings;
• goodwill;
• fixed plant and machinery;
• ships and hovercraft;
• aircraft, and
• Lloyd’s syndicate capacity.

Timing of sale and purchase

The replacement asset must be purchased within 12 months before or three years after the
sale of the old asset.

Example
Sale proceeds of qualifying assets (eg aircraft) 200,000
Less acquisition cost (100,000)
Less indexation allowance (20,000)
Chargeable gain before rollover relief 80,000
Price of qualifying replacement asset (eg spacecraft) 250,000
Less gain to be rolled over (80,000)
New tax base cost of spacecraft 170,000

Use of proceeds of sale

Rollover Relief can be restricted when not all of the sale proceeds of the original asset are used
to acquire the new asset.
The amount by which the sale proceeds of the original asset exceed the cost of the replacement
asset is deducted from the chargeable gain before Rollover Relief and only the remaining
amount of the gain can be rolled over.
Essentially the gain to be rolled over is reduced by £1 for every £1 of the sale proceeds not
reinvested.
Example
Sale proceeds of qualifying asset (e.g. aircraft) 200,000
Less acquisition cost (100,000)
Less indexation allowance (20,000)
Chargeable gain before Rollover Relief 80,000
Price of qualifying replacement asset (e.g. spacecraft) 180,000
Less gain to be rolled over (80,000 - (200,000 – 180,000)) (60,000)
New tax base cost of spacecraft 120,00
If, when the cost of the replacement asset is deducted from the sale proceeds of the original
asset, the resulting figure is greater than the amount of the gain, no Rollover Relief claim can be
made.

Example
£
Sale proceeds of qualifying asset (e.g. aircraft) 200,000
Less acquisition cost (100,000)
Less indexation allowance (20,000)
Chargeable gain before Rollover Relief 80,000
The price of the new qualifying asset is £110,000.
The sale proceeds from the original asset (£200,000) exceed the cost of the new asset
(£110,000) by £90,000. This is greater than the gain of £80,000 so no claim for Rollover Relief
can be made.

Dividend received and paid by companies

• Dividends paid to UK companies are subject to corporation tax unless the dividend falls
within one of a number of exemptions. However, the exemptions are very broad and
the general effect of the rules is that all dividends are exempt from corporation tax
unless certain anti-avoidance provisions apply.
• Dividend income received by a company is therefore generally exempt from
corporation tax and is therefore not included in that company’s TTP for tax purposes.
A company pays a dividend out of profits that have already been taxed so the tax
already paid satisfies the recipient company’s tax liability in respect of the dividend.
• For the same reason, the dividend is not tax deductible for the company paying it.

Straddling
Sometimes a company’s accounting year does not coincide with a financial year (‘FY’). This
complicates the corporation tax calculation if the rates of corporation tax for the FYs are
different.

Where this occurs, the TTP of the accounting period must be apportioned between FYs and
the relevant proportions of TTP must be taxed at the applicable rates for the FYs.
Loss Relief: Deductibility of trading losses
A trading loss occurs where tax deductible expenditure exceeds income receipts for a specific
period. Trading losses can be set off against other taxable profits in, broadly, four different
ways.
4. Current year profits
Trading losses can be set off against all other profits (ie income profits and chargeable gains) of
the same accounting year. A claim must be made within two years after the end of the
accounting period in which the loss arose.
5. Previous year profits
If trading losses cannot be used in whole or part against current profits, a company can carry
back any remaining losses against taxable profits (income and chargeable gains) of the previous
accounting period. The company must have been carrying on the same trade in both years to
be able to carry the loss back to be set off against the previous year’s profits. A claim must be
made within 2 years after the end of the accounting period in which the loss arose. If a
company ceases trading, any trading loss in the final 12 months of trading can be carried back
and set against any profits made in the three years prior to the start of the final 12 months.
6. Future trading profits
If there are still trading losses unused they are automatically carried forward and set against all
the company’s taxable profits (income and chargeable gains) in the future.
The company must continue to trade the loss-making trade in the period in which the losses are
used but use of the losses is not restricted to profits of the same trade.
7. Group relief
Where a group relief group exists, one company with a trading loss can surrender that loss to
another profitable company in the group so that the surrendered loss can reduce or eliminate
that company’s profits.

Anti-avoidance rules
There are rules that prevent trading losses being carried forward or back where the company
has been sold to a new owner and the nature of the trade of the company has substantially
changed within three years after the sale. These rules were introduced to prevent buyers
acquiring loss-making companies purely to make use of their losses.

Temporary extension of carry back of trading losses

As a temporary measure to assist those companies who have suffered losses due to the
pandemic, the Government has temporarily extended the period over which the companies
may carry back losses.
Trading losses incurred in accounting periods ending between 1 April 2020 and 31 March
2022 can be carried back as follows:
• one year without a cap (same as under current rules); and
• a further two years, but against more recent years first and subject to a cap of
£2,000,000 of losses arising in accounting periods ending in the 1 April 2020 to 31 March
2021 period and a separate cap of £2,000,000 losses arising in accounting periods
ending in the 1 April 2021 to 31 March 2022 period.
Loss Relief: Deductibility of capital losses
Capital losses can only generally be set off against capital gains (also called chargeable gains).
Capital losses can be set off against capital gains in the current year but they cannot generally
be carried back to a previous year.

If there are still capital losses unused in the current year, they can be carried forward and set
against any capital gains in future accounting periods.

The company may use carried forward capital losses against capital gains of up to the available
Deductions Allowance in the relevant accounting period, provided that the Deductions
Allowance has not already been used for the purposes of setting off carried forward trading
losses against trading profits in that same period (see above for the current cap/allowance).

Where, in any accounting period, the company has unrelieved capital gains in excess of the
available Deductions Allowance for that period, carried forward capital losses may be used to
relieve a maximum of 50% of the unrelieved gains.

Capital losses can be carried forward indefinitely within the company that made them but in
order to crystallise the loss, a claim must be made to HMRC within four years from the end of
the accounting period in which the loss arose.

Mechanics of corporation tax self-assessment

1. Procedure for companies with TTP of £1,500,000 or less
• Company estimates its tax liability and pays HMRC within 9 months and one day of the
end of the accounting period.
• Company must file (electronically) a tax return within 12 months of the end of the
accounting period to which it relates, together with its accounts. This will show how a
company has calculated its tax liability.
• Unless HMRC examine or make enquiries into the tax return to establish whether or not
the correct tax has been paid, the company’s tax computation will usually be regarded
as finalised 12 months after the filing date for the tax return.
• Interest will accrue on any under or over-payments.
2. Procedure for companies with TTP of more than £1,500,000
Companies with TTP ofmore than £1.5m are required to pay their tax bills in four installments
over the course of the relevant accounting period and the next one.

Interest paid and received by companies

1. Deductibility of interest paid
Interest paid on business loans will generally be a deductible income expense ie a company can
deduct the amount of the interest it has paid from its profits to reduce the TTP and thereby
reduce the overall tax bill.

Where a company (or group of companies) has more than £2 million of net interest expense in
the UK any year, the amount of interest a company may deduct is restricted to, broadly, a
maximum amount equal to 30% of its income receipts. This is known as the corporate interest
restriction, or CIR.
2. Obligation to withhold tax from certain interest payments
Tax is deducted at source from certain payments (eg income tax under the PAYE system). This is
known as ‘withholding tax’, the person making the payment (in the case of PAYE, the employer)
has an obligation to withhold the tax payable by the person receiving payment and pay it over
to HMRC.

A company which pays interest may have an obligation to withhold tax from the payment,
especially in an international context. However, a company which pays interest to another UK
corporation tax paying company or a UK bank is allowed to make those payments without
deducting tax from the payments (ie the company can make a gross payment of interest).

Summary
• Corporation tax is charged on ‘Taxable Total Profits’. ‘Profits’ in this context means
income profits and chargeable gains.
• Deductible expenditure can reduce income profits if it is incurred wholly and exclusively
for the purposes of the trade, is not prohibited by statute and is of an income nature.
• Capital allowances can reduce income receipts.
• Allowable expenditure (such as the original cost of an asset or any allowable subsequent
expenditure on it) can reduce chargeable gains.
• Rollover relief on replacement of business assets defers any tax due on the disposal of a
qualifying asset by rolling the gain into and thereby reducing the base cost of the
replacement asset.
• Dividends received by companies are exempt from corporation tax and is therefore not
included in that company’s TTP for tax purposes.
• Losses can be used to reduce a company’s tax liability.

Introduction to close companies

Introduction
Companies which are ‘close’ companies (broadly, small companies, but see further below), are
subject to special tax treatment. The close company regime is an example of anti-avoidance
legislation.

The close company tax regime is an example of anti-avoidance legislation as it prevents or

discourages taxpayers from exploiting some of the tax benefits of incorporation.

There are various special tax rules applicable to close companies. The most important of these
are as contained in this element.

Definitions
A company will be a close company if it is under the control of:
• five or fewer participators; or
 • any number of participators who are also directors.

A ‘Participator’ is a person having a share or interest in capital or income of the company, for
example, shareholders and some creditors.

‘Control’ means the ability to exercise control over the company’s affairs, normally by voting
rights, or the possession of or entitlement to:
• issued share capital allowing the greater part (ie more than 50%) of income of the
company if distributed; or
• the greater part of assets of the company on winding up.
• However, there are some exclusions from the definition, eg a company will not be a
close company if:
• its shares are quoted on a recognised stock exchange; or
• it is controlled by one or more non-close companies, and it could only be a close
company by treating a non-close company as one of the five or fewer participators
having control.
Therefore, for example, a company which is a wholly-owned subsidiary of a non-close company
will not be subject to the close company tax regime.

In assessing a person’s ‘control’, rights and entitlements of that person’s ‘nominees’,

‘associates’ and companies controlled by the individual need to be considered.
‘Associate’ means any close relative, ie spouse, parent (or remoter forebear), child (or remoter
issue), brother or sister.
‘Nominee’ means a person owning property on behalf of another.

Close companies: Taxation effect - Loans to Participators

1. ‘Loans’: All advances of credit are caught, except for:
• a loan in the form of credit given by a company in respect of goods or services normally
supplied by the company in the course of business where the duration of the credit does
not exceed six months or the company’s normal limit; or
• a loan made in the ordinary course of a company’s business which includes money
lending; or
• a loan to a borrower which, together with other outstanding loans made by the
company to that borrower, does not exceed £15,000 in aggregate and the borrower
works full time for the company and does not have a ‘material interest’ in the close
company.
• Material Interest’:This means indirect control of more than 5% of the ordinary share
capital of the company or an entitlement on winding up of more than 5% of the assets
available.

The tax effect for the company

The company must pay corporation tax to HMRC on the amount of the loan, calculated at the
rate of income tax payable on dividends by higher rate taxpayers. The tax must be paid within
nine months and one day after the end of the accounting period in which the loan is made.
The company may claim a refund of the tax paid if the loan is repaid, satisfied, written off or
waived.

The tax effect for the recipient participator

If the loan is written off or waived, the participator is deemed, for income tax purposes, to
receive a dividend equal to the amount of the loan written off/waived. There is no tax effect for
the participator if he pays back the loan in full.

Close companies: Taxation effect – Distributions and IHT Implications

2. Distributions
The term ‘distribution’ has an extended meaning for close companies.
It includes living accommodation and other benefits in kind provided (ie distributed) to
participators (but not where such benefits are provided by reason of employment).
3. Inheritance Tax Implications
As only individuals pay IHT, it is possible to form a company and make a transfer through that
company. There is anti-avoidance legislation, which means that a transfer of value by a close
company results in the value of the gift being apportioned between its shareholders.

Close companies: Taxation effect - Transactions in Securities rules

4. Transactions in Securities rules
The transactions in securities rules may apply, broadly, to a transaction involving a close
company, where the transaction gives any person a tax advantage by changing a receipt which
would have been treated as income for tax purposes, into a capital receipt. For example, where
a close company has substantial distributable profits and instead of being passed to
shareholders as a dividend (taxed as income), the close company is wound up and the profits
passed to shareholders as a (capital) payment on a winding up, the transactions in securities
rules may apply. Where they apply, the rules operate to counteract the tax advantage.
When acting on a transaction which may fall within the transactions in securities rules, it may
be advisable to apply to HMRC for advance clearance. Clearance would state that HMRC is
satisfied that the provisions do not apply to the transaction. Your client’s specialist tax advisers
will be responsible for assessing whether this would be advisable on a particular transaction.

Summary
• Companies which are ‘close’ companies are subject to special tax treatment.
• The close company tax regime is an example of anti-avoidance legislation as it prevents
or discourages taxpayers from exploiting some of the tax benefits of incorporation.
• Close companies are generally speaking smaller companies.
• A company will be a close company if it is under the control of:
• five or fewer participators; or
• any number of participators who are also directors.
• There are tax effects on the company and the borrower if a close company lends money
to a participant.
Business Law and Practice – Workshop 8
Business Accounts
Double entry book-keeping, ledgers and the trial balance

Accounts and solicitors in practice

It is important for professional advisers, such as solicitors, to have an understanding of the
financial statements of a business. For example:
• Most business transactions have a financial motivation and have an effect on the
accounts. Having knowledge of a company’s accounts will help a solicitor to understand
a client’s concerns.
• A solicitor needs to be able to follow what is going on in negotiation meetings with
accountants and financial advisors.
• An understanding of accounts is important when working on acquisitions
and understanding the value of a business.
• Reviewing accounts can be an important part of the litigation process(eg deciding
whether it is financially worth bringing an action against the owner of a business).
• It is easier to interpret financial statements if you have an understanding of how they
are put together. Furthermore, solicitors are in business themselves and need accounts
as much as any other business.

Accounts and businesses – financial statements

Financial statements are prepared in respect of each accounting period of a business. An
accounting period is usually a full year. Every business is free to choose its own accounting
period; it is common for this to match the calendar year or the tax year.

The financial statements prepared in respect of each accounting period are:

• a profit and loss account
• a balance sheet
Businesses have a formal system of accounts. They keep a routine record of all their money
transactions, which is then used in order to prepare the year-end financial statements (the
balance sheet and profit and loss account). Businesses are treated as being separate from their
owner/owners. For example, if an owner puts capital into his business, the business ‘owes him’
that capital

Book-keeping ledgers
The process by which businesses record money transactions is called 'book-keeping'.
Each day there will be a number of financial transactions that take place within a business eg
sale of stock or payment of employees’ wages. These need to be recorded in a logical and
useful way. As such, transactions of a similar type (eg the payment of rent and electricity bills
by the business) are grouped together and recorded in a single place referred to as a 'nominal
ledger' (eg a nominal expense ledger).
There are several different types of ledgers (also referred to in a general sense as 'accounts').
The collective name for all of the different ledgers/accounts used by the business is 'books'.

Double entry book-keeping

The principle of this system of book-keeping is that every money transaction that a business
undertakes will have a dual effect in its accounts. For example, if a sole trader purchases an
asset for £5,000, there will be a reduction of £5,000 in the record of its cash and an increase of
£5,000 in the record of the assets of the business.

Having identified, in respect of a particular transaction, the types of account affected and
whether there is an increase or reduction, the next step is that the transaction will be recorded
in two places in the books of the business. One aspect will be recorded as a 'debit' entry and
the other as a 'credit' entry.

As the value of every individual debit will be equal to the matching credit when all the
debits/credits for all transactions are added together, the sum of the business’s debits should
be equal to the sum of all its credits over the relevant accounting period.

Note: There are accounting rules that determine the debit and credit classification but the
detail of this is beyond the scope of the material covered here.

Example: Mr X trading as XYZ Trading – ledgers extract

Mr X is a sole trader running the business of XYZ Trading. XYZ Trading purchases a printer for
£10,000 for business purposes. The following is an extract of the changes made to the relevant
ledgers.
The accounting period and trial balance
To make sense of the financial performance of a given business, it is helpful to be able to
compare the position year-on-year. Periodically, therefore, the ledgers/accounts of a business
will be 'ruled off' so that the balances on the various accounts can all be looked at together.
This is done at the end of each accounting period/financial year. Many businesses also prepare
‘interim accounts’ during the course of a financial year for various reasons and at different
points during the year.

Due to double entry book-keeping, if we take all the balances on all of a business’s
ledgers/accounts as at the end of an accounting period and list them, showing debit balances in
one column and credit balances in another column, the total of each of the two columns should
be the same. This list is called a trial balance.

A trial balance is usually put together by a business or its accountants and forms the basis of
information from which the financial statements, principally the profit and loss account and
balance sheet are then compiled.

Trial balance

What is a trial balance?

A trial balance is a list of all the balances on all of a business’s ledgers/accounts as at the end
of an accounting period.

The trial balance shows debit balances in one column and credit balances in another column.
The total of each of the two columns should be the same (and thus balance).

The classification of ledgers/accounts

Every entry on the trial balance will relate to a ledger, which could be characterised as an asset,
liability, capital, income or expense (ALCIE) account. You need to be able to recognise and
classify the different types of account for the purpose of understanding the preparation of the
financial statements.
Asset: something a business owns. A business will have a separate account for each category of
asset (eg motor vehicles, cash at bank).

Liability: something a business owes. A business will have an account for each different type of
liability (eg loans, trade debts).

Capital: usually identifiable as an injection of value from an owner or investor rather than
money generated by the business.

Income: money earned by the business, usually from a regular source. Each main income
source of the business will have a separate account (eg a theatre might record income from
ticket sales and from venue hire in separate accounts).

Expense: money spent by the business. Each different type of expense is recorded in a separate
account (eg heating and lighting).

Example: The importance of the ALCIE classification

You should be able to see the importance of classifying the different types of account by
looking at an example financial statement of a business (which would have been prepared after
an initial trial balance).

One such financial statement is a balance sheet. An example of an extract from a balance sheet
of a business is on the next slide.

Notice on the following extract of a balance sheet that the assets and liabilities of the business
have been separated (on the left side of the extract).

For now, you do not need to consider the figures on the right side of the following balance
sheet extract.

Example: Balance sheet extract

Assets – Fixed Assets
A fixed asset is any asset, tangible (such as a building) or intangible (such as a trade mark),
owned by a business that will enable it to make profit.

To be defined as a fixed asset, it must be held by the company for over a year and provide some
long lasting benefit to the company.

A tangible fixed asset is a physical asset.

An intangible fixed asset does not have a physical existence, for example, a trade mark, patent
or goodwill.

Fixed assets may also be called 'non-current assets'.

Assets – Current Assets

Current assets include cash and items owned by the business (or owed to the business) which
can quickly be turned into cash (as a rule of thumb, within one year).

These assets are current as they are continually flowing through the business and therefore
have a shorter-term nature; for example:
• stock (goods for use or resale), also known as 'inventory';
• debtors, which are people who owe money to the business (most commonly 'trade
debtors', who are customers who have bought on credit and have not yet paid);
• cash, including cash that the business has in its bank account(s) and 'cash in hand'/'petty
cash'. When looking at the accounts of companies, the various types of cash are
combined into a 'cash and cash equivalents' entry in the Balance Sheet.

Liabilities
A liability is an amount owedby the business tosomebody else. These are categorised as
current liabilities (broadly, those due to be paid within a year) and long-term liabilities (falling
due after one year) (also known as 'non-current liabilities').

Examples of current liabilities include a bank overdraft (repayable on demand) and trade
creditors(such as suppliers of raw materials). A trade creditor is the mirror image of a trade
debtor.

A common example of a long-term liability (or non-current liability) (falling due after more
than one year) is a term loan.

Capital
Where a business is owned by a sole trader, the assets of the business are the sole trader’s
property since the business has no separate legal personality and cannot own property on its
own account. However, for accounting purposes, the business and its owner are seen as two
separate entities. A sole trader may invest a lump sum of his own money in the business when
setting it up. As well as any such original capital contribution, a sole trader’s capital account will
include the profits the business has retained over the years.

A sole trader will hope to earn a living from the profits of his business. Since the business is not
a separate person, it cannot employ its owner and pay him a salary. Instead, the owner pays
himself by means of drawings out of the profits of the business. The account labelled 'drawings'
in the trial balance is a capital account because it represents transactions between the business
and its owner.

As you will see in later elements, the differing nature of the relationship between the business
and its owners (depending on whether the business is a sole trader, a partnership or a
company) explains some significant differences in the accounting treatment of capital accounts.

Income and expense accounts

As summarised previously, these two accounts relate to the business’s trading activity.

Expense accounts record day-to-day spending such as the examples in the previous summary,
known as 'revenue' or 'income' expenditure. 'Expenses' for these purposes do not include
spending on long-term assets (eg a car or a building) which are sometimes, confusingly,
referred to as 'capital expenditure'.

When a business pays for services or buys items that it will not hold for very long before it uses
them up, it treats the purchase as an expense. By analogy to your everyday life, if you buy some
bread from the supermarket you will think of this as a day-to-day living expense. However, if
you buy a car or a television, you will think of this as acquiring an asset.

Income accounts record sums received by the business such as payments from customers in
relation to sales of goods or services made by the business.

Year-end adjustments
Before the trial balance can be used to prepare the financial statements, year-end
adjustments will need to be made to some of the figures. The purpose of the year-end
adjustments is to ensure that all income and expenditure shown on the final financial
statements relate only to the relevant accounting period.

For example, if a business’s accounting period matches the calendar year and it pays a year’s
rent in advance on 1 June, only half of this payment will correspond to the current accounting
period (1 June – 31 Dec.). The remaining half (1 Jan – 31 May) will relate to the subsequent
accounting period. According to the unadjusted trial balance, it will seem that the business has
spent twice as much on rent for the current accounting period than it really has. The
adjustments made effectively ‘correct’ this imbalance and you will see how this is done in a
later element.
Summary
Book keeping ledgers → Trial balance → ALCIE classification and year end adjustments → Profit
and loss account and balance sheet
• Each transaction will be recorded in two places in the books of the business. One aspect
will be recorded as a 'debit' entry and the other as a 'credit' entry.
• If we take all the balances on all of a business’s ledgers as at the end of an accounting
period and list them in a trial balance, showing debit balances in one column and credit
balances in another column, the total of each of the two columns should be the same.
• Every entry on the trial balance will relate to a ledger, which could be characterised as
an asset, liability, capital, income or expense account.
• Before the trial balance can be used to prepare the financial statements, year-end
adjustments will need to be made to some of the figures to ensure they are accurate for
the relevant accounting period.

Profit & Loss Account

Introduction
What is a profit and loss account?
Accountants use the entries from the trial balance (outlined in the previous element) to
construct the year-end financial statements of a business:
1. the profit and loss account, and
2. the balance sheet.

The profit and loss account essentially records the income of a business throughout an
accounting period minus expenses incurred in that period, to arrive at a profit (or a loss) figure
for the period.

The contents of a profit and loss account

As you have seen, the profit and loss account records the income of a business throughout an
accounting period minus expenses incurred in that period, to arrive at a profit (or a loss) figure
for the period. A profit and loss account is therefore a summary of the fortunes of a
business over a passage of time. It is always vital to note the period to which a profit and loss
account relates in order to understand it. The accounting period to which it relates is recorded
in the heading for the account, always with the words 'for the period ending on [last day of the
period]' or 'for the year ended [last day of the period]'.

As a general rule, only the income and expense entries from the trial balance are transferred
into the profit and loss account.

For example, 'sales' in the trial balance is an income account and this appears at the top of the
profit and loss account. In contrast, 'telephone', 'postage' is a business expense and appears in
the expenses section of the profit and loss account.
'Cash at bank', on the other hand, is an example of an asset account and so does not appear on
the profit and loss account.

The format of a profit and loss account

There are standard formats for presenting the layout of the profit and loss account and all
profit and loss accounts for UK businesses follow a similar structure.

Please note that you may see the profit and loss account referred to as an 'income statement'
in the accounts of businesses prepared according to international accounting standards.

You can now consider the example profit and loss account below.

Example: Profit and Loss Account for the year ended [dd/mm/yy] (page 1)

Example 2: Profit and Loss Account for the year ended [dd/mm/yy] (page 2)
Summary
• The profit and loss account essentially records the income of a business throughout an
accounting period minus expenses incurred in that period, to arrive at a profit (or a loss)
figure for the period.
• All income entries from the trial balance are put at the top of the profit and loss
account.
• The 'cost of sales' figure in the profit and loss account is calculated using figures for
'opening stock' and 'closing stock'. These are both asset accounts, so these two accounts
are exceptions to the general rule that a profit and loss account shows only income and
expense accounts.
• The 'gross profit' calculation represents all the income of the business less the 'cost of
sales'.
• Towards the end of the profit and loss account, all of the expenses of the business
excluding purchases are deducted from the 'gross profit'.
• At the end of the profit and loss account is the 'net profit'.

Balance Sheet

Introduction
What is a balance sheet?
You will recall that the profit and loss account and the balance sheet are the year-end financial
statements prepared by a business. On its own, a profit and loss account (covered in a previous
element) is an incomplete record of a business’s financial position as it only records two
categories of account (income and expenses accounts).

For this reason, a balance sheet will record the position of a business in respect of its asset,
liability and capital accounts from the trial balance.

The date of a balance sheet

The balance sheet of a business differs from a profit and loss account as it is
a snapshot relevant on a given date (unlike the profit and loss account which relates to a
period, which in most cases is a year).

The date at the top of a balance sheet is the last day of the accounting period to which it
relates. The heading of a balance sheet always contains the words 'as at' a specified date. For
example, it will record the value of the total assets held by the business at that date.

That balance could be different the very next day, for example, if an asset were sold and the
proceeds used to pay bills.

The contents of a balance sheet

The balance sheet principally tells the reader two key things:
 • The net worth or net asset value (NAV) of the particular business (ie the value of the
assets it has, less the liabilities it owes). This is recorded in the top half of the balance
sheet.
• The capital invested in the business to achieve that net worth. This is recorded in
the bottom half of the balance sheet.
These two figures (one in each half of the balance sheet) will always be the same, unless
something has gone wrong. The two halves of the balance sheet must always balance. This
balancing effect is because the top half of the balance sheet demonstrates how the money
invested by the owners of the business (shown in the bottom half of the balance sheet) has
been used.

As a general rule, asset, liability and capital entries from the trial balance are transferred into
the balance sheet. For example, 'debtors' in a trial balance is an asset entry and this appears in
the top half of the balance sheet. However, 'capital at the start of the year' is a capital entry and
appears in the bottom half of the balance sheet.

There are standard formats for presenting this information on a balance sheet. The first
example balance sheet which follows (which is for XYZ Trading) and the accompanying notes
help explain the format of the entries. A second example balance sheet is then provided to
assist your learning. Review the examples and make sure that you understand the construction
of each.

Please note that the example balance sheets represent the position after any year-end
adjustments have been made. This means that entries relating to those year-end adjustments
(eg the account labelled 'accruals') will not be recognisable to you at this stage. These
adjustments will be covered in a later element.

Example: Balance sheet as at [dd/mm/yy]

Summary
• Asset, liability and capital entries from the trial balance are transferred into the balance
sheet. The balance sheet is a snapshot relevant only on the given date.
• The NAV of the business is recorded in the top part of the balance sheet.
• Assets are categorised as either fixed assets or current assets on the balance sheet.
• The net book value takes into account the depreciation of fixed assets over time.
• The liabilities of the business are categorised as either current or long term.
• To calculate the net current assets of a business you deduct all current liabilities from all
current assets.
• Fixed assets (net book value) + net current assets – long term liabilities = NAV.
• The amount of capital invested in the business is recorded in the bottom part of the
balance sheet.
• The NAV and total capital figures must always be the same in order for the balance
sheet to effectively balance and demonstrate how the capital invested in the business
has been used.

Year-end adjustments: Depreciation

Introduction
What are year-end adjustments?
Year-end adjustments are transactions or modifications to the account entries on the trial
balance. They are needed in order to apply theaccruals concept to the preparation of financial
statements. This concept requires that:
• all income and expenditure must be 'matched' to the relevant accounting period; and
• all current obligations must be anticipated as liabilities and all asset values must be
assessed to make sure they can be recovered through future profits in conditions of
uncertainty.

Year end adjustments

There are five year-end adjustments:
1. Depreciation
2. Accruals
3. Prepayments
4. Bad debts
5. Doubtful debts.
In this element you will consider DEPRECIATION.

Depreciation
A fixed asset (which for a company may be referred to as a 'non-current asset') may have a
useful life of several years, after which it may be of little or no value.

Depreciation is a mechanism used in the accounts to deal with this decline in value and to
spread the cost of the asset over its useful life.

If depreciation were not used, the accounts would not give a true reflection of the position of
the business. The assets would be stated at their cost value, which may, over time, be well
above their actual value.

Depreciation must be carried out in a systematic (ie regular) way but the method used should
mirror as closely as possible how the asset loses value over the relevant accounting periods

Depreciation methods
There are two methods of depreciation:
1. the straight-line method, and
2. the reducing balance method.
The method that is chosen will depend not only on how the asset loses value but how it
produces revenue for the business on an ongoing basis.

An asset such as shelving will use the straight-line method because the asset is being used up
consistently over its lifespan and is generating a consistent amount of income.

An asset such as a van, however, will produce much more revenue for the business in its earlier
years of use and hence the reducing balance method will be more relevant. This amount is
known as the 'charge to depreciation' or 'depreciation charge'.

The straight-line method the most common and straightforward method, so we will focus on it.

Straight-line method
• spreads the depreciation charge evenly over the life of the asset; and
• gives rise to the same charge for depreciation each year.
This is the most common and straightforward method.
The straight-line method is used where the service provided by the asset continues throughout
its useful economic life on a consistent basis (eg the shelving unit mentioned earlier).

If plotted on a graph, the depreciation of the asset would form a straight line.

Reducing balance method

• The depreciation charge each year is expressed as a percentage (x %) of the reducing
balance (ie the net book value of the asset at the start of the relevant accounting
period).
• More depreciation is thus charged in earlier years than in later years since the net book
value of the asset reduces year on year.
This method is less common and slightly more complicated.

The reducing balance would be used where an asset is likely to lose a large part of its value in
the first few years of ownership eg motor vehicles.

If plotted on a graph the depreciation of the asset would form a curved line.

Example: Straight line depreciation

Marleys Department Store buys some shelving for its warehouse, costing £6,000. The shelving
is expected to last for 5 years.

The cost will be spread evenly over the five-year period. A depreciation charge of £1,200 (ie
£6,000  5) will be made each year.

This annual depreciation charge will 'accumulate' over the years. In year one, the accumulated
charge will be £1,200, year two £2,400, year three £3,600 etc.

The charge each year (ie £1,200 in the Marleys example) will be included in a depreciation
account as the loss in value of the shelving constitutes a ‘cost’ to the business and will be
shown on the Profit and Loss Account as an expense.

The accumulated depreciation will be included in an accumulated depreciation account (liability

account) thereby reducing the net book value of the asset and will be shown on the Balance
Sheet. In the Marleys example, the accumulated depreciation after Year 3 will be £3,600.

Net Book Value

As you have seen, the fixed (or non-current) assets are recorded at the top of the Balance
Sheet.

The original cost of the asset is shown, as is the accumulated depreciation relating to that asset.
A calculation is then performed to show the current value of the asset after taking into account
its loss of value due to depreciation.
 COST – ACCUMULATED DEPRECIATION = NET BOOK VALUE
The Net Book Value of an asset is an estimate of the current value of the asset to the business.

Summary
• Year-end adjustments are transactions or modifications to the account entries on the
trial balance.
• They are needed in order to apply theaccruals concept to the preparation of financial
statements.
• Depreciation is a year end adjustment and can be calculated using two methods:
o Straight line (more common method), or
o Reducing balance
• Depreciation is a mechanism used in the accounts to deal with this decline in value and
to spread the cost of the asset over its useful life.
• The depreciation charge for the year will appear in the profit & loss account.
• The depreciation charge for the year will be added to the (accumulated) provision for
depreciation (liability) account, which will appear in the balance sheet.

Year-end adjustments: Accruals and Prepayments

Introduction
Reminder: What are year-end adjustments?
Year-end adjustments are transactions or modifications to the account entries on the trial
balance. They are needed in order to apply the accruals concept to the preparation of financial
statements. This concept requires that:
• all income and expenditure must be 'matched' to the relevant accounting period; and
• all current obligations must be anticipated as liabilities and all asset values must be
assessed to make sure they can be recovered through future profits in conditions of
uncertainty.
There are five year-end adjustments: depreciation, accruals, prepayments, bad debts, doubtful
debts.

In this element you will consider ACCRUALS and PREPAYMENTS.

Accruals
An accrual arises when an expense has been incurred and should be charged against profit in
the current year but for some reason - for example, the business has not received an invoice
for the item - by the time the accounts are drawn up, that expense has not been included in
the trial balance.

An accrual occurs when a business has had the benefit of something in one accounting period
but will not pay for it until the next. Making an adjustment in this way complies with the
accruals concept referred to above.
If an adjustment is not made for an accrual then the accounts will not be giving a true
reflection of the position of the business for that year. The business will have had the benefit
of something but not yet paid for it. Therefore, the profit of the business will be shown as
artificially high unless the adjustment is made.

Example
Panache Beauty Salon ('Panache') has called on the services of its solicitors several times during
the year just ended. The preliminary trial balance includes a balance of £27,000 in the Legal
Fees account.

At the year end, Panache has not yet received a bill of costs for some work done by the
solicitors a month ago. The bill is expected to be for £5,000.

The trial balance shows that Panache has used £27,000 of legal advice in the accounting year
when really it has used £32,000 (ie £27,000 + £5,000) of legal advice.
As a result of the adjustment:
• The figure of £32,000 (including the £5,000 which Panache has not yet paid for) must be
included in the Legal Feesexpense account and shown in the Profit and Loss Account.
• The £5,000 which Panache owes must be included as an Accrual current liability account
and shown on the Balance Sheet.

Prepayments
A prepayment arises when an expense is paid for in the current year but all or part of the cost
should be charged as an expense next year. It occurs when a business has paid for something
in advance during one accounting period but does not get the benefit of all or some of what it
has paid for until the next. It is, in effect, the opposite of an accrual.

If an adjustment is not made for the prepayment then the accounts will not be giving a true
reflection of the position of the business. If the business has paid for something but not yet
received the benefit, then the profit of the business will be artificially low. Again, this is an
example of the accruals concept.

Example
Flitwick Carpentry ('Flitwick') has paid £30,000 rent for its business premises. The rent was paid
on 1 October (when the business moved in) for 12 months in advance. Flitwick has an
accounting year end of 31 December.

The trial balance will show that Flitwick has paid £30,000 of rent in the accounting year.
However, Flitwick should only be paying rent in the present accounting period for the three
months of October, November and December (ie £7,500, ((£30,000 ¸ 12 months) x 3 months)).
The rest of the £30,000 (£22,500) should be accounted for in the next accounting period. The
figure of £22,500 is the amount that Flitwick has prepaid in respect of rent.

As a result of the adjustment:

 • The correct figure of £7,500 must be shown in the Rent expense account on the Profit
and Loss Account.
• The £22,500 (ie the amount of the prepayment) will be shown in a Prepayment current
asset account that will be created on the Balance Sheet since the business has yet to
enjoy the benefit of the rental already paid for.

Summary
• Year-end adjustments are transactions or modifications to the account entries on the
trial balance.
• They are needed in order to apply theaccruals concept to the preparation of financial
statements.
• Accruals occur when a business has had the benefit of something in one accounting
period but will not pay for it until the next.
• Prepayments occur when a business has paid for something in advance during one
accounting period but does not get the benefit of all or some of what it has paid for until
the next.

Year-end adjustments: Bad and doubtful debts

Introduction
Reminder: What are year-end adjustments?
Year-end adjustments are transactions or modifications to the account entries on the trial
balance. They are needed in order to apply theaccruals concept to the preparation of financial
statements. This concept requires that:
• all income and expenditure must be 'matched' to the relevant accounting period; and
• all current obligations must be anticipated as liabilities and all asset values must be
assessed to make sure they can be recovered through future profits in conditions of
uncertainty.
There are five year-end adjustments: depreciation, accruals, prepayments, bad debts, doubtful
debts.
In this element you will consider BAD AND DOUBTFUL DEBTS.

Bad Debts
The Receivables figure shows the amount of money owed to the business and the total of these
amounts is shown in the 'Receivables' account. The 'Receivables' entry in the accounts of
partnerships and companies is made up of all those who owe money to the company, each of
whom are a 'debtor' of the company. This is an asset account because it represents money
which the business can look forward to receiving.

An unfortunate fact of business is that not all debts are paid. This should be taken into
account when preparing financial statements.

A debt is a 'bad debt' when a business knows with certainty that it is never going to receive
it. It might be that the debtor has gone into an insolvency procedure. When this happens, the
bad debt or debts are 'written off'. The owner of the business gives up any prospect of
collecting the debt andthe debt is therefore removed from the 'Receivables' entry in the
accounts.

Bad debts may be written off during the accounting year. If this is the case, there will already be
a bad debts expense account in the trial balance. (If no bad debts are written off in a given
accounting year, there will be no such account).

The business may also need to carry out a further year-end adjustment as other debts may be
written off at the end of the accounting year when a review is made of the debts then owed to
the business.

If it is decided that a further debt needs writing off as a bad debt, but the year-end adjustment
is not performed, the accounts will not give a true reflection of the position of the business.
Instead, it will seem that the business is expecting more money to be paid to it than is actually
the case.

Bad debts - example

At the end of its accounting period Woburn Hardware Store ('Woburn') has a balance on its
receivables account of £7,000. At year end it is discovered that one of its trade customers has
been declared bankrupt. The bankrupt customer owes the store £360. The trial balance will
show that £7,000 is owing to Woburn but the store knows that £360 of that will never be paid.

The receivables asset account must be reduced to £6,640 (ie £7,000 - £360).

The bad debt itself will be shown as part of a 'bad and doubtful debts' expense account.

Note: In company accounts this expense account is referred to as 'Impairments'.

Doubtful Debts
A doubtful debt occurs when a business is providing for the possibility that a debt or debts
may not be paid.

A doubtful debt differs from a bad debt in that the business is not writing off the debt
completely. It is just making sure that the accounts accurately reflect the fact that the business
may not receive all of the money owed to it.

There are two ways of 'being doubtful' about debts:

• Specific doubtful debts: A business may know that a particular debtor is in trouble
financially or is disputing its liability to pay the debt. The debtor may not have entered
into an insolvency process or the dispute may be settled on favourable terms and
therefore, the owner of the business has not given up hope (so the debt is not a bad
one) but the business wants to show that it may not receive the amount owed.
• General doubtful debts: A business may not have any information on a specific debtor
but knows that the market generally is not doing well and wants to make a general
 provision for a certain percentage of its debtors not to pay, e.g. it is estimated that 5%
of its receivables may not be paid.

Specific and general provisions

A business may choose to make a specific or general provision, or a combination of both, to
quantify its doubts and express them as an actual figure. This figure will be shown as the
balance on an account called 'Provision for Doubtful Debts'. The amount allocated to the
provision for doubtful debts account is set afresh at each year-end. It might increase, reduce or
stay the same compared with the previous year’s provision.

A provision account provides some cushioning for the business. Such an account can be viewed
as a mechanism by which the business 'ring-fences' a certain amount of its net asset value, just
in case it transpires that the doubtful debts need to be written off.

Using A/L/C/I/E terminology, what type of an account is a provision for doubtful debts?
Its nature, and effect on the Balance Sheet, is most similar to that of a liability account and it is
treated as such, because the amount of assets available to the business is reduced by the
amount of the provision.

Remember that we are discussing accounting procedures: a business will not literally set aside
cash in order to make a provision for doubtful debts.

Doubtful Debts as Expenses in the Profit and Loss Account

A doubtful debt may, in future, be written off as a bad debt and become a real cost to the
business. For this reason, doubtful debts are accounted for in the same expense account in the
Profit and Loss Account as bad debts, a 'Bad and Doubtful Debts' expense account.

You have seen why the 'bad debts' element of this account should be categorised as an
expense. Bad debts represent a cost to the business. Doubtful debts, on the other hand,
represent potential costs which the business may (or may not) incur.

Therefore, it would be incorrect to show the whole amount of a business' provision for doubtful
debts as an expense. Instead, only the increase (if any) in the provision for doubtful debts over
the amount of the previous year’s provision is treated as an expense.

Doubtful debts example - Nightingales

Nightingales Fashion Wholesale ('Nightingales') is a new business. In this example, references to
'Years' are to accounting periods of the business. Nightingales' first accounting period is 'Year
1'.

Year 1: At the end of Year 1, Nightingale’s receivables amount to £101,000. Nightingales

believes that one of its debtors, Contact Retail Ltd ('Contact'), is on the brink of insolvency. It is
unlikely that Contact will pay its outstanding invoice of £1,000. Nightingales makes a specific
provision for doubtful debts for this £1,000.
In addition, Nightingales decides that, taking into account the general economic conditions in
the market, it is likely that 1.5% of the remaining receivables may never be paid. Nightingales
therefore wishes to create a general provision of £1,500 for doubtful debts (£100,000 x 1.5% =
£1,500).

The total Provision for Doubtful Debts at the end of Year 1 is £2,500.

Year 1 Profit and Loss Account: Nightingales is a new business, so the provision for doubtful
debts at the start of Year 1 was £0. Therefore, at the end of Year 1 there has been an increase
in the provision from £0 to £2,500. The whole of this £2,500 increase is treated as an expense
and must be included in the balance of the Bad and Doubtful Debts account in the Profit and
Loss Account.

Year 2: When preparing the financial statements for Year 2, Nightingales decides that the total
Provision for Doubtful Debts should be £3,000. This represents an increase of £500 from Year 1
(£3,000 - £2,500= £500).

Year 2 Profit and Loss Account: It is the increase of £500 that is an expense. By increasing its
provision, Nightingales is in effect £500 ‘worse off’ than it was last year. Therefore, £500 is
added to the Bad and Doubtful Debts Expense in the Profit and Loss Account.

Year 3: At the end of Year 3, Nightingales decides that trading conditions have improved and
therefore the total Provision for Doubtful Debts is to be reduced to £2,000.

Year 3 Profit and Loss Account: A decrease in the Provision for Doubtful Debts reduces
expenses. It ‘frees up” £1,000 for other purposes. Therefore, when preparing the Profit and
Loss Account for Year 3, the Bad and Doubtful Debts expense is reduced by £1,000 (£3,000 -
£2,000).

The Provision for Doubtful Debts on the Balance Sheet

The Provision for Doubtful Debts is treated as a liability on the Balance Sheet. As a matter of
presentation, it is shown in a different way from other liabilities and is 'matched' to the asset it
most directly affects, the receivables asset account (see example below).

This is because the business will wish to show its affairs accurately. It is appropriate to show the
actual value of the receivables account but the business will also wish to demonstrate that it is
prudently providing for the possibility that some debts may not be paid and allow a reader to
see what the figures are.
Summary
• A bad debt is a debt which a business knows with certainty that it is never going to
receive.
• Bad debts can be written off during the financial year or at the end of the financial year.
• A doubtful debt occurs when a business is providing for the possibility that a debt or
debts may not be paid.
• A doubtful debt can be specific or general.
• Bad debts will appear on the balance sheet by a reduction in the Receivables account
and in the P&L account as an expense.
• The increase/decrease in the provision for doubtful debts will be shown in the P&L
account and they will appear on the balance sheet as a liability (matched to the asset
that they reduce ie the receivables).

Partnership Accounts

Introduction
In general, the accounts of a partnership are very similar to those of a sole trader. The year-end
adjustments are the same. The accounts of LLPs and limited partnerships are prepared in a
similar way to those of 'ordinary' partnerships.

The main differences are in the bottom half of the Balance Sheet (denoting capital). This is
because, in a partnership, the business will be owned by at least two different people.

To show the capital of a partnership correctly on the Balance Sheet, it is necessary to take an
additional, intermediate step, which is to prepare a profit appropriation statement. This
records how the profits of the business for the relevant accounting period are divided between
the partners.

Separate accounts for each partner

'Drawings' are withdrawals of profits by the partners during the year, to pay themselves (in
the same way as sole traders). They are usually based on an estimate of the partner’s share of
expected profits for the year. If they draw too much, they could be liable to contribute a
balancing payment back to the partnership depending on the terms of the partnership
agreement.

Within a partnership, each partner will have their own account. Commonly there are two
accounts for each partner:
• Capital account, for long-term capital. This represents the partner's original investment
in the partnership (along with any subsequent investments). This capital cannot be
withdrawn in normal circumstances.
• Current account, for capital that can be withdrawn at the partner's discretion. This
account records the partner's share of the ongoing business profits. It will also show any
drawings that the partner has taken out over the year.
Applying the A/L/C/I/E classification, both these accounts are capital accounts.
Appropriation of profits
After the profit for the business as a whole has been calculated, ie after the Profit and Loss
Account has been drawn up, the profit which the partnership has made needs to be divided
amongst the partners.

This is done as follows: firstly, sums are allocated to individual partners corresponding to any
'interest' on their capital or 'salaries' due to each of them under the partnership agreement.
Then the remaining profit will be distributed to the partners according to an agreed profit share
ratio.

Notional 'interest' on capital

This is a payment representing interest on the capital in the partner's long-term capital account.
The rate of interest would be specified in the partnership agreement. Although it is labelled
'interest', this should not be treated as an expense item in the Profit and Loss Account. It is
notional interest, ie it is really an appropriation of profit under a different name.

Notional 'salary'
One or more partners might receive a notional salary. Again, the amount of such salary (if any)
will be specified in the partnership agreement and it is really an appropriation of profits.
Generally, for partners, any salary paid to them:
a. must be treated as an appropriation of profit, not an expense in the Profit and
Loss Account (which is how the salaries of employees are represented), and
b. will be treated as drawings.

Share of profits/share of 'residual profits'

The residual profits are the profits remaining after each partner has appropriated the
amount(s), if any, to which they are entitled under the partnership agreement as notional
interest and/or as notional salary.

The residual profits are divided amongst the partners according to an agreed ratio.

Summary
• Within a partnership, each partner will have their own accounts – commonly both a
capital account and a current account.
• These are capital accounts.
• Partners in a partnership will take 'drawings' – ie a share of the profits of the
partnership.
• Surplus profits are distributed to partners in the following order:
o 'interest' on their capital
o 'salaries'
o remaining profit will be distributed according to an agreed profit share ratio.
• The Profit Appropriation Statement must be completed before the Balance Sheet can be
drawn up.
 • The top half of a partnership Balance Sheet is similar to that of a sole trader. The bottom
half, which shows capital, follows a different format.

Introduction to Company Accounts

Introduction
Companies prepare accounts because they are obliged to do so by statute. The accounts also
have to take on a particular appearance and format and must also present a true and fair view
of the profits, assets and liabilities of the company. This is because the accounts need to
provide the reader, be that a shareholder, potential investor or an individual investigating an
allegation of fraud, with certain key information. Unless that information is presented in a
particular way, and in the same way each year, then the story that the accounts tell may not be
true or fair.

In earlier elements, you were introduced to the format of the Profit and Loss Account and
Balance Sheet for a sole trader and a partnership. You also learned about the need to make
year-end adjustments to the trial balance before such accounting statements can be drawn up,
such as accruals, prepayments, depreciation and bad and doubtful debts. Such principles apply
equally to companies as they do to sole traders and partnerships.

Interpretation of accounts in practice

Accounts are used by a wide range of people for different purposes, for example by the
management to determine the performance of the business, by potential investors or by the
HMRC for the calculation of taxation.

It is important that solicitors are able to interpret the accounts of businesses and companies,
both for their own purposes as partners but also to enable them to put the commercial
reality of their clients' business in context. In order to give comprehensive advice, a solicitor
needs to know what effects an event will have on the accounts of their client and also what
events the accounts may be concealing.

In practice, a common method of analysing accounts is to calculate a number of financial ratios

(eg gearing - see the Corporate Finance topic) from figures in the Profit and Loss Account and
Balance Sheet in order to give meaning and significance not readily apparent from the
accounts.

Accounting Reference Date

A company is free to choose its own accounting reference period, subject to provisions of the
Companies Act 2006.

Under s 391(4) CA 2006, a company’s accounting reference date ('ARD') (the date on which the
accounts are 'ruled off') is the last day of the month in which the anniversary of its
incorporation falls.
A company is, however, able to change its ARD to a date of its choice provided the provisions
of s 392 CA 2006 are complied with.

Under s 442(2)(a) CA 2006, a private company must file its accounts at Companies House within
nine months after the end of the relevant accounting reference period.

Under s 442(2)(b) CA 2006, a public company must file its accounts at Companies House within
six months after the end of the relevant accounting reference period.

What is different about company accounts?

There are three main differences in the content of financial statements for companies.
1. Capital accounts: the bottom half of the balance sheet
a. Company accounts follow a format which differs from those of sole traders and
partnerships. The main difference relates to the bottom half of the Balance
Sheet and this is because the capital of a company consists of share capital,
reserves andretained earnings.
2. Tax
a. Partnerships and businesses run by sole traders do not have separate legal
personality, and therefore do not pay tax. The partners or the sole trader pay tax
by reference to their own personal tax computations. However, companies do
have separate legal personality, and as such, they must pay tax on their own
account. In practice, therefore, the Profit and Loss Account of a company
includes a statement of the tax the company should pay on its profits. This is
corporation tax and will ultimately affect the profitability of the company.
3. Dividends
a. The owners of companies are shareholders. Shareholders' return on their
investment is the dividend that they may receive. Like drawings that a sole
trader takes from their business, a dividend is an appropriation of profits (after
tax). It is not an expense of the business.
b. In practice, dividends will usually appear in a financial statement called the
'statement of equity' (or 'statement of changes in equity') because they are
transactions between the company and its shareholders.
c. For the purposes of this topic, dividends are included in an addition to the
Balance Sheet called the Statement of Changes in Equity (SoCiE). This shows
profits brought forward and added to current year profits subject to any
deductions for dividends. The resulting 'Retained Earnings' will appear on the
bottom half of the Balance Sheet, showing the total profits carried forward to
the next accounting period.

Consolidated accounts
Companies with one or more subsidiaries are required to publish accounts for the group of
companies as a whole as well as their own annual accounts (s 399 CA 2006). This is because
(subject to certain exemptions) shareholders of the parent company should have access to
some information regarding the subsidiary company. In principle, every subsidiary in the group
also has a duty to prepare its own individual accounts, but exemptions are widely available, so
it is likely to be rare in practice for subsidiaries to do so (ss 394A and 479A CA 2006).

Summary
• Companies prepare accounts because they are obliged to do so by statute.
• Companies are required to make up their accounts by their Accounting Reference Date.
Companies are permitted to change their ARD.
• Year-end adjustments such as accruals, prepayments, depreciation and bad and
doubtful debts apply equally to companies as they do to sole traders and partnerships.
• There are three main differences in the financial statements for companies:
• Format;
• Tax
• Dividends.
• The bottom portion of the Balance Sheet, shows what is referred to as ‘Total Equity' or
'Equity and Reserves'.
• Companies can make an adjustment to the financial statements to reflect the fact that
their assets have decreased in value.

Share Capital and reserves

Introduction
In this element you will consider some of the entries in the bottom half of a company's balance
sheet, particularly:
• Called up share capital
• Share Premium Account
• Revaluation Reserve
You might also see reference to a Capital Redemption Reserve ('CRR') on a company's balance
sheet. A CRR can only be created as a consequence of certain transactions between the
company and its shareholders under detailed provisions of the Companies Act 2006. Such
transactions are relatively unusual and do not form part of the course of everyday business for
any company. Therefore, you will not consider them any further in this module.

Remember: the bottom half of a company's balance sheet shows the equity and will balance
with the top half of the balance sheet (the Net Asset Value).

Called up share capital

The share capital account tells the reader the aggregate amount that has been 'called up' (ie
the amount of the nominal value of its shares that the company has required its shareholders
to pay) on each class of issued shares, not including any premium. This called up value may, or
may not, be the same as the aggregate of the nominal value of the issued shares, for example,
if they are not fully paid. It is relatively rare to encounter shares which are not fully paid up.

Example: partly paid shares

A newly-incorporated company has issued 200,000 ordinary shares of £1 and has called up 75p
per share. The value of the called-up share capital in the company’s Balance Sheet will
therefore be £150,000.

Reserves
Reserves can be described as the capital of the company in excess of the called up value of the
issued share capital.
Reserves can be split into two categories:
• capital reserves (eg share premium account, revaluation reserve, capital redemption
reserve), discussed later in this element; and
• revenue reserves (eg retained earnings), discussed in the next element.
Broadly speaking, assets representing the capital reserves cannot be distributed by way of
dividend or other payment to shareholders. However, revenue reserves are distributable
reserves and therefore, assets representing such reserves can be distributed to shareholders in
the form of dividends.

Share premium account

The share premium account represents the difference between the nominal value of the
shares and the amount that the shareholders actually paid for the shares ie the subscription
price (if greater).

Note: the market price of the shares, once they have been issued, has no bearing at all on the
company's accounts and so, if their market price goes up or down, the share premium account
will remain unaltered.

The share premium account is a capital reserve. Assets representing it therefore cannot be
distributed to shareholders, except in exceptional circumstances such as a bonus issue (see the
next element).

Revaluation reserve
A revaluation reserve is created when a company's directors, as a matter of accounting
policy, wish to show more up to date values of non-current assets in the accounts. For
example, the value of its real property portfolio may have increased, and so the company re-
values the assets in question to their current value.

The increase in the value of the asset in the Balance Sheet causes the figure for Net Assets to
rise correspondingly ie in simple terms, the top half of the Balance Sheet has increased. It is
therefore necessary to make a corresponding change to the bottom half of the Balance Sheet.
This is achieved by creating or increasing an existing revaluation reserve by the same value.

The revaluation reserve represents a notional profit to the company from the rise in value of
the asset. This profit is, however, unrealised until the asset is sold, and as such it is a capital
reserve and is not distributable as a dividend until the company sells the asset and realises
the profit (s 830(2) CA 2006).
Any subsequent reduction in a re-valued asset's value can be set off against the revaluation
reserve.

Summary
• The bottom half of a company's balance sheet shows the equity and will balance with
the top half of the balance sheet (the Net Asset Value).
• There are different entries to consider on the bottom half of a company’s balance sheet.
• The called-up share capital is the amount of the nominal value of its shares that the
company has required its shareholders to pay.
• There are different kinds of reserves, ie:
o Capital
o Revenue
• The share premium account represents the difference between the nominal value of the
shares and the amount that the shareholders actually paid for the shares.
• A revaluation reserve is created when a company's directors, as a matter of accounting
policy, wish to show more up to date values of non-current assets in the accounts.

Dividends

Introduction – Reminder
• The owners of companies are shareholders.
• Shareholders’ return on their investment is the dividend that they may receive. Like
drawings that a sole trader takes from his business, a dividend is an appropriation of
profits (after tax). It is not an expense of the business.
• In practice, dividends will usually appear in a financial statement called the ‘statement
of equity’ (or ‘statement of changes in equity’) because they are transactions between
the company and its shareholders.
• For the purposes of this element, dividends are included in an addition to the Balance
Sheet called the Statement of Changes in Equity (SoCiE). This shows profits brought
forward and added to current year profits subject to any deductions for dividends.
• The resulting ‘Retained Earnings’ will appear on the bottom half of the Balance Sheet,
showing the total profits carried forward to the next accounting period.

Retained Earnings
The ‘retained earnings’ is the reserve account for retained profits.
The retained earnings represent profits after tax earned by the company over its history and
not distributed by way of dividend or appropriated to another reserve. It generally increases
from year to year as most companies do not distribute all of their profits.

Statement of Changes in Equity

As mentioned earlier in this topic, profit for the year is not carried over directly from the Profit
and Loss Account to the bottom half of the Balance Sheet. Instead, it is carried over into a
separate calculation, the Statement of Changes in Equity (the 'SoCiE') which, for the purposes of
this topic, is appended to the bottom of a company’s Balance Sheet, laid out as follows:

Dividends
Dividends are paid or payable out of profits generated in the current or previous accounting
periods. Any company can make a distribution (eg a dividend) provided that it has 'profits
available for the purpose' (s 830(1) CA 2006). It is only after the financial statements have been
completed that the profits generated in a given accounting period can finally be determined.

In ALCIE terminology, dividends are recorded in a capital account as they are transactions
between the business and its owner(s). For this reason, dividends do not belong on a Profit and
Loss account. When a company declares a dividend, this will show up in the SoCiE

Example: X Co Ltd has drawn up its accounts for the year ending xxxx. During the course of that
year, X Co Ltd has declared and paid a dividend. The accounting statements on the next slide
are shown in simplified format.
Ordinary shares ('ordinary dividend')
There are two types of dividend that can be paid on ordinary shares; a final or an interim
dividend. Both are calculated in exactly the same way, the only difference between the two
being that:
• 1. The final dividend is declared after the year end and paid some time thereafter
• 2. The interim dividend is paid during, and in respect of, the current accounting period

Final Dividend
The size of the final dividend is declared by the company's directors in the Directors' Report,
and approved by the company's shareholders by ordinary resolution, typically passed at the
Annual GM if the company has one.

If the directors have recommended a final dividend, but the shareholders have not yet
approved it, the dividend is called a proposed dividend. A proposed dividenddoes not
constitute a debt enforceable by the relevant shareholders until it is approved ie declared by an
ordinary resolution of the shareholders. Therefore, any final dividend which is proposed but not
been approved will not appear in the accounts of that accounting period.

Example:
A company with an accounting period of a year ending on 31 December 2020 wishes to pay a
final dividend in respect of that accounting period. The directors of the company tell you that
the final dividend will be approved by an ordinary resolution of the shareholders at a general
meeting which is due to take place in April 2021. If the final dividend is declared by ordinary
resolution at the general meeting, it will appear in the accounts for the period ending 31
December 2021.

A final dividend that has been approved by the shareholders is called a declared dividend.

A declared dividend constitutes a debt of the company enforceable by the relevant

shareholders. A declared dividend will be taken into account in the SoCiE, as a deduction in
calculating the Retained Earnings (profit and loss carried forward) which will appear in the
bottom half of the Balance Sheet (see X Co Limited).

If the declared dividend has not yet been paid to shareholders by the time the accounts for that
year have been prepared, it willappear in the Balance Sheet at the end of the year in which it
was declared (as part of 'current liabilities'). It will also be taken into account in the SoCiE at
that year-end.

A declared dividend which has been paid to shareholders before that year end will only be
taken into account in the SoCiE.

Interim dividend
The articles of a company normally give the directors the power to decide to pay interim
dividends (eg Model Article 30). Interim dividends can therefore be paid without the need for
an ordinary resolution of the shareholders. Any board resolution to pay an interim dividend
may be rescinded before the interim dividend is paid, so an unpaid interim dividend is not a
debt that the shareholders are legally entitled to sue upon.

For this reason, the accounting treatment of interim dividends is different to the treatment of
final dividends. Interim dividends will only be reflected in a company's accounts if they have
actually been paid. When an interim dividend has been paid in any year the amount of the
dividend will have been deducted from the assets, ie cash and cash equivalents, and will be
shown as an item on the trial balance. A dividend is an allocation of profit and not an expense
of the company so it will not be shown in the Profit and Loss Account. The interim dividend will
be taken into account in the SoCiE (in this respect, interim dividends are treated the same as
declared (and paid) dividends).

Any profits after tax not paid to shareholders as dividends are retained in the company.

Example:
Lennon Limited's accounting period ends on 31 March 2020. The directors decide to propose a
final ordinary dividend of £10,000 in respect of that accounting period. Lennon Limited holds a
general meeting in June 2020. As expected, the shareholders declare the final ordinary dividend
proposed by the directors. The dividend is eventually paid to the shareholders in September
2020.

Accounting Period ending 31 March 2020:

The final dividend will not appear in the financial statements for this accounting period (ie the
period ending 31 March 2020) as it was not declared during this accounting period.

Accounting Period ending 31 March 2021:

Top half of Balance Sheet: the final dividend will not appear as part of Current liabilities on the
Balance Sheet as at 31 March 2021 because it was paid in September 2020.

Bottom half of Balance Sheet: the final dividend will impact on the Retained Earnings (profit
and loss carried forward) as it will be taken into account in the SoCiE.

Preference shares
('preference dividend')
Preference dividends are usually paid in two instalments each year. Because of the nature of
preference shares, the amount of the dividend will already be known each year.

Example:
A company which has issued 150,000 non-redeemable non-cumulative 7% preference shares of
£1 each pays an annual dividend of 7 pence on each preference share (subject to there being
sufficient profits to do so). If part of that dividend has already been paid to preference
shareholders as an interim dividend in any year, that part will not appear on the top half of the
company’s Balance Sheet for the relevant year.
However, it will appear as a deduction in the SoCiE to calculate the Retained Earnings in the
bottom half of the Balance Sheet. The remainder of the preference dividend is declared by the
shareholders, and though paid after the year end, will appear in the SoCiE to calculate retained
earnings and be shown as a Current liability in the top half of the Balance Sheet.

Bonus issue of shares

A 'bonus issue' of shares is also known as a 'capitalisation issue' or 'scrip issue'.
A company may decide to convert some of its reserves into share capital by issuing fully paid
shares to existing shareholders on a pro rata basis for no consideration; in other words,
shareholders do not have to pay for the bonus shares. 'Pro rata' means that the proportion of
shares held by each shareholder pre- and post-bonus issue will not change, and therefore the
proportions of voting rights will also remain the same.

Shares that are issued pro rata are often expressed by way of a ratio, ie x:y, where x is the
amount of shares issued to the shareholder for every amount of shares (y) they currently hold.
This process does not raise any money for the company, but rather the company will use its
reserves to fund the issue. A company may use its retained earnings or its share premium
account to fund a bonus issue (s 610(3) CA 2006).

The assets and liabilities of the company are unchanged after the bonus issue.

Example:
Epsilon Limited had the Balance Sheet shown on the next slide.
The company decided to make a 2:1 bonus issue, ie issue two new ordinary shares to
shareholders for every share that they currently hold. The company will use its share premium
account to fund this new issue.
The Balance Sheet of the company before and after the bonus issue will appear as set out on
the next slide:

(1) Before the bonus issue

Non-current assets (net book value) £1,000,000
Current assets £1,500,000
Total £ 1,500,000
Current liabilities (£350,000)
Total £ 1,150,000
Non-current liabilities (£200,00)
Net assets £950,000

Equity
Share capital (Ordinary shares of £1 each) £100,000
Share premium £200,00
Revaluation reserve £50,000
Retained earnings (profit and loss carried forward) £600,000
Total Equity £950,00
(2) After the bonus issue
Non-current assets (net book value) £1,000,000
Current assets £1,500,000
Total £ 1,500,000
Current liabilities (£350,000)
Total £ 1,150,000
Non-current liabilities (£200,00)
Net assets £950,000

Equity
Share capital (Ordinary shares of £1 each) £300,000
Share premium - Zero
Revaluation reserve £50,000
Retained earnings (profit and loss carried forward) £600,000
Total Equity £950,00

Summary
• Shareholders' return on their investment is the dividend that they may receive.
• Dividends are paid or payable out of profits generated in the current or previous
accounting periods.
• Dividends do not belong on a Profit and Loss account; when a company declares a
dividend, it will show up in the SoCiE.
• Dividends can be interim or final.
• Some shares will pay a preference dividend.
• A company may decide to convert some of its reserves into share capital by issuing fully
paid shares to existing shareholders on a pro rata basis.

Debt finance
Debt finance
Security
Effect of equity and debt finance on the balance sheet
Business Law and Practice – Workshop 9
Insolvency
Introduction to corporate insolvency

Corporate insolvency – the law

The main statute dealing with corporate insolvency is the Insolvency Act 1986 (IA 1986), which
we will refer to throughout this topic.
IA 1986 has been significantly amended by various legislation including:
• the Enterprise Act 2002 (EA 2002) which aimed to promote the rescue of companies;
• the Small Business Enterprise and Employment Act 2015;
• the Insolvency (England and Wales) Rules 2016; and
• the Corporate Insolvency and Governance Act 2020 (CIGA 2020) which commenced on
26 June 2020.
The most significant reforms to insolvency law since the IA 1986 were contained in the EA 2002
and CIGA 2020.

Summary of EA 2002 and CIGA 2020 reforms

The EA 2002 came into force on 15 September 2003. This date is also known as the ‘Relevant
Date’ and you will consider the importance of this date later in this topic.
The aims of the corporate insolvency reforms in the EA 2002 were:
• To promote the rescue culture; and
• To increase entrepreneurship by giving prominence to collective insolvency procedures
over enforcement procedures.
The EA 2002 achieved these aims by streamlining the administration procedure to encourage
company rescue and restricting the use of administrative receiverships on or after the Relevant
Date.

CIGA 2020 introduced two new insolvency procedures which are:

1. The pre-insolvency moratorium
2. The restructuring plan for companies.
The aim of these new procedures is to make restructurings which avoid an administration or
liquidation more likely.

Meaning of "insolvency"
The meaning of insolvency is set out in s 122(1)(f) IA 1986 which states that a company may be
wound up:
"…..if it is unable to pay its debts".
There are four tests for insolvency, which are set out below. The most commonly used are the
cash flow test and the balance sheet test.
1. The Cash Flow test: An inability to pay debts as they fall due (s 123(1)(e))
 2. The Balance sheet test: The company's liabilities are greater than its assets (s 123(2))
3. Failure to comply with a statutory demand for a debt of over £750 (s 123(1)(a))
4. Failure to satisfy enforcement of a judgment debt (s 123(1)(b))

Directors' obligations towards companies in financial difficulties

The directors must continually review the financial performance of a company and recognise
when it is facing financial difficulties. Examples of financial difficulty include:
1. The company has many unpaid creditors who are putting pressure on the company to
pay its bills.
2. The company has an overdraft facility that is fully drawn, and the bank is refusing to
provide further credit.
3. The company has loans and other liabilities that exceed the value of its assets
It is the directors who need to decide what action to take on behalf of the company. In making
that decision, the directors will need advice on their duties, responsibilities and liabilities under
the IA 1986 and general law and their options under the IA 1986 and CIGA 2020 for resolving
their companies’ financial difficulties and the exposure of creditors to losses.

Options for a company facing financial difficulties

Faced with a company in financial difficulty, the directors have a number of options which we
will explore in this topic:
1. Do nothing - the directors risk personal liability under IA 1986 and breach of directors’
duties under the Companies Act 2006.
2. Do a deal - reaching either an informal or formal arrangement with the company’s
creditors with a view to rescheduling debts.
3. Appoint an administrator - this is a collective formal insolvency procedure (a procedure
which considers the interests of all creditors) and will be considered later in this topic.
4. Request the appointment of a receiver - this is an enforcementprocedure (where a
creditor, or a small group of creditors, are acting to pursue their rights and recover their
debt). This will be considered later in this topic.
5. Put the company into liquidation - this a collective insolvency procedure and will be
considered later in this topic.

Summary
• The meaning of insolvency is set out in s 122(1)(f) IA 1986 which states that a company
may be wound up "…..if it is unable to pay its debts".
• There are four tests for insolvency, which are set out in s 123 IA 1986. The most
commonly used are the cash flow test and the balance sheet test.
• Directors must monitor the financial position and have a range of options available to
them when dealing with a company in financial difficulty:
Do nothing Do a deal Appoint an administrator Request the appointment of a receiverPut the
company into liquidation

Formal and informal arrangements

Informal agreements
To avoid the time and cost of formal insolvency arrangements or proceedings, a company can
negotiate informally with its creditors. These are contractually binding agreements which are
not regulated by IA 1986 or CIGA 2020. The difficulty is in getting all of the creditors to agree.
To obtain creditor agreement, the company may have to do one or more of the following:
• Grant new or additional security;
• Replace directors or senior employees; and/or
• Sell failing businesses/subsidiaries or profitable ones to raise cash;
• Reduce the workforce or the salary bill
• Issue new shares to the creditors (‘debt for equity swap’)
• Creditors, including banks, could enter into Standstill Agreements where they agree not
to enforce their rights or remedies for a certain period of time to give the company a
breathing space to reach agreement with its other creditors.

Pre-insolvency moratorium
CIGA 2020 introduced a new pre-insolvency 'moratorium' for struggling companies that are not
yet in a formal insolvency process. Pre-insolvency moratoriums can be used to achieve an
informal agreement or as a preliminary step to proposing a restructuring plan, CVA or a scheme
of arrangement.

A 'moratorium' is a period during which creditors are unable to take action to enforce their
debts, thereby creating a breathing space for the company to attempt to resolve the
situation. The actions restricted by the moratorium include:
• no creditor can enforce its security against the company’s assets;
• there is a stay of legal proceedings against the company and a bar on bringing new
proceedings against it;
• no winding up procedures can be commenced in respect of the company (unless
commenced by the directors) and no shareholder resolution can be passed to wind up
the company (unless approved by the directors); and
• no administration procedure can be commenced in respect of the company (other than
by the directors).

Procedure for obtaining the pre-insolvency moratorium

A company can obtain a pre-insolvency moratorium by filing documents at court including
• A statement that the company is, or is likely to become, unable to pay its debts as they
fall due.
• A statement from a licensed insolvency practitioner (usually an accountant), known as
a Monitor for these purposes, stating that it is likely that a moratorium will result in the
rescue of the company. The Monitor has a supervisory function during the pre-
insolvency moratorium.
The pre-insolvency moratorium lasts for 20 business days but can be extended by the directors
for a further 20 business days. Further extensions are possible with the consent of a requisite
majority of creditors and/or court order. The maximum period is one year subject to a court
order to extend further.
The moratorium will terminate automatically if the company enters liquidation or
administration, or at the point that a CVA is approved, or a court sanctions a scheme of
arrangement or a restructuring plan.

Pre-moratorium and moratorium debts

Pre-moratorium debts
The company does not have to pay pre-moratorium debts whilst the pre-insolvency
moratorium subsists. These are debts which have fallen due before or during the moratorium
by reason of an obligation incurred before the moratorium. But the holiday repayment does
not apply to the following pre-moratorium debts which must still be paid:
• The monitor's remuneration or expenses;
• Goods and services supplied during the moratorium;
• Rent in respect of a period during the moratorium;
• Wages or salary or redundancy payments; and
• Loans under a contract involving financial services. This means that a company remains
liable to pay all sums due to a bank which made a loan to it before it obtained the
moratorium.

Moratorium debts
All moratorium debts must be paid. These are debts that fall due during or after the
moratorium by reason of an obligation incurred during the moratorium.

This means that in practice companies must be ‘cash flow’ solvent and capable of paying their
way during the moratorium period.

Formal arrangements (using statutory procedures)

The main advantage of a formal arrangement is that if the requisite majorities of creditors
and/or shareholders vote in favour of it, it is legally binding, even if some of those creditors
voted against it or did not vote on it at all.
There are two possible types of formal arrangement that we will consider in detail:
• a Company Voluntary Arrangement under ss 1-7 IA 1986; or
• a Restructuring Plan under CIGA 2020, the provisions of which are contained in part 26A
CA 2006.

Company Voluntary Arrangement

A CVA, is a compromise between a company and its creditors. CVAs are defined in s 1(1) IA
1986 as:
“a composition in satisfaction of its debts or a scheme of arrangement of its affairs”.

The essence of a CVA is that the creditors agree to part payment of the debts or to a new
timetable for repayment. The agreement must be reported to court but there is no
requirement for the court to approve the arrangement.
The CVA is supervised and implemented by an Insolvency Practitioner but the company's
directors remain in post and are involved in the implementation of the CVA.
CVAs can also be used together with administration or liquidation, which we consider later.

Setting up a CVA
1. Provided the company is not in liquidation or administration, the directors draft the
written proposals and appoint a Nominee (an insolvency practitioner). If the company is
in liquidation or administration, the administrator or liquidator drafts the proposals.
2. The directors submit the proposals and a statement of the company's affairs to the
nominee.
3. The nominee considers the proposals and, within 28 days, must report to court on
whether to call a meeting of company and creditors – s 2(1) and s2(2).
4. Nominee gives 14 days' notice of meeting to creditors. A meeting of the members must
take place within 5 days of the creditors' decision.
5. Voting – the proposals must be approved by:
• 75% in value of creditors (excluding secured creditors) and a majority in value
of unconnected creditors (eg related companies, directors); and
• a simple majority of members.
6. Nominee reports to court on approval.
7. Nominee becomes supervisor and implements proposals.

Effect of a CVA
A CVA is binding on all unsecured creditors, including those who did not vote or voted against
it. However, secured or preferential creditors are not bound unless they unanimously consent
to the CVA (s 4 IA 1986) – this is a major disadvantage of the CVA procedure.

A creditor can challenge a CVA within 28 days of the CVA's approval by creditors being reported
to the court on the grounds of 'unfair prejudice' that is the CVA treats one creditor unfairly
compared to another or material irregularity relating to the procedure which the company has
followed in seeking approval of the CVA, for example, the way in which the creditors' votes
were calculated. Subject to that, the CVA becomes binding on all creditors at the end of the 28-
day challenge period.

The supervisor's role will be to agree creditors’ claims, collect in the funds to pay dividends to
the creditors and generally ensure that the company complies with its obligations under the
CVA. When a CVA has been completed, the supervisor will send a final report on the
implementation of the proposal to all members and creditors who are bound by the CVA.

How are CVAs used?

CVAs are commonly used within the retail sector to reach a compromise with creditors,
particularly landlords to agree a reduction in rent in order to allow the company to attempt to
continue trading. CVAs can be used alone or as part of an administration.
Examples of companies which used CVAs during the coronavirus pandemic to agree rent
reductions with landlords include All Saints (June 2020), Frankie & Benny’s (owned by The
Restaurant Group) and Clarks (October 2020).

From the company's perspective, CVAs are advantageous as the directors remain in control of
the company, and the company can continue to trade. However, the major disadvantage is that
a CVA cannot bind secured or preferential creditors.

Trade creditors tend to support CVAs as they are likely to recover more than if the company
goes into liquidation. For landlords the company's ongoing trading means heavily discounted
rents so less income. Equally, retail properties are not easy to re-let so a landlord may prefer to
receive reduced rents rather than have empty properties.

It is envisaged that the use of CVAs will gradually decline and be replaced by the Restructuring
Plan introduced by CIGA 2020.

Restructuring Plan
The other formal agreement to be considered is the Restructuring Plan (Plan). Introduced by
CIGA 2020, the purpose of the Restructuring Plan (Plan) is to compromise a company’s creditors
and shareholders and restructure its liabilities so that a company can return to solvency.

A Plan is a hybrid of CVAs and ‘schemes of arrangement’, which are a type of restructuring
mechanism that may be used for solvent or insolvent companies. The Plan, however, can only
be used by companies which have or are likely to encounter financial difficulty.

A Plan requires court sanction. Creditors and members must be divided into classes and each
class which votes on the Plan must be asked to approve it. The votes needed by the class
meetings for approval are similar to those under a CVA, so that the Plan must be approved by
at least 75% of each class voting.

The court must sanction the Plan and it will then bind all creditors including secured
creditors.

Advantages of Restructuring Plan

Novel features of the Plan include:
• The court can exclude creditors and shareholders from voting even if they are
affected by the Plan if they have no genuine economic interest in the company;
• The court can sanction a plan which brings about a “cross-class cram down” if it
is just and equitable to do so even if one or more classes do not vote to
approve the Plan.
A cross class cramdownmeans that one rank of creditor can force the Plan on another class of
creditor who has voted against the Plan. A cramdown of shareholders means forcing
shareholders to accept the Plan by creating debt for equity swaps.
The Plan is likely to be used by directors alongside the pre-insolvency moratorium but can also
be used by administrators and liquidators considered in later topics.

The Plan may be better than a CVA because it can compromise the rights and claims of secured
creditors and shareholders. A CVA cannot do this. The other advantage of a Plan is that it can be
sanctioned by the court to bind all creditors even where the requisite majority approval is not
obtained in every class of creditors and shareholders who voted.

A comparison of formal arrangements

CVA

Who can initiate?

Directors, liquidator or administrator

Approval?
• 75% in value of unsecured creditors
• Over 50% of shareholders

Who does it bind?

Binds all unsecured creditors

Advantages
Not court sanctioned so quicker and less costly

Limitations
Preferential & secured creditors not bound

Restructuring Plan

Who can initiate?

Company, creditor, member, liquidator or administrator

Approval?
• Sanctioned by the court
• 75% in value of each affected class of creditors/shareholders

Who does it bind?

Binds all creditors

Advantages
Binds all creditors including dissenting creditors and potentially classes of creditors who do not
approve the plan
The court can sanction a plan even if one or more classes do not approve

Limitations
Court process can be costly and time consuming

Summary
• The company can enter into informal agreements with its creditors, standstill
agreements with a view to not enforcing rights for a period of time to rescue the
company.
• The company can apply to court for a pre-insolvency moratorium which will give the
company a temporary breathing space to rescue the company.
• A CVA is an arrangement agreed by the company's creditors and members to achieve an
agreement in respect of its debts.
• CVAs do not bind secured creditors and there is no requirement for court approval.
• The Restructuring Plan is a court-sanctioned compromise between a company and its
creditors and shareholders to restructure the company’s debts.

Administration and receivership

The objectives of the administrator

After liquidation, administration is the next most common insolvency procedure. Recent
examples of companies that have gone into administration include amongst others, Laura
Ashley, Debenhams, Cath Kidston and Carluccios. Administration is a 'collective' procedure,
meaning that the administrator acts in the interests of the creditors as a whole rather than on
behalf of a particular creditor.

The primary objective of administration is to rescue the company (eg Cath Kidston, which went
into administration in 2020 resulting in the closure of their high street shops, but the
continuation of the online business). However, if that is not possible, then its secondary
objective is to achieve a better result for creditors than a liquidation. In practice, it is this
secondary objective that is most likely to be achieved.

Administrators are qualified insolvency practitioners who may be appointed by the court or
under the out of court procedure (see below). They are required to perform their functions in
the interests of the company's creditors as a whole and owe duties to both the court and to the
creditors collectively.

The statutory objectives of administration

Schedule B1 IA 1986 set out the objectives of the administration, stating that an administrator:
"...must perform his functions with the objective of:
(a) rescuing the company as a going concern, or
(b) achieving a better result for the company's creditors as a whole than would be
likely if the company were wound up...,
 (c) realising the property in order to make a distribution to one or more secure or
preferential creditors."

These cascading objectives are extremely important as they guide the actions of the
administrator throughout the process. Objective (b) is most likely to be achieved.

Appointment of administrator – court procedure

There are two different procedures for the appointment of an administrator: the court
procedure and the out of court procedure. We will deal first with the court procedure.

The court may appoint an administrator where the company is or is likely to become unable to
pay its debts (Sch B1 para 11(a)) on the application of: the company, the directors, a creditor,
the supervisor of a CVA or a liquidator. The court must consider that the appointment is
reasonably likely to achieve the purpose of the administration (Sch B1 para 11(b)). I

An interim moratorium temporarily freezing creditor action comes into effect on the
application to court and until the administration order is made.

Appointments by court order are fairly uncommon. The usual case when this happens is where
a creditor has begun winding up proceedings against the company and the directors wish to
appoint administrators before the court has made a winding up order. In this situation, the out-
of-court appointment procedure is not available to the directors and they must apply to court
for an order to appoint administrators.

If the court makes an administration order, the pending winding up proceedings are
automatically dismissed.

A summary of the court procedure is below:

Appointment of administrator – out of court procedure

Either the company or the directors (Sch B1 para 22 IA 1986) or a qualifying floating charge
holder (“QFCH” ) may appoint an administrator using the out of court procedure (Sch B1 para
14 IA 1986) which is the most common method of appointing an administrator.

A QFCH means the holder of a qualifying floating charge which relates to the whole or
substantially the whole of the company's property. A qualifying floating charge is a floating
charge which specifies one of the following things (1) that Sch B1 para 14 IA 1986 applies to the
charge (2) that the holder has the power to appoint an administrator (3) that the holder has the
power to appoint an administrative receiver. A QFCH is often a bank.
If the company has a QFCH, then the company/directors will have to file a notice of intention to
appoint an administrator ("NOI") at court giving the QFCH 5 business days' notice to consent or
appoint its own choice of administrator. Once a NOI has been filed the company will benefit
from a 10 business day interim moratorium.

A first ranking QFCH can appoint its own administrator by filing a Notice of Appointment which
appoints an administrator immediately on its filing.

A summary of the out of court procedure is below:

Role of the administrator

The administrator is an officer of the court and has a duty to act in the interests of all the
creditors to achieve the purposes of the administration. The directors are unable to exercise
any of their management powers without the consent of the administrator.

An administrator’s powers include the power to carry on the business of the company, take
possession and sell the property of the company, raise money on security and execute
documents in the company’s name. Generally, administrators do not have the power to pay a
dividend to unsecured creditors without obtaining court permission.

Once appointed, the administrator has up to eight weeks to produce a report setting out
proposals for the future of the company's business. This must be put to all creditors for their
approval. If the administrator's proposals are rejected, the company will usually be put into
liquidation. However, if the administrator's proposals are accepted, the administrator has
several options including restructuring the creditors' rights under a scheme of arrangement or
implementing a CVA so that the company exits administration.
There is a 12-month fixed time limit for the completion of administrations, although it is
possible to obtain extensions.

Administrative moratorium
One key benefit of administration is that during administration, the company has the benefit of
a full moratorium (Sch B1 para 42-44 IA 1986). During this time, all business documents and the
company's website must state that the company is in administration.

During the moratorium (except with consent of the court or the administrator):
1. No order or resolution to wind up the company can be made or passed;
2. No administrative receiver of the company can be appointed;
3. No steps can be taken to enforce any security over the company’s property or to
repossess goods subject to security, hire purchase and retention of title;
4. No legal proceedings, execution or other process can be commenced or continued
against the company or its property, and
5. A landlord cannot forfeit a lease of the company’s premises.

Where the interim moratorium applies on an application to appoint an administrator as

mentioned above, items 1, 3-5 above apply, but without reference to the consent of the
administrator. In addition, the interim moratorium does not prevent a QFCH from appointing
an administrator.

Powers of the administrator

Administrators have wide powers under IA 1986 to 'do all such things as may be necessary for
the management of the affairs, business and property of the company' (s 14(1) IA 1986).
These include the powers to:
• Remove and appoint directors (s 14, Sch 1 and para 61 Sch B1);
• Dispose of property subject to a floating charge (para 70 Sch B1);
• Dispose of property subject to a fixed charge (with the court's consent) (Para 71 Sch B1)
In addition, the Small Business, Enterprise and Employment Act 2015 (SBEEA 2015) granted
additional powers to administrators to allow them to bring proceedings against directors for
fraudulent and wrongful trading (see Topic 10).

Pre-packaged sales in administration

A pre-packaged administration is where the business and assets of an insolvent company is
prepared for sale to a selected buyer prior to the company's entry into administration. The
terms of the sale agreement are negotiated and agreed before the administrators’ appointment
and become immediately effective following the appointment.

Pre-packaged sales have the advantage that the goodwill and continuity of the business are not
damaged by the administration and certainty of result is achieved for the creditors. Often the
pre-pack purchaser will be one or more of the existing owners or directors of the insolvent
company.
Pre-packaged sales are controversial, particularly where the sale is to existing members or
management. The concern is that often creditors are given insufficient information to
determine whether the sale was in their best interests.

The Administration (Restrictions on Disposal to Connected persons) Regulations 2021 come into
force in April 2021. The regulations restrict the ability of an administrator to execute a pre-pack
where there is a sale to a connected person and, either the administrator has not obtained the
approval of the company's creditors or the purchaser has not obtained an evaluator's qualifying
report. This report must be sent to Companies House and all creditors.

Examples

Debenhams
The UK department store group appointed administrators for a second time in May 2020 to
protect itself from its creditors. The administrators were pursuing three strategies; a sale of the
business, a restructure of the business and the wind-down of the business. Debenhams had
heavy debts of around £600m.

Debenhams initially closed its Irish division, which had eleven stores, 958 staff and 300
concessions, and also closed its Hong Kong and Bangladeshi subsidiaries.

The Debenhams brand was bought by fashion retailer Boohoo for £55m in January 2021. The
stores reopened to clear stock and then began to close. The last remaining UK stores closed in
May 2021. The Debenhams brand will continue its operations online as part of the internet-only
fashion retailer Boohoo.

Cath Kidston
The fashion and accessories chain appointed administrators in April 2020. Like many fashion
retailers, the company had longstanding problems in maintaining sales and profitability. It lost
£27m between 2018 - 2020, resulting in its closing stores and cutting head-office staff. There
were 200 stores globally.

In May 2020, the company’s parent company, Baring Private Equity Asia, bought the company’s
brand and online operations through a pre-packaged deal from the administrators. This led to
the closure of all 60 UK stores, with the loss of 900 jobs. The company went on to trade in the
UK as an online-only retailer.

In December 2020, Cath Kidston returned to the UK high street with the re-opening of its
flagship store in London’s Piccadilly.

Receivership
Whilst administration is a collective procedure; in contrast, receivership is an individual
enforcement procedure which benefits only the appointing creditor.
There are three types of receivers that we will consider in this topic:
1. Administrative receivers (note that this is now a rare procedure);
2. Fixed charge receivers;
3. Court-appointed receivers.

Administrative receivers
Administrative receivership is now a rare procedure which allows a secured creditor to appoint
an administrative receiver to seek repayment of the secured debt. It is an individual procedure
(benefitting only the appointing creditor) rather than a collective procedure which looks to
benefit all creditors such as administration. Administrative receivers can only be appointed by
QFCH's: where the charge was created prior to 15 September 2003; or where one of the
statutory exceptions applies. Since this procedure is now rare, we will not consider it any
further.

Receivership

Fixed Charge Receivers

• Fixed charge receivers are the most common type of receivership.
• They often referred to colloquially in practice as 'LPA receivers', although strictly this is
only correct if they have been appointed pursuant to a mortgage.
• Fixed charge receivers are appointed by the holders of a fixed charge pursuant to the
terms of the security documentation.
• They are appointed to enforce the security and recover the debt that is owing to their
appointor, often a bank.
• They owe their duties primarily and exclusively to the appointor; the duty to the chargor
is to act in good faith in the course of their appointment. It is a legal anomaly that fixed
charge receivers are usually an agent of the chargor. They usually have extensive
powers set out in the security documentation and some limited powers under the Law
of Property Act 1925, these powers typically include the ability to sell, mortgage and
collect rents from property.

A fixed charge receiver becomes the receiver and manager only of the property charged and is
only entitled to deal with that property and not any other property of the company.
A fixed charge receiver cannot be appointed while a pre-insolvency moratorium subsists or if
the company is in administration.

Court-appointed receivers
Court-appointed receivers are relatively rare at the moment. They are appointed by the court
and their powers and duties are set out in the court order.

Appointments are sometimes made where shareholders are locked in dispute. Receivers may
also be appointed by the court under the Proceeds of Crime Act 2002 and associated
legislation. Given the move towards imposing criminal sanctions for corporate misconduct, such
orders are likely to become more common.
The court-appointed receiver’s duty is typically to run the business until the dispute is
determined.

Summary
• Administration is a collective procedure for the benefit of the creditors as a whole,
Administrators are insolvency practitioners who may be appointed by the court but are
more likely to be appointed using the out of court procedure by either the
company/directors or a QFCH.
• The administrator performs their duties in accordance with the statutory objectives.
• Once the administrator is appointed, the directors are unable to exercise any of their
powers without the consent of the administrator. The administrator has wide powers to
manage the company and may also bring actions against directors.
• The appointment of an administrator gives rise to a moratorium, protecting the
company from hostile actions by creditors.
• Receivership is an enforcement procedure for the benefit of individual creditors . There
are three types of receivership :
o (1) administrative receivership;
o (2) fixed charge receivership; and
o (3) court-appointed receivership.

Liquidation

Liquidation – solvent or insolvent

Liquidations are the most common type of insolvency procedure. In 2019 more than 87% of all
company insolvencies were liquidations. The bulk of these were creditors' voluntary
liquidations.

You have seen references to "liquidation" earlier in this module, but it is important to
understand the meaning of this term.

Liquidation is the process by which a company's business is wound up and its assets
transferred to creditors and (if there is a surplus of assets over liabilities) to its members.

The company will then be removed from the register of companies and dissolved.
The terms "liquidation" and "winding up" are used interchangeably.

However, it is important to note that it is not only insolvent companies which are wound up or
liquidated. Solvent companies may also be wound up and this is not uncommon. Companies
may be wound up simply because the business opportunity has come to an end, due to internal
disputes, or where the members wish to move on to new ventures.
Liquidation
Liquidation is the most basic and oldest of the corporate insolvency procedures.

The liquidator’s function is to realise the company’s assets for cash, determine the identity of
the company’s creditors and the amount owed to each of them and then pay a dividend to
the creditors on a proportionate basis relative to the size of their determined claims
(creditors of the same rank are said to rank "pari passu").

The ranking of creditors’ claims (that is, the order in which they must be repaid) is set out in the
IA 1986, the IR 2016 and by general law.

Liquidation is the end of the road for the company and a liquidator has only very limited powers
to carry on the business of a company. They will usually close a company’s business and dismiss
employees very soon after their appointment. They will usually sell assets on a piece-meal basis
rather than selling the assets and business as a going concern. The stay on legal proceedings
which applies in a liquidation is very limited.

For these reasons, it is common for companies to enter into liquidation after having been
through a different insolvency procedure (eg administration) first.

Types of liquidation
There are two types of liquidation:
1. Compulsory liquidation
2. Voluntary liquidation – which is further subdivided into:
a. Members' voluntary liquidation
b. Creditors' voluntary liquidation.

Following liquidation, the company’s life is generally brought to an end automatically by

dissolution. In the case of a compulsory liquidation, this will be three months after notice by the
liquidator to the Registrar of Companies that the winding up of the company has been
completed.

In the case of voluntary liquidation, dissolution will occur three months from the filing by the
liquidator of the final accounts and return. On dissolution, the company ceases to exist.

Compulsory liquidation
Compulsory liquidation is a court-based process for placing a company into liquidation.

To begin the process, an applicant presents a winding up petition to the court under which the
applicant requests the court to make a winding up order against the company on a number of
statutory grounds.

When the court grants a petition for compulsory liquidation, the order operates in favour of all
the creditors and contributories (members and some former members) of the company.
The Official Receiver will become the liquidator and continue in office until another person is
appointed (s 136(2) IA 1986). The Official Receiver will notify Companies House and all known
creditors of the liquidation. The Official Receiver has the power to summon separate meetings
of the company's creditors and contributories for the purpose of choosing a person to become
the liquidator of the company in his place (s 136(4)).

Who can apply for a winding up order?

The following persons can apply to the court for the issue of a winding up petition:
1. a creditor;
2. the company (acting by the shareholders; this would happen where there are
insufficient assets in the company to fund a voluntary liquidation);
3. the directors (by board resolution); again, this would happen where there are
insufficient assets to fund a voluntary liquidation;
4. an administrator;
5. an administrative receiver;
6. the supervisor of a CVA; and
7. the Secretary of State for Business, Energy & Industrial Strategy (on public policy
grounds).
The key grounds on which the court can order a company to be wound up, are set out in s
122(1) IA 1986 and include: (1) the company is unable to pay its debts; and (2) it is just and
equitable for the company to be wound up.

Inability to pay debts – s 123 IA 1986

The most common ground for a winding up petition is the company's inability to pay its debts
under s 122(1)(f) IA 1986. This can be evidenced by (s 123 IA 1986):
1. Failure by the company to comply with a creditor’s statutory demand. A statutory
demand is a written demand in a prescribed form requiring the company to pay a
specific debt. The statutory demand can only be used if the debt exceeds £750 and is
not disputed on substantial grounds. The company has 21 days in which to pay the debt,
failing which the creditor has the right to petition the court to wind up the company.
2. The creditor sues the company, obtains judgment and fails in an attempt to execute
the judgment debt.
3. Proof to the satisfaction of the court that the company is unable to pay its debts as
they fall due (the "cash-flow test"). The cash flow test is usually satisfied by going
through the statutory demand process in 1 above but that is not essential.
4. Proof to the satisfaction of the court that the value of the company’s assets is less
than the amount of its liabilities, taking into account contingent and prospective
liabilities**(the "balance sheet test")**.

Consequences of winding up order

To prevent an insolvent company from transferring its assets to third parties at the expense of
its creditors, under s 127 IA1986 certain dispositions of a company's property, transfers of its
shares and changes to its members will be void if made after the commencement of the
winding-up. This means if these dispositions etc were made during the period between the
presentation of the winding up petition and a winding up order being made, then they will be
void.
Once a court finds that the grounds for a winding up order are satisfied and it makes a
compulsory winding up order, the consequences include as follows:
• an automatic stay will be granted on commencing or continuing with proceedings
against the company;
• all employees will be automatically dismissed, and
• the directors lose their powers and they are automatically dismissed from office.

Voluntary winding up
Section 84(1) IA 1986 allows for the company to be wound up without a court order in 3
situations:
1. Where the company's purpose according to the articles has expired and resolution of
the shareholders – RARE
2. Where the company resolves by special resolution to wind up the company. The
company must be solvent – MVL
3. Where the company resolves that it is advisable to wind up the company due to its
inability to carry on its business. Here the company is insolvent – CVL

Members' voluntary winding up (MVL)

This method of voluntary winding up may only be used for companies which are solvent.
The directors are required to swear a declaration of solvency stating that they have made a full
enquiry into the company's affairs and they have formed the opinion that the company will be
able to pay its creditors in full, together with interest at the official rate, within a period not
exceeding 12 months from the commencement of the winding up (s 89(1) IA 1986). The
declaration must also contain a statement of the company's assets and liabilities as at the latest
practicable date before making the declaration.

Any director making a declaration of solvency who does not have reasonable grounds for their
opinion is liable to a fine or imprisonment (s 89(4) IA 1986). If the debts are not actually paid in
full within the specified period it will be presumed that the director did not have reasonable
grounds for his opinion.

The members must then pass a special resolution to place the company into MVL and
an ordinary resolution to appoint a liquidator. The winding up commences when the special
resolution is passed (s 84(1) and s 86 IA 1986).

On a MVL, if the liquidator considers that the company will be unable to pay its debts, they
must change the members' winding up into a creditors’ voluntary liquidation.

Creditors' voluntary winding up (CVL)

This is the most common insolvency procedure and in 2019 almost 80% of all liquidations
were CVLs. It is a form of insolvent liquidation commenced by resolution of the shareholders,
but under the effective control of the creditors who can choose the liquidator. Where a
directors' declaration of solvency has not been made, the liquidation will be a creditors'
voluntary liquidation.

The procedure is for the shareholders to pass a special resolution to place the company into a
CVL and an ordinary resolution to appoint a nominated liquidator.

Within 14 days of the special resolution being passed the directors of the company must ask
the company’s creditors to either approve the nominated liquidator or put forward their own
choice of liquidator. Where the creditors’ choice of liquidator differs from that of the
company’s shareholders, the creditors’ nomination will take precedence.

The directors must also draw up a statement of the company’s affairs (setting out the
company’s assets and liabilities) and send it to the company’s creditors.

Role of the liquidator

As noted above, the appointment of a liquidator terminates the management powers of the
company's directors, and these powers are transferred to the liquidator together with their
fiduciary duties, meaning that liquidators must act in good faith, avoid conflicts of interest and
not make a secret profit.

The liquidator must be either a qualified Insolvency Practitioner (s 230 IA 1986) or the Official
Receiver (appointed by the court in the short term) and acts as an officer of the court.

The liquidator in both a CVL and a compulsory liquidation have extensive statutory powers. The
principal functions of a liquidator in a winding up by the court are:
• To secure and realise the assets of the company then distribute to the company's
creditors (s 143 IA 1986); and
• To take into their custody or under their control all the property of the company (s 144
IA 1986).

Liquidator's powers to manage the company

The liquidator's powers to manage the company are set out in Part I to III Sch 4 IA 1986 and
include the ability to:
• Sell any of the company's property;
• Execute deeds and other documents in the name of the company;
• Raise money on the security of the company’s assets;
• Make or draw a bill of exchange or promissory note in the name of the company;
• Appoint an agent to do any business that the liquidator is unable to do;
• Do all other things that may be necessary to wind up the company's affairs and to
distribute its assets.
• Carry on the business of the company, but only to the extent that is necessary for the
beneficial winding up of the company.
• Commence or defend court proceedings in the name of the company, for example to
recover debts owed to it or dispute debts alleged to be owed by the company.
 • Pay debts and compromise claims.

Liquidator's powers to avoid certain transactions

Liquidators have a duty to preserve the company's property and to maximise the value of the
company's assets available for distribution. They are empowered to avoid certain antecedent
transactions in order to maximise the amount of assets available for distribution to creditors as
follows:
• Disclaim onerous property (s178 IA 1986);
• Apply to court to set aside a transaction at an undervalue (s238 IA 1986);
• Apply to court to set aside a preference (s 239 IA 1986);
• Apply to court to set aside, or vary the terms of, an extortionate credit transaction (s
244 IA 1986);
• Claim that a floating charge created for no new, or inadequate, consideration is invalid
(s 245 IA 1986);
• Apply to court to set aside a transaction that will defraud creditors (s 423 IA 1986).
Note that many of these powers also apply to administrators.

Summary
• There are two main types of liquidation: compulsory liquidation or voluntary (members'
or creditors' voluntary liquidation).
• A members' voluntary liquidation applies only to solvent companies where the directors
swear a statutory declaration of solvency.
• Compulsory liquidation may be ordered by the court on any of the grounds under s
122(1) IA 1986. The most common ground is that the company will be unable to pay its
debts.
• Once the liquidation commences, the directors lose their powers and the liquidator
takes control of the company.
• The role of the liquidator is to realise the assets of the company and to distribute these
in accordance with the statutory order of priority.

The statutory order of priority

The statutory order of priority

In order to make a payment to creditors (known as a dividend), a liquidator will (and an
administrator may) be required to distribute the assets of the company to its creditors in a
specified order of priority in payment in accordance with complex rules. Inconveniently, these
rules have no single source: they are found piecemeal in different parts of the IA 1986, the IR
2016 and general law.

The following (simplified) order of priority in payment summarises the cumulative effect of
these rules. This order assumes that that there is a qualifying floating charge (QFC) granted on
or after the Relevant Date (15 September 2003).
Administrators may also pay dividends to unsecured creditors if they have court permission to
do so and the rules set out below will also apply to them. It should also be noted that the
statutory order of distribution can be affected by priority or subordination agreements entered
into by creditors under which one class of creditor agrees to rank behind another.

A summary of the statutory order of priority is set out below, followed by a more detailed
explanation.
Summary of the statutory order of priority:
1. Liquidator’s fees and expenses of preserving and realising assets subject to fixed
charges.
2. Amount due to fixed charge creditor out of the proceeds of selling assets subject to the
fixed charge.
3. Other costs and expenses of the liquidation.
4. Preferential creditors (the first tier and then the secondary tier).
5. Creation of the prescribed part fund (if available) for unsecured creditors.
6. Amount due to creditors with floating charges.
7. Unsecured/trade creditors (including payment of the prescribed part).
8. Interest owed to unsecured creditors.
9. Shareholders.

1. Fixed charge assets

The assets subject to fixed charges are realised first by the liquidator and the proceeds are
applied as follows:
1. Liquidator’s costs of preserving and realising assets subject to a fixed charge
2. Fixed charge creditors (in respect of assets subject to a fixed charge)
The proceeds of selling assets which are subject to a fixed charge (or mortgage) must first be
used to pay off the debt secured by such charge (or mortgage). The proceeds will be paid net of
the liquidator’s costs and associated fees of selling the assets (that is, net of sums falling into
the first category of priority above eg estate agent fees in selling property).

If the proceeds are not sufficient to discharge the debt in full, then the creditor may be able to
recover the balance lower down the order of priority depending on whether the same debt is
secured by a floating charge or is an unsecured debt.

2. Assets subject to the floating charge (all assets)

In this example we are presuming that there is a QFC therefore all remaining assets of the
company are subject to this. The remaining assets are therefore realised and the proceeds
applied as follows:

3. Other costs and expenses of the liquidation

This includes all other costs and expenses of the liquidation, including the costs of selling assets
secured by a floating charge and the costs and expenses incurred in pursuing litigation (such as
actions in respect of wrongful trading or voidable transactions). Such litigation will require prior
approval from preferential creditors and floating charge holders, or alternatively from the
Court, otherwise the liquidator cannot claim the costs of litigation. The reason for this rule is
that it is these creditors who will effectively pay the costs of litigation should it fail.

4. Preferential debts (Schedule 6)

For insolvencies that commence on or after 1 December 2020, there will be two tiers of
preferential creditors: a first and secondary tier. The first tier consists of the existing
preferential creditors, the main category being employees for remuneration due in the 4
months before the ‘relevant date’ (generally the date of the winding up resolution or petition)
but subject to a maximum of £800 per employee plus accrued holiday pay, and for certain
contributions owing to an occupational pension scheme.

The secondary tier consists of Crown debts comprising (i) the PAYE and employee national
insurance deductions made by companies from employee salaries and wages and (ii) the VAT
they have received on supplies they have made and which they are then due to account to
HMRC. Note that these Crown debts used to be preferential until the EA 2002 reforms came
into force when they were removed from the list of preferential debts. The Government has
now restored their preferential status.

5. Prescribed part fund

The Enterprise Act 2002 introduced the "prescribed part" fund into the IA 1986 to increase the
chance that unsecured creditors would get paid something in a liquidation. The idea is that
some money is reserved for the unsecured creditors and does not flow into the pocket of
floating charge holders. The prescribed part fund is sometimes referred to as the "ring fenced"
fund and applies to realisations from floating charges created on or after 15 September 2003.

The prescribed part fund is calculated by reference to a certain percentage (the ‘prescribed
part’) of the company’s ‘net property’. This is set aside (ring-fenced) for distribution to the
company’s unsecured creditors - s. 176A. ‘Net property’ means the proceeds of selling property
other than that which is subject to a fixed charge, after deduction of the liquidator’s expenses
and any preferential debts.

The amount of the company’s net property that will be ring-fenced is 50% of the first £10,000
and 20% thereafter up to a maximum fund of £600,000 for floating charges created before 6
April 2020 and £800,000 for floating charges created on or after that date.This pot of money is
reserved at this stage to be shared rateably among the unsecured creditors when they are paid
(ie at step 7 below).

It should be noted that for this purpose, a floating charge holder who suffers a shortfall on
floating charge realisations does not share in the prescribed part fund, although the shortfall
does constitute an unsecured claim against the company.

6. Floating charge creditors

After payment of the general expenses of the liquidation, paying preferential debts and dealing
with the prescribed part, the liquidator then pays any remaining realisations from assets
subject to floating charges to the floating charge holders themselves (according to the priority
of their security, if there is more than one floating charge holder).

7. Unsecured creditors
For example:
• ordinary trade creditors who have not been paid;
• secured creditors to the extent that the security is invalid or assets subject to the
security have not realised sufficient funds to pay off the secured debt.
All the unsecured creditors rank and abate equally. This is known as the “pari passu” rule. For
example, if a company has only two creditors (A and B) and creditor A has a claim against the
company of 100 and creditor B has a claim against the company of 50 (making total claims of
150) but the assets available for distribution to the creditors are 75, creditor A will receive 50
and creditor B will receive 25.

Note that secured creditors who have not been paid in full from the realisation of assets subject
to their security can only claim as unsecured creditors against realisations from unsecured
assets, so they are not eligible to any payment from the prescribed part fund.

8. Interest on unsecured (including preferential) debts

Interest accruing on unsecured debts from the commencement of the winding up.

9. The shareholders
The shareholders who participate in the equity of the company will rank last. However, their
rights, as between themselves, will depend on the rights attributable to their particular class or
classes of shares. This will be written into the Articles of Association. For example, preferential
shareholders may have preferential rights to a return of their capital on a winding up in priority
to ordinary shareholders.

It is clear that in most insolvent liquidations, the shareholders are unlikely to receive any value
from their shares, since they are the last to be paid in the statutory order of priority.
The benefit of fixed charges is also clearly illustrated – fixed charge holders receive their value
first and are therefore more likely to receive their money back in a liquidation.

Personal insolvency
Personal insolvency

This element covers two formal personal insolvency procedures:

(1) Individual Voluntary Arrangements ('IVAs'); and
(2) bankruptcy, including the challenge of voidable transactions by individuals

Introduction: Personal Insolvency

The principles relating to personal insolvency and corporate insolvency are similar although the
terminology is different.
Just as the directors of a company need to recognise when a company is in financial difficulty,
individuals need to do the same. The indicators of financial difficulty and the options available
to individuals are similar for individuals as for companies, namely: (1) do nothing; (2) do a deal;
or (3) declare bankruptcy (only relevant to personal insolvency).

The two formal insolvency procedures for insolvent individuals that are the focus of this topic
are bankruptcy and individual voluntary arrangements ('IVAs'). The key statute governing
bankruptcy and IVAs is the Insolvency Act 1986 (IA86), together with the Insolvency Rules 2016.
Bankruptcy is a collective insolvency procedure enabling an orderly collection, sale and
distribution of an insolvent individuals' assets for the benefit of all the bankrupt's creditors. An
IVA is often an alternative to bankruptcy (Part VIII sections 252-263 IA) and is also a collective
procedure. Both of these procedures are considered further below.

IVA - Overview
An IVA has many similarities to a company CVA. It is a contractual arrangement under which a
debtor comes to an arrangement with their creditors eg to settle their debts by paying a
proportion of the debts. It is a flexible procedure that can be tailored to a debtor’s
circumstances. It usually requires the debtor to make funds available to their creditors out of
their income or assets, or a combination of both.

If approved by the requisite percentage of creditors (see below), the IVA binds the debtor and
all of their creditors to accept the terms of the IVA in settlement of their debt.

An authorised professional (usually an Insolvency Practitioner) supervises the debtor’s

implementation and compliance with the terms of the IVA.

An IVA can last any length of time, but three to five years is common in practice.

Setting up an IVA
1. The debtor drafts proposals setting out a statement of their affairs (eg full details of
assets and liabilities) usually with the assistance of an Insolvency Practitioner who is
known as a nominee at this stage.
2. The nominee submits a report to the court stating their opinion as to whether the
arrangement has a reasonable prospect of being approved and implemented and
whether a creditors’ meeting should be called.
3. A debtor can apply to the court for an interim order. If the court grants the order, it
brings about a moratorium, freezing existing or proposed bankruptcy and other
proceedings and legal process (including execution, landlord’s right of peaceable re-
entry and/or distress for rent) against the debtor, without leave (in any such case) of the
court. The interim order (and the moratorium) lasts 14 days which the court can extend.
4. If the nominee decides to call a creditors’ meeting, creditors holding more than 75% (by
value) of the debt must vote to approve the terms of the IVA.
Effect of approval of an IVA
If approved, the IVA binds the debtor and all of their creditors (except secured creditors unless
they consent to the IVA).

The nominee becomes the supervisor of the IVA and its implementation. They can apply to
court for directions and must report to the court periodically. If the debtor fails to comply with
the terms of the IVA, the supervisor can usually petition for their bankruptcy.

At the end of the IVA, if the debtor’s payments into the IVA have not been sufficient to pay off
their debts in full, the shortfall will usually be written off by the creditors.

Some advantages of an IVA include the following:

• it is an alternative to bankruptcy;
• it can bind all creditors (except secured creditors); and
• a moratorium is available if an interim order is made.
Some disadvantages of an IVA include the following: it may last longer than a bankruptcy eg
where income payments are made over a number of years, and it can be an expensive process.

Bankruptcy - petition grounds and requirements

The next formal insolvency process is bankruptcy. A bankruptcy petition is usually brought by a
creditor but may also be made by the debtor.

Creditors’ Petition
A ground for the petition is that the debtor is unable/has no reasonable prospect to pay its
petition debts.

The debt must be for a liquidated sum exceeding £5,000, generally unsecured, and the debtor
must usually be domiciled or present in England and Wales.

Debtor’s Petition
The only ground for this petition is that the debtor is unable to pay its debts.

The petition must be accompanied by a statement of affairs setting out the debtors’ assets and
liabilities.

Bankruptcy – Inability to pay debts and bankruptcy order

The debtor’s inability to pay their debts is evidenced by:
• a statutory demand that has neither been satisfied within three weeks from service of
that demand, nor set aside by the court; or
• an unsatisfied execution of a judgment or of another legal process.
• If a court is satisfied that the grounds for a petition and other requirements set out
above have been met, the court has discretion to make a bankruptcy order. Upon the
making of a bankruptcy order, either a trustee in bankruptcy (‘Trustee’) is appointed or
the court will pass the bankruptcy file to the Official Receiver, a government body, who
 will become the Trustee until an alternative (if any) is appointed by the creditors. If
there are insufficient assets, it may be difficult to persuade anyone other than the
Official Receiver to become the Trustee.
• On the making of a bankruptcy order, the bankrupt (whilst undischarged) is prohibited
from doing a number of things, including acting as a director or being involved in the
management of a company, obtaining credit of over £500 without disclosing the
bankruptcy, giving gifts and practising in certain professions. They are also deprived of
ownership of their property except for their reasonable domestic needs.

Trustee - powers and duties

The bankrupt’s estate vests in the Trustee immediately upon their appointment taking effect or
the appointment of the Official Receiver. This means that the bankrupt will have to pass their
assets (present and future) to the Trustee.

The Trustee has wide statutory powers to sell or otherwise deal with the assets in the estate
and generally including the carrying on of the bankrupt’s business and the mortgaging of
property as well as statutory duties.

The Trustee will collect in the assets (and may disclaim any onerous property or contracts),
including those assets which may be available to swell the estate as a result of challenging
certain fraudulent or undervalue transactions or preferences (see below). The Trustee will sell
those assets and must distribute the estate in accordance with the statutory provisions. The
Trustee will give notice to the creditors who have proved their debts, stating the amount of the
sale proceeds of any assets, any deductions that have been made from these proceeds, and the
amount of any dividend that they can expect to receive from the bankruptcy estate. The final
distribution will take place when the Trustee has sold all the assets that it can, and distributed
them in the order of priority set out below.

Bankruptcy - order of priority of payments

The bankruptcy order of priority differs from the order of priority in corporate insolvencies and
is as follows:
1. secured creditors (but limited to the value of the security itself and ranking with
ordinary unsecured creditors for any excess amount owing);
2. expenses of the bankruptcy;
3. specially preferred creditors (training/apprenticeship fees);
4. preferential creditors (similar to those on corporate winding up);
5. ordinary unsecured creditors;
6. statutory interest;
7. debts of a spouse (must be provable but they are postponed to other creditors); and
8. finally, any surplus is payable to the bankrupt.

Bankrupts' Duties
A bankrupt has a number of duties to the Trustee. The bankrupt has to provide information and
assistance to the Trustee to enable the Trustee to carry out their functions.
Section 333(1) IA86 states as follows:
“The bankrupt shall-
a. give to a trustee such information as to his affairs;
b. attend on the trustee at such times, and
c. do all such other things,
as the trustee may for the purposes of carrying out his functions reasonably require.”

It is a criminal offence for the bankrupt to fail to comply with their obligations under s 333 IA86
and they could face imprisonment for up to two years and unlimited fines. Also, the bankrupt
runs the risk of having their automatic discharge suspended (see below).

Bankruptcy Discharge
Generally, a bankrupt is automatically discharged from bankruptcy after a maximum period of
one year. Discharge means that the bankrupt is released from most of the bankruptcy debts
and the personal restrictions eg acting as a director, obtaining credit etc mentioned above.

The Official Receiver or Trustee may apply for an order suspending the automatic discharge if
the bankrupt fails to comply with their obligations under IA 1986.

The bankrupt may be discharged in less than a year if the Official Receiver or Trustee files a
notice stating that the bankruptcy does not require investigation or stating that they have
concluded any such investigation within the one year period.

Bankruptcy Restriction Orders/Undertakings

The Secretary of State, or the Official Receiver acting on the Secretary of State’s direction, may
apply to the court for a Bankruptcy Restriction Order (“BRO”) if the court considers it
appropriate having regard to the conduct of the bankrupt (before or after the bankruptcy
order).

Behaviour to be taken into account is listed in Schedule 4A IA86 and includes failure to keep
records, entering into preferences or transactions at an undervalue, fraud and incurring a debt
without reasonable expectation of being able to pay it. Generally, the application must be made
within a year of the start of the bankruptcy.

A BRO will operate for a period of between two and 15 years. For the duration of the order, the
bankrupt is unable to act as a director or obtain credit of more than £500 without disclosing
that they are subject to a BRO.

Breach of a BRO is a criminal offence punishable by fine and/or imprisonment.

Instead of being subject to court process, a bankrupt can offer the Secretary of State a
bankruptcy restriction undertaking (BRU) which, if accepted, will have the same effect as a BRO.
Voidable Transactions
A Trustee has the power to challenge voidable transactions and will do this with the aim of
increasing the assets available to creditors. In doing so, the Trustee will have to balance the
costs and risks of litigation with the chances of success in making recoveries for the bankruptcy
estate. The principles for voidable transactions for individuals are similar to corporate
insolvencies but sometimes involve different time periods and different sections of IA86.

The voidable transactions that are the focus of this topic are:
1. Transactions at an undervalue (s 339 IA86)
2. Preferences (s 340 IA86)
3. Transactions defrauding creditors (s 423 IA86)
If the requirements for each of these voidable transactions are met, the court has the power to
make such order as it thinks to restore the position to what it would have been but for the
transaction or preference.

Transaction at an Undervalue (‘TUV’) s 339 IA86

What is a TUV
A Trustee can bring a claim for TUV if the transaction is either:
• a gift; or
• in consideration of marriage or the formation of a civil partnership; or
• for a consideration the value of which in money or money’s worth is significantly less
than the consideration provided by the bankrupt

Relevant time
The transaction must take place within 5 years preceding the day of the presentation of the
bankruptcy petition

Is insolvency required
It must be proved that the individual was insolvent but only if the transaction took place
between 2-5 years from the day of the presentation of the petition.

Presumption available
Insolvency of the bankrupt is presumed (subject to rebuttal) where a transaction at an
undervalue is entered into with an ‘associate’ of the bankrupt (see s 435 IA86 for the definition
of associate).

Preferences s 340 IA86

What is a preference
A Trustee can bring a claim for a preference if:
• that person is a creditor (or a surety or guarantor of their debts or liabilities); and
• the individual does anything or suffers anything to be done which has the effect of
putting that person in a better position than they otherwise would have been in the
event of the individual being made bankrupt.
Relevant time
Within 6 months preceding the day of the presentation of the petition if to an unconnected
person; or within 2 years preceding the day of the presentation of the petition if to an
associate.

Is insolvency required
It must be proved that the individual was insolvent at the time of the preference or became
insolvent as a result of it.

Other requirements
It must be shown that the individual was influenced by the desire to prefer the creditor. There
is a rebuttable presumption that the bankrupt individual was influenced by the desire to prefer
the creditor where the preference is to an associate

Transactions Defrauding Creditors (TDC) s 423 IA86

• The same provisions apply to TDCs for individuals as they do for companies. The detail is
in the Voidable Transactions element in corporate insolvency. The key points are
summarised below.
• In addition to the list of persons that can bring a claim for TDC mentioned in the
corporate insolvency element, the Trustee or Official Receiver can also bring a claim.
• To bring a claim for TDC it must be shown that the transaction was a transaction at an
undervalue with an intent to defraud creditors and there is therefore a high evidential
burden.
• There is no relevant time for bringing a TDC claim and therefore a Trustee is most likely
to bring a TDC claim when they are outside the time limits for a transaction at an
undervalue claim.
• There is also no need to prove that the debtor is or was insolvent.

Summary (all references to IA 1986)

Transactions at an undervalue s 339 :
• Transaction for an undervalue
• Within 5 years preceding the day of presentation of bankruptcy petition
• Individual insolvent at time / as a result (this is presumed with associates)
Transactions defrauding creditors s 423:
• Transaction for an undervalue
• Intention to defraud creditors
• No need for individual to be insolvent
Preferences s 340:
• Individual puts creditor in better position and influenced by desire to prefer
• Within 2 years preceding the day of presentation of bankruptcy petition
• Within 6 months preceding the presentation of bankruptcy petition if connected person
and presumption of preference
• Individual insolvent at time / as a result
Summary
• An IVA is often an alternative to bankruptcy and allows an individual to make proposals
for repayment and reach a contractual agreement with their creditors under the
supervision of an insolvency practitioner.
• A creditor, or the debtor themselves, can file a bankruptcy petition on certain specified
grounds, most likely that the debtor is unable to pay its debts. The court has discretion
to make a bankruptcy order and either the Official Receiver or a Trustee is appointed to
gather in and distribute the bankruptcy estate in accordance with the statutory order of
priority. The Trustee has a wide range of powers in carrying out its duties.
• The Bankrupt has a duty to cooperate with the Trustee. The Bankrupt is automatically
discharged and released from their bankruptcy debts after one year from the date of
the bankruptcy order, provided they have complied with their duties to the Trustee.
• The Trustee can bring claims for TUV’s, TDCs and preferences (summary above) and the
court can make a restoration order.
Business Law and Practice – Workshop 10
Insolvency II

Fraudulent trading

This element considers the liability of directors of an insolvent company for fraudulent trading.

Liability of directors of an insolvent company

When a company becomes insolvent, the directors need to be extremely careful in how they
act, since they may be held to be personally liable to compensate the company and its
creditors if found guilty of one of the following:
• Fraudulent trading (s 213 / 246ZA IA 1986)
• Wrongful trading (s 214 / 246ZB IA 1986)
Liquidators and administrators have the power to bring proceedings for compensation against
the directors personally (for fraudulent trading and wrongful trading).

Liability of directors for fraudulent trading

The provisions on fraudulent trading were enacted to prevent the abuse of limited liability by
those running companies.

The concern is that directors may continue to trade and incur further debts at a time when the
company is in financial difficulty, with the result that losses to creditors are increased.
Therefore, the IA86 gives the court power to impose both criminal and civil sanctions on
directors (and other persons, see below) if they are found guilty of fraudulent trading.

However, claims for fraudulent trading are rare due to the evidential requirements in proving
an intent to defraud creditors (see below).

A claim for fraudulent trading may be made by a liquidator (s 213 IA86) or an administrator (s
246ZA IA86) by making an application to court. The provisions in s 246ZA reflect those in s 213
IA86 with the necessary changes for administration and liquidation, respectively.

Fraudulent trading
A claim for fraudulent trading under s 213 / 246ZA IA 1986 can be brought against:
• any person (s 213(2) and s 246ZA(2))
• who is knowingly party to the carrying on of any business of the company
• with intent to defraud creditors or for any fraudulent purpose (s 213(1) and s
246ZA(1)).
Although claims for fraudulent trading are usually brought against directors, 'any person' is a
wide definition and includes banks, who may also be liable for fraudulent trading by virtue of
their employees' knowledge (Morris v State Bank of India[2005] 2 BCLC 328).
Sections 213 (in liquidation) and 246ZA (in administration) IA 1986 impose a civil liability to
contribute to the funds available to the general body of unsecured creditors suffering loss
caused by the carrying on of the company’s business with intent to defraud.

There is also a corresponding criminal claim for fraudulent trading under s 993 CA 2006.

Actual dishonesty
Actual dishonesty must be proven for a claim for fraudulent trading to succeed. Examples of
the meaning of dishonesty and fraud are set out below.

Dishonesty is assessed on a subjective not objective basis ie what the particular person knew or
believed. Knowledge includes blind-eye knowledge, which requires a suspicion of the relevant
facts together with a deliberate decision to avoid confirming that they did exist.

The meaning of fraud for the purposes of s 213 has been defined as requiring "real dishonesty
involving, according to current notions of fair trading among commercial men at the present
day, real moral blame." (Re Patrick and Lyon Ltd[1933] Ch 786).

It is not necessary to show that all of the company's creditors have been defrauded. Provided at
least one creditor has been defrauded, this will be enough to bring a claim.

Remedies
A person found to be liable under s 213 / 246ZA can be ordered to make such contribution to
the company’s assets as the court thinks proper. The court does not have the power to include
a punitive element in the amount of any contribution to be made. The contribution should only
reflect and compensate for the loss caused to the creditors.

Any sums recovered are held on trust for the unsecured creditors generally and not for the
defrauded creditor.

Where the court makes an order against a person under s 213 / 246ZA, and that person is also a
director, the court is likely also to make a disqualification order under s 10 CDDA 1986.

In addition, criminal sanctions can be imposed by the court under s 993 CA 2006, to punish a
person knowingly party to fraudulent trading, whether or not the company is being wound up.
The penalties are imprisonment (of up to 10 years on indictment) and/or fines.

Fraudulent trading vs wrongful trading

In practice, a very high standard of proof is required for a successful claim in fraudulent trading,
which is likely to be extremely difficult for a liquidator or an administrator to establish.

It is for this reason that claims for fraudulent trading are rare and claims for wrongful trading
under s 214 / 246ZB IA 1986 are more often brought against directors.
Summary
• Claims for fraudulent trading may be brought by a liquidator or an administrator.
• The claim can be brought against any person who is knowingly party to the carrying on
of any business of the company with intent to defraud creditors or for any fraudulent
purpose, including directors and banks.•Actual dishonesty must be proven on a
subjective basis.
• A person found to be liable can be ordered to make such contribution to the company’s
assets as the court thinks proper. There is no punitive element to the remedy however –
the contribution should only reflect and compensate for the loss caused to the creditors.
• The court is likely also to make a disqualification order under s 10 CDDA 1986 where a
director has been found liable for fraudulent trading.
• There is also a criminal claim for fraudulent trading under s 993 CA 2006. The remedies
for this are up to 10 years' imprisonment or fines.

Wrongful trading

This element considers the liability of directors of an insolvent company for wrongful trading.

The claim for wrongful trading

Liability for fraudulent trading existed long before liability for wrongful trading was introduced.
However, the requirement for proof of dishonest intent to establish liability for fraudulent
trading has meant that proceedings for fraudulent trading are rarely brought.

Following criticism of the ineffectiveness of the fraudulent trading provisions, the concept of
wrongful trading was introduced in order to establish liability for directors who carry on
business negligently rather than fraudulently.

A civil claim for wrongful trading can be brought against a director by a liquidator under s 214
or an administrator under s 246ZB IA 1986. There are no criminal provisions for wrongful
trading, in contrast to fraudulent trading which is both a civil and a criminal wrong.

Wrongful trading is now the major risk run by the directors of a company trading on the brink
of insolvency. Directors must take the risk of liability for wrongful trading seriously and it is an
important part of a lawyer’s job to advise on the risk and how to mitigate it.

Wrongful trading – purpose

The purpose of s 214 and 246ZB is to ensure that when directors become aware (or ought to
become aware) that an insolvent liquidation (or insolvent administration, as the case may be) is
inevitable, they are under a duty to take every step possible to minimise the potential losses
to the company’s creditors.

If they fail to do this, the court can, under s 214 and 246ZB, order the directors to contribute to
the insolvent estate by way of compensation for the losses that the general body of creditors
have suffered as a result of the directors’ conduct, and thereby, increase the funds available for
distribution to unsecured creditors in the insolvency.

Wrongful trading liability therefore imposes personal liability on directors and marks a very
important exception to the principle of limited liability under which those who run a company
cannot be liable for its unpaid debts.

Since there is no requirement to show intent or dishonesty, it is easier for a liquidator or

administrator to prove wrongful trading than it is fraudulent trading.

Who may bring a claim? - s 214(1) / 246ZB(1)

A claim for wrongful trading may be brought by:
• Liquidators under s 214(1), and
• Administrators under 246ZB(1).
Administrators and liquidators can also now (under the SBEEA 2015) assign wrongful trading
claims to a third party as a way of raising funds for the insolvent estate and thereby, avoid the
risk of litigation.

Against whom may a claim be brought?

A claim may be brought against any person who was at the relevant time a director.

This includes shadow directors as defined in s 251 CA 2006, de facto and non-executive
directors

Contrast this with fraudulent trading where a claim can be brought against any person who has
the intention to commit a fraud (so not only directors).

Requirements for liability – s 214(2) / 246ZB(2)

For a director to be liable for wrongful trading, the court must be satisfied that the company
has gone into insolvent liquidation and:
1. at some time before the commencement of the winding up or insolvent
administration (for convenience, that time is referred to as the 'point of no return')
2. the director knew or ought to have concluded that
3. there was no reasonable prospect that the company would avoid going into insolvent
liquidation (or insolvent administration).
Note that a company goes into insolvent liquidation (or as the case may be, an insolvent
administration) at a time when its assets are insufficient for the payment of its debts and
other liabilities and the expenses of winding up or administration (s 214(6) / 246ZB(6)).

Insolvency for wrongful trading purposes is therefore judged solely on the 'balance sheet test'
and not on the 'cash flow test' (see s 123).

Continued trading
It must be proven that:
 • the director in question allowed the company to continue to trade during the period in
which they knew or ought to have known that there was no reasonable prospect that
the company would avoid going into insolvent liquidation or administration, and
• that the continued trading made the company's position worse.
Note however, if the company has not reached the point of no return, then wrongful trading
liability cannot arise and there is no need to consider the 'every step' defence which we
consider below.

The 'every step' defence - s 214(3) / 246ZB(3)

Assuming the company has reached the point of no return, a director may be able to escape
liability if they can satisfy the court that, after they first knew or ought to have concluded that
there was no reasonable prospect of the company avoiding an insolvent administration or
liquidation (ie from the 'point of no return' onwards), they took every step with a view to
minimising the potential loss to the company’s creditors.

Examples of evidence that may be supportive of establishing the every step defence include:
• Voicing concerns at regular board meetings;
• seeking independent financial and legal advice;
• ensuring adequate, up-to-date financial information is available;
• suggesting reductions in overheads/liabilities;
• not incurring further credit; and
consulting a lawyer and/or an insolvency practitioner for advice on continued trading and the
different insolvency procedures.

The 'reasonably diligent person' test – s 214(4) / 246ZB(4)

The court applies the 'reasonably diligent person' test in order to determine whether:
• a liquidator or administrator has established that a director ought to have concluded
that there was no reasonable prospect of avoiding an insolvent liquidation or
administration (the s 214(2) / 246ZB(2) liability), and
• whether the director then took every step to minimise the potential loss to the
company’s creditors (the s 214(3) / 246ZB(3) defence).

Under that test, the facts which a director ought to have known or ascertained, the conclusions
which he ought to have reached and the steps which he ought to have taken, are those which
would have been known or ascertained, or reached or taken, by a reasonably diligent person
having both:
• the general knowledge, skill and experience that may reasonably be expected of a
person carrying out the same functions as are carried out by the director in question (an
objective test); and
• the actual knowledge, skill and experience of that particular director (a subjective test).
The court then applies the higher of the two standards.
Advice to directors
• To minimise the risk of a wrongful trading claim, directors should:
• hold regular board meetings to review the company’s financial position and write up
minutes of each meeting so there is a written record on which the directors can later
rely to justify decisions that were taken. It is quite common for lawyers advising a
company in financial difficulties to take an active role in helping directors to prepare
minutes and to ensure that board meetings consider all the relevant issues; and
• consider whether it is appropriate to incur new credit and liabilities.
• A director cannot escape liability by simply resigning without previously taking every
step with a view to minimising the potential loss to the company’s creditors, since a
claim for wrongful trading can be brought against any person who was a director at the
relevant time.
The best course of action for a company is to seek professional advice as soon as possible.
However, it is important to note that case law suggests that the absence of warnings from
advisers does not relieve directors of the responsibility to review the company's position
critically.

Remedies – s 214(1) / 246ZB(1)

If a director is found to be liable for wrongful trading, the court can order that director to make
such contribution to the assets of the company as the court thinks fit. The contribution will
increase the assets of the company available for distribution to the general body of unsecured
creditors.

The court has a wide discretion to determine the extent of the directors’ liability. The
contribution will ordinarily be based on the additional depletion of the company’s assets
caused by the directors’ conduct from the date that the directors ought to have concluded that
the company could not have avoided an insolvent administration or liquidation (ie from the
‘point of no return’).

An order by the court for a director to contribute to the company’s assets under s 214 / 246ZB
is compensatory and not penal in nature. An order to contribute may be made against the
directors on a joint and several basis. However, the court has a discretion to apportion liability
between directors based on their culpability by ordering the more culpable directors to pay
more than the less culpable ones.

Where the court makes a contribution order against a director under s 214 / 246ZB, the court
also has a discretion to make a disqualification order against them under s 10 CDDA 1986.

No relief under s 1157

Under s 1157 CA 2006, the court may ordinarily relieve a director from liability in proceedings
for negligence, breach of duty or breach of trust, on such terms as it thinks fit, if satisfied that
he/she acted honestly and reasonably,and having regard to all the circumstances of the case,
the director ought fairly to be excused. However, that relief is not available in wrongful trading
proceedings (Re Produce Marketing Consortium Ltd [1989] BCLC 513, ChD).
Summary
• Claims for wrongful trading may be brought by a liquidator under s 214 IA 1986 or an
administrator under s 246ZB IA 1986.
• The claim can be brought against any person who was at the relevant time a director.
• The court must be satisfied that at some time before the commencement of the winding
up or insolvent administration, the director knew or ought to have concluded that there
was no reasonable prospect that the company would avoid going into insolvent
liquidation (or insolvent administration).
• A director may be able to escape liability if they can satisfy the court that, after they first
knew or ought to have concluded that there was no reasonable prospect of the
company avoiding an insolvent administration or liquidation, they took "every step with
a view to minimising the potential loss to the company’s creditors" (s 214(3) / 246ZB(3).
• The court applies the reasonably diligent person test under s 214(4) / 246ZB(4).
• A person found to be liable under s 214 / 246ZB can be ordered to make such
contribution to the company’s assets as the court thinks proper and may also be
disqualified under s 10 CDDA 1986.

Voidable transactions

This element considers the following voidable transactions:

1. Transactions at an undervalue
2. Transactions defrauding creditors
3. Preferences
4. Avoidance of Floating Charges.

Voidable transactions
The IA 1986 gives both a liquidator and an administrator the ability to challenge certain
transactions that have taken place within specified statutory periods prior to the insolvency of a
company. These are known as ‘voidable’ or ‘antecedent’ transactions.

The aim of a challenge is to restore the company to the same position it would have been in
had the transaction not taken place and thereby, increase the funds available in the insolvent
estate for the benefit of creditors.

These provisions are often described as ‘antecedent’ or ‘clawback’ or provisions which can
result in an order reversing transactions or more usually, providing for financial restitution to be
paid, in order to increase the assets of the insolvent company for the benefit of creditors. It is
the beneficiary of the transaction with the insolvent company that is the target of the
proceedings, rather than the directors of the company responsible for entering into the
transaction.

All references below are to IA 1986 unless stated otherwise.

Questions to ask
A liquidator or administrator seeking to challenge any voidable transaction (except for a
transaction defrauding creditors under s 423) will need to ask the following questions in each
case:
1. Did the transaction involve a ‘connected person’ or ‘associate’?
2. Did the transaction take place within the ‘relevant time’?
3. Was the company insolvent at the time of the transaction or did it become insolvent as
a result of the transaction?
4. Is there a presumption available which shifts the burden of proof from the
liquidator/administrator to the other party?

Transactions by a company at an undervalue (TUV) – s 238 IA 1986

The provisions under s 238 concern loss of value from a company, whether through gifts or a
significant inequality in consideration, to the company’s detriment at a time when it is
“insolvent”.

Insolvency means ‘inability to pay debts’ under s 123 ie the company is insolvent on either the
cash flow or balance sheet basis.

Note that “insolvency” has a wider definition for voidable transaction purposes than it has for
wrongful trading purposes (in the latter case, “insolvency” is restricted to balance sheet
insolvency only).

A claim may be brought under s 238(1) by ‘an office-holder’ which means:

• a liquidator, or
• an administrator.

TUV: What is a transaction at an undervalue?

A transaction at an undervalue is either:
• A gift; or
• A transaction for a consideration the value of which, in money or money’s worth, is
significantly less in value than the consideration provided by the company. This
involves a comparison in monetary terms between what the company gave away and
what it received under the transaction. The comparison to be made is aimed at
establishing if there has been an inequality of exchange adverse to the company under
the transaction. A simple example would be where a company sells an asset worth
£100,000 but only received £50,000 in payment.
• In some situations, the granting of security or payment of a dividend may be held to
amount to a transaction at an undervalue.

TUV: Granting security / payment of a dividend

It was generally thought that the granting of security by a company cannot amount to a
transaction at an undervalue on the basis that the security does not itself deplete the assets of
the company or diminish their value (Re MC Bacon Ltd [1990] BCLC 324).
However, in Hill v Spread Trustee Company Limited [2006] EWCA Civ 542, it was found that the
granting of security for no consideration (or for consideration significantly less than the value of
the charge) can be challenged as a transaction at an undervalue. In Hill, the main purpose for
the granting of security was to put assets beyond the reach of HMRC. The law is somewhat
uncertain on this point because of the difference in view between the MC Bacon and Hill cases.

Similar uncertainty existed around whether a dividend, lawfully paid, could amount to a
transaction at an undervalue. The case of BTI 2014 LLC v Sequana SA & others [2019] EWCA Civ
112 now suggests that a dividend can be attacked as a transaction at an undervalue.

TUV: When and how can the transaction be avoided?

The court may set aside a transaction as a transaction at an undervalue if:
1. The company made a gift or otherwise entered into a transaction for a consideration,
the value of which in money or money’s worth is significantly less in value than the
consideration provided by the company.
2. It took place within the ‘relevant time’ (s 238(2)) - in the two years preceding the onset
of insolvency (s 240(1)(a)), which is the commencement of the relevant insolvency
procedure (administration or liquidation) (s 240(3)). Note that the relevant time is two
years regardless of whether the transaction took place with a connected person or not.
3. It is proved by the applicant that the company was insolvent at the time of the
transaction or became so as a result of it (s 240(2)). Where a transaction at an
undervalue is entered into with a person connected with the company, insolvency is
presumed unless the connected person proves otherwise (s 240(2)).
Sections 249 and 435 set out the definitions of ‘connected persons’ and ‘associates’
respectively.

TUV: Defence
Even if all of the requirements set out above are satisfied, no order will be made to set aside
the transaction if the court is satisfied that:
1. the company entered into the transaction in good faith and for the purpose of carrying
on its business; and
2. at the time there were reasonable grounds for believing that the transaction would
benefit the company.
This defence is often relied on in practice and can save many transactions which would
otherwise be open to challenge.

One example when the defence may be available is where a company grants new security to
stave off a genuine threat made by an unsecured bank to terminate facilities and begin winding
up proceedings if the security is not granted, in circumstances where the directors consider on
reasonable grounds that the company can turn around its financial difficulties and thereby
avoid entering into an insolvency procedure.
TUV: Sanctions
The court has a discretion to make such order as it thinks fit to restore the position as if the
company had not entered into the transaction (s 238(3)).

Section 241(1) provides a non-exhaustive list of the types of restoration order that the court
might make under s 238 (and also under s 239 in relation to voidable preferences; see below).

Any such order should not prejudice a subsequent purchaser from the party which transacted
at an undervalue with (or received a preference from) the company, provided they were acting
‘in good faith and for value’ (s 241(2)).

However, under s 241(2A) there is a rebuttable presumption that an acquisition by a

subsequent purchaser was not in good faith where the subsequent purchaser either:
1. had notice of the relevant surrounding circumstances (ie the transaction at an
undervalue or preference) and of the relevant proceedings; or
2. was connected with or was an associate of either the company or the party which
transacted at an undervalue with (or received a preference from) the company. In such
circumstances the burden of proof shifts to the subsequent purchaser to show good
faith.

Transactions defrauding creditors (TDC) - s 423 IA 1986

Claims under s 423 do not necessarily relate to insolvency – these claims may also be brought
by a victim of the transaction in question where the company is solvent.

The requirements for the claim are:

1. there has been a transaction at an undervalue; and
2. the intention or purpose of the transaction was to put assets beyond the reach of
creditors of the company or otherwise prejudice their interests, this transaction may
be avoided under s 423(3). This even includes future creditors who were unknown at
the time of the transaction.
Insolvency practitioners may prefer to bring claims under s 238 (TUV) than under s 423. The
reason is that, under s 238, it need not be proved that the purpose of the transaction was to
put the assets beyond the reach of creditors or otherwise prejudice them. Where the challenge
is made by an administrator or liquidator, it may therefore be easier to establish the claim
under s 238, assuming that the claim satisfies the criteria for challenging an undervalue
transaction under the above sections (ie ‘relevant time’ and insolvency).

TDC: Who may claim and sanctions

An application to the court to set aside the transaction can be made by any of the following (s
424):
1. a liquidator or an administrator;
2. a supervisor of a voluntary arrangement; or
3. a victim of the transaction in question.
There is no ‘relevant time’ or period within which the transaction must have taken place.
However, generally speaking, the more recent the transaction, the more likely it is that the
applicant will be able to show the necessary intent.

The court may make such order as it thinks fit to restore the position to what it would have
been but for the transaction in question (s 423(2)). A non-exhaustive list of orders is set out in s
425(1).

The main advantage of a claim under s 423 is that it does not face the risk of becoming time-
barred in the same way as a claim under s 238.

Preferences by a company – s 239 IA 1986

The purpose of s 239 is to prevent a creditor obtaining an improper advantage over other
creditors of a company at a time when that company is insolvent.
A claim may be brought under s 239(1) by:
• a liquidator, or
• an administrator.
A company gives a preference to a person if:
1. that person is a creditor of the company (or a surety or guarantor of any of the
company’s debts or liabilities); and
2. the company does anything or allows anything to be done which has the effect
of putting that person in a better position in the event of the company going into
insolvent liquidation than he/she would otherwise have been in.
An example of a preference would be paying an unsecured creditor in priority to other creditors
or granting security to an unsecured creditor.

When can a preference be avoided?

The preference is voidable if:
1. it was given within the ‘relevant time’ (s 239(2)) - in the 6 months preceding the ‘onset
of insolvency’ (s 240(1)(b)), being the commencement of the relevant insolvency
procedure (s 240(3)). The relevant time is extended to2 years for preferences to
connected persons and associates (s 240(1)(a)). (See sections 249 and 435 for
definitions of ‘connected persons’ and ‘associates’);
2. it is proved that the company was insolvent (on either a cash flow or balance sheet
basis) at the time of the transaction or became so as a result of it (s 240(2)); and
3. It is proved that the company was ‘influenced … by a desire’ to prefer the creditor (s
239(5)). This is a subjective test. The company must have positively wished to put the
party in a better position (see Re MC Bacon Ltd).
Note in relation to 2 above, that unlike transactions at an undervalue, there is no statutory
presumption of insolvency where the preference is given to a person who is connected with the
company.
Preferences: Connected persons
If the preference is given to a connected person or associate, there is a rebuttable presumption
that the company was influenced by the desire to prefer the creditor (s 239(6)).

This shifts the burden of proof from the liquidator or administrator to the preferred person to
rebut the statutory presumption.

Connected persons and associates are defined in s 249 and s 435 IA 1986.

Preferences: Defence
The defence available is an absence of the desire to prefer required by s 239(5).

In Re MC Bacon Ltd[1990] BCLC 324, the company granted fixed and floating charges to its
bank to secure an existing overdraft, as a condition of the bank not calling in the overdraft, at a
time when it was insolvent. It was held that this was not a transaction at an undervalue because
it had not diminished the value of the company's assets. In relation to the claim that this was a
preference, the court said it is not necessary to prove an intention to prefer (which is
objective), but a desire to prefer (which is subjective).

On the facts, the security could not be challenged as a preference because the directors, in
granting the security, had not been influenced by a desire to prefer the bank, but only by the
desire to continue trading and to avoid the calling in of the company’s overdraft (ie the security
was granted as a result of genuine commercial pressure exerted by the lender and the presence
of such pressure negated any desire on the debtor’s part to prefer the lender).

Preferences: Sanctions
The court has a discretion to make an order to restore the position as if the company had not
given the preference (s 239(3)).

Section 241(1) provides a non-exhaustive list of the types of restoration order that the court
may make.

Note that s 241(2) and s 241(2A) apply to both preferences and transactions at an undervalue.

Avoidance of certain floating charges - s 245 IA 1986

The purpose of s 245 is to prevent an unsecured creditor obtaining a floating charge to secure
an existing loan for no new consideration, at the expense of other unsecured creditors.

The section only applies in a liquidation or administration. Unlike transactions at an undervalue

and preferences, s 245 avoids certain floating charges automatically and without the need for
the office-holder to challenge the floating charge by bringing legal proceedings (as set out
below). However, if there is a dispute between the putative floating charge holder and the
office-holder about the application of s 245, legal proceedings may be necessary to determine
the dispute.
A high-profile example of a contentious floating charge was seen in the liquidation of BHS,
where its liquidators were seeking to challenge a floating charge under s 245 held by Phillip
Green’s Arcadia Group. A settlement agreement was reached and the legal proceedings by the
liquidator were discontinued, apparently with no judgment as to the validity of the floating
charge.

When can floating charges be avoided?

For the floating charge to be invalid:
1. The floating charge must have been created within the ‘relevant time’. The relevant
time is 12 months preceding the onset of insolvency, ie the commencement of
administration or liquidation (s 245(2) and 245(3)(b)).

The relevant time is extended to 2 years in the case of a floating charge granted to a connected
person (s 245(3)(a)). (See s 249 and 435 for definitions of ‘connected persons’ and ‘associates’).
2. Unless the floating charge was granted to a ‘connected person’ or an ‘associate’ (in
which case there is no insolvency requirement), it must be proved that the company
was insolvent (on either a cash-flow or balance sheet basis) at the time of the floating
charge’s creation or became insolvent in consequence of the transaction under which
the charge was created (s 245(4)).

When are new floating charges valid?

Even if the above requirements are met, a floating charge will be valid to the extent that ‘new
money’ or other fresh consideration (which can include goods or services) is provided to the
company (or existing debts of the company are extinguished) in return for the grant of the
floating charge on or after its creation (s 245(2)).

The effect of s 245(2) is that if a floating charge is granted to secure the repayment of a new
loan made on or after the creation of the charge, then it will be valid.

An example of when a floating charge would be void is where an existing unsecured creditor is
granted a floating charge by a company which is insolvent (as defined above) and the charge
purports to secure the repayment of existing monies owed to that creditor. If s 245 did not
apply, such an unsecured creditor would thereby improve its position in the order of priority if
the company later went into an insolvency procedure, which would be unfair on the company’s
other unsecured creditors. However, if (and to the extent that) an existing unsecured creditor
provides further credit to the company (or to the extent that any other new credit is given by a
new creditor) then that creditor is entitled to have the protection of a valid floating charge.

Overdrafts
The position regarding the grant of a floating charge to secure an existing overdraft is fairly
complex due to case law and the effect of s245(2) in these cases is reduced.

In Re Yeovil Glove Co. Ltd [1965] CH 148, the company granted a floating charge to its bank to
secure an existing unsecured overdraft, as a condition of the bank not calling in the overdraft,
at a time when it was insolvent. The company went into liquidation a few month later. The
liquidator challenged the validity of the floating charge as it related to past unsecured
indebtedness. The court held that the floating charge was valid because (1) each time the
company used its overdraft facility after the creation of the floating charge, this was deemed to
be ‘new money’ advanced by the bank (2) The rule in Devaynes v Noble [1816] 1 Mer. 572
provides that payments into a bank account discharges the earliest advances made by the bank
first. As the company had paid more than £67,000 into the account since the grant of the
floating charge, it could be said that the pre-charge debt of £67,000 had been paid off and that
the existing overdraft balance at the time of appointment of the officeholder was ‘new’ debt.

Avoidance of floating charges

Where a floating charge is void under s 245, only the security (and its advantage to a floating
charge creditor in the order of priority) is void and not the debt itself.

Remember that a floating charge is also void against a liquidator, administrator and other
creditors if it is not duly registered with Companies House under s 859H CA 2006.

Note that a floating charge granted to a creditor may also be voidable as a transaction at an
undervalue or a preference under s 238 and 239.

Summary
Transactions at an undervalue s 238:
• Transaction for an undervalue
• Within 2 years prior to onset of insolvency
• Company insolvent at time / as a result (this is presumed with connected persons)

Avoidance of floating charges s 245:

• Floating charge created for no new consideration within 12 months prior to onset of
insolvency
• Within 2 years if connected person
• Company insolvent at time / as a result

Transactions defrauding creditors s 423:

• Transaction for an undervalue
• Intention to defraud creditors
• No need for company to be insolvent

Preferences s 239:
• Company puts creditor in better position and influenced by desire to prefer
• Within 6 months prior to onset of insolvency
• 2 years if connected person and presumption of preference
• Company insolvent at time / as a result