Fractional shares and ISAs – HMRC are probably wrong

The FT ran a fascinating story yesterday about a dispute between HMRC and some ISA platforms over whether the ISA platforms can sell investors fractional shares. HMRC are saying the ISA rules don’t permit this.

HMRC is usually right, but in this case we think they’re probably wrong (perhaps misled by some confusing ESMA guidance).

This article aims to provide an explanation of the dispute, and why we think HMRC is probably wrong. That requires a reasonably detailed legal and tax analysis of the arrangements, so this article is somewhat more technical than our usual reports.¹We are still considerably simplifying the underlying plumbing, but we believe the additional complexity doesn’t change the analysis. If you disagre, please write to us, or comment below. But it’s an important issue: we believe fractional shares are in the interests of investors (particularly young investors), and we believe the existing rules permit them.

We hope HMRC will reconsider its position, and start from a detailed English law/UK tax analysis of the effect of the arrangements, rather than from the ESMA guidance.

To understand the issues raised by fractional shares, we first have to explain how ISAs work with normal shares:

How shares work

If you open an ISA account with (say) Hargreaves Lansdown²We’re using Hargreaves Lansdown as an example; they don’t actually offer fractional shares, and pay £1,100 to buy ten AstraZeneca shares, what happens?

Important caveat up-front: all of the below rates to English law arrangements only – it should be correct where shares are held through CREST but may or may not be correct for comparable foreign law arrangements, and the analysis can sometimes be very involved.

Ownership

You don’t actually own ten AstraZeneca shares.

Hargreaves Lansdown has a “pooled omnibus account” in which all its customers’ shares are held. Let’s imagine it used to hold 99,990 AstraZeneca shares. When you clicked the button to buy ten shares, Hargreaves Lansdown bought another ten in the market³Simplification alert – it’s much more complicated than this. In particular, Hargreaves Lansdown will have numerous buy and sell trades on the same security, and only trades out its net position in the market (so you may actually be buying your shares from another Hargreaves Lansdown customer, albeit at the market price). For the purposes of this article “the market” will do., so the account now holds 100,000 AstraZeneca shares.

None of those 100,000 shares are “yours” in the sense that they are labelled with your name. Or indeed in any legal sense.

What you have instead is an “undivided beneficial interest” in all of the shares. To be precise, you own 0.01% of the pool (i.e. 10 divided by 100,000), and therefore you own 0.01% of each share. Legal ownership of the shares (i.e. the person shown in the share register) is with Hargreaves Lansdown.⁴I am simplifying; the precise arrangements with CREST etc are more complicated than this. In legal terms, Hargreaves Lansdown are the nominee or trustee, and the investors are the beneficiary.

It’s worth repeating this, because it’s so counter-intuitive: your ISA app shows you holding ten shares. In realistic, economic, commercial terms, you own ten shares. But in legal terms you don’t own ten shares at all – you own 0.01% of 100,000 shares.⁵To be more pedantic: you don’t have legal ownership of any shares; Hargreaves Lansdown does. You have an undivided beneficial interest of 0.01% in their pool of 100,000 shares.

Dividends

When AstraZeneca pays a dividend, they pay it to Hargreaves Lansdown, and you own 0.01% of that dividend.

Voting

If you vote to oppose the directors’ remuneration report then Hargreaves Lansdown will cast that vote on 0.01% of their shares. Not “your shares”, but any ten shares that they picked randomly.

Selling

If you later sell your shares, then it is absolutely not the case that Hargreaves Lansdown identifies the ten shares you own, sells those, and gives you the proceeds. You don’t own ten shares. You own 0.01% of 100,000 shares. They sell ten of those shares in the market⁶Again, it’s more complicated than that, and HL are trading the net position, but we’ll ignore that to keep this article under 10,000 words – and then you have a 0% interest in the remaining 99,990 shares. The £110 proceeds of the sale goes into a cash bank account, and you will acquire an interest in that account (e.g. if there is £1.1m in the cash account then you will beneficially own 0.01% of the account). Your account will then show you as holding £110 of cash. Just like with the shares, there obviously isn’t £110 sitting in a pot with your name on it; cash is “fungible” (all cash is mutually interchangeable) in the same way as shares.

The implications

This isn’t just mechanics – it has legal reality to it. If Hargreaves Lansdown goes bust, then the only people entitled to the AstraZeneca shares are the ISA investors – because they own them. The investors only lose out if the shares aren’t in that account; and modern custody arrangements mean that really shouldn’t be able to happen (absent a very sophisticated insider fraud involving multiple people).

This is how most retail share ownership works. It has the advantage of being efficient and scalable – no need to create a separate account for each customer. The disadvantage⁷Possibly there is an additional disadvantage that a pooled omnibus account is more susceptible to losses from fraud/error than if you had your own “segregated” account. However, it’s not clear if this is really the case in practice. A good test here is whether veteran regulatory and insolvency lawyers insist that their own investments are held in segregated accounts – in the authors’ experience they don’t. is that AstraZeneca only sees Hargreaves Lansdown as the shareholder; AstraZeneca has no idea who the beneficial owners are. If you, with your ten shares held through Hargreaves Lansdown, write to AstraZeneca and ask them to pay you a dividend, they’ll rightly refuse. If you try to go to a shareholder meeting, they won’t let you in.⁸These days, that’s not quite right, as some providers have systems and arrangements that let ISA investors attend meetings, but the important point is that Hargreaves Lansdown has to facilitate this; otherwise AstraZeneca won’t treat you as a shareholder.

The whole system is designed so that investors (from the largest hedge fund to your granny) don’t have to think about the plumbing. They can say, very comfortably, that they own ten shares. Their app says they own ten shares. Economically, they do own ten shares. But legally that is not how it works.

The rest of this article won’t make sense if the above didn’t make sense. Hopefully it does – if not, please drop us a line and we will try to make it as clear as we can.

Fractional shares

It’s useful to allow investors to buy fractions of shares. Some shares are expensive, and a small investor wouldn’t want to buy a whole one, particularly if they’re (sensibly) making small monthly additions to their portfolio. Fractional shares are also convenient for larger investors. If someone wants to invest £500 in AstraZeneca shares, then it’s a bit annoying to instead have to pay £440 for four shares. What they really want is to pay £500 for 4.545 shares, and get 5p change. In fact there’s a good argument that all retail share ownership should offer fractional holdings as the default.

These issues are magnified for some US shares. NVR, Inc. shares trade at over $6,000 – so it’s not just small investors who’d want to buy a fractional share.⁹The exemplar of this is Berkshire Hathaway, whose Class A shares currently trade at over $500,000 – but the company created a much smaller denomination Class B shares twenty years ago which now trade at around $350.

You’ve always been able to buy fractional units in a unit trust, but as a matter of company law, fractional shares don’t exist (at least in the UK and US).

Some providers have, nevertheless, found ways to offer fractional interests in shares to UK ISA investors. We will call the product “fractional shares” for clarity, although strictly there is no such thing.¹⁰There is no contradiction here; it’s common for beneficial ownership of an asset to be split between different parties when legal ownership cannot be split.

They do this in two ways.

• One approach is to simply agree in a contract with the investor that they’ll get exactly the same return as if they bought a fraction of a share. They don’t actually own any shares – they just have a contract with the provider – a kind of derivative. It’s clear a derivative can’t go in an ISA¹¹Because it isn’t legally “shares” even if it economically behaves like shares, and we don’t think anyone would disagree with that. Another important element: only sophisticated investors should be buying this product, and extensive disclosure would be required of the risks created by the product.¹²In particular, it may not exactly track the value of the share, and it may leave the investor exposed if the provider goes bust.
• They can simply use the normal ownership arrangement, tweak some of the mechanics slightly, and give the investor a fractional interest in shares. This is the kind of arrangement that the FT article was discussing.

The rest of this article will look at how the second solution works, and whether it can go into an ISA. We’ll ignore the “derivative” structure for the rest of this article.

Full disclosure: neither Dan Neidle nor the other contributors to this article own any fractional shares, or have any interest in or relationship with the affected providers.

How fractional shares work

Let’s take the AstraZeneca example above, and replace the ten shares in the example with a fractional 0.1 share.

When you buy the 0.1 shares, you pay £11 and receive an undivided beneficial interest of 0.0001% in each share in the omnibus account. Now, Hargreaves Lansdown didn’t just go out and buy 0.1 shares in the market, because that’s not possible. Instead, Hargreaves Lansdown “topped-up” the trade to the nearest whole trade,¹³Again, in the interests of simplicity, we’re ignoring the fact that brokers only trade their net position. The more accurate way to put this is “if the net position includes a fraction then Hargreaves Lansdown tops up/down the trade to the nearest whole number of shares”. and bought one share for £110 – 0.1 of that share is for you, and the other 0.9 is for Hargreaves Lansdown (so Hargreaves Lansdown own 0.0009% of the omnibus account).¹⁴Or perhaps they’ve already done this for another customer, in which case Hargreaves Lansdown are selling 0.1 of “their” share to you. And again there’s the complication that Hargreaves Lansdown only trade the market for their net position

You’re entitled to 0.0001% of the dividends – that’s easy.

Selling also hits the snag that Hargreaves Lansdown can’t actually sell fractional shares to the market,¹⁵Again, in the interests of simplicity, we’re ignoring the fact that brokers only trade their net position. The more accurate way to put this is “if the net position includes a fraction then Hargreaves Lansdown rounds up/down the trade to the nearest number of whole shares, and if there’s an excess then Hargreaves Lansdown holds the residual fraction of the excess share themselves”. so (broadly speaking) they’ll acquire your 0.0001% interest themselves, and pay you in cash for it (from their “float”).

Voting is also different. If you hold a 0.1 fractional share, want to vote against the directors’ remuneration report, and no other fractional shareholders do, then you’re out of luck. The Companies Act doesn’t permit Hargreaves Lansdown to vote on a fraction of a share. If in fact there are 100 people all owning 0.1 fractions, and half of them want to vote against the report then it’s easy: Hargreaves Lansdown votes that way on ten shares. But if there are 101 people, then Hargreaves Lansdown still votes that way on ten shares, so in a philosophical sense someone’s vote has been “lost” (but not an identifiable person).

Finally: transfers. You can transfer your account to another provider. Quite often there are systems/operational reasons why some of the securities can’t transfer. For example it may be a special unit that’s only offered to customers of the old provider, or it may be a security of a type that the new provider’s systems can’t handle (e.g. US$ denominated securities). In that case, the awkward securities are sold, and the new provider receives the cash, plus the nice straightforward securities. Fractional shares will always fall in the “awkward” bucket.

And some providers – but not all – let you transfer individual securities – either out of an ISA account to yourself, or to a third party (“in specie transfers“). You can’t do that with fractional shares.

What is HMRC’s position?

We understand that HMRC believes that fractional share ownership shouldn’t be permitted from a policy perspective. We would speculate this is influenced by a statement from ESMA earlier this year, which said most fractional share ownership is via derivatives – this is not accurate in relation to the UK market. The statement added that derivative fractional ownership is problematic from a regulatory perspective – that is a sensible conclusion. But then, significantly, it also said:

“It should be noted, however, that other structures of fractional shares [i.e. other than derivatives] also raise some investor protection concerns and that some of the clarifications given in this statement may also be relevant for such structures.”

Our regulatory contacts did not understand what the “concerns” referred to might be. It is possible that ESMA misunderstands how fractional share ownership works, or is thinking about a variety of fractional share ownership used in some jurisdictions/circumstances, but not relevant to the UK. But we would speculate that this has influenced HMRC’s approach.

Regardless, these policy rationales are not strictly relevant. The only real question is: what does the law say?

We believe the key legal questions are as follows:

1. Are fractional shares “shares”?

The ISA regulations only let you hold certain things in an stocks and shares ISA – “qualifying investments”, as defined in regulation 7:

HMRC take the view that a fractional interest is not a “share”. They told us:

“Our long-established and clear position is that ‘shares’, as referred to (for example) in Regulations 7(1) and 7(2)(a) of The Individual Savings Account Regulations 1998, refers only to whole shares and not part thereof. Fractional shares are not a whole share and therefore cannot be held in an ISA.”

In our view it is reasonably clear HMRC are wrong, for the simple reason that all shares held in an ISA are fractional interests.

In our original AstraZeneca example, the investor with “ten shares” actually holds 0.01% of 100,000 shares. In the fractional share example, the investor with “0.1 shares” actually holds 0.0001% of 100,000 shares. Both are fractional shares; there is no tax or legal distinction between the two.

Neither is a problem, because when we read the word “shares” in regulation 7, we should read it as “a beneficial interest in shares”. The ISA regulations are incorporated into income tax and capital gains tax legislation, and that’s how we apply income tax and capital gains tax.

Now you could say “but the difference is that it is actually possible to own ten shares; it isn’t possible to own 0.1 shares”. That is true, but we are unaware of any legislation or caselaw which makes that relevant to the legal test. If it was the case that fractional ownership of something changed the nature of that thing for income tax and capital gains tax purposes, then weird things would happen and you could play all kinds of fun games with the rules (yes you can’t own 0.1 of a share, but you also can’t own 0.1 of a building… but plenty of people do).

Another way to put that argument is to say that (in our example) Hargreaves Lansdown can’t actually buy or sell 0.1 of a share, so the investor doesn’t have an interest in it. That is simply wrong: they are buying and selling beneficial ownership of 0.1 of the share. They can’t buy or sell legal title to 0.1 of the share, but – again – that’s true for real estate and all kinds of other property, and it doesn’t mean you can’t hold a fraction of it.¹⁶The rule in Saunders v Vautier is not that any one beneficiary can call for the trust property; it’s that the beneficiaries together can call for the trust property.

So a fractional interest in a “share” is, in our view, a share – just as much as a conventional non-fractional shareholding. Indeed we understand that providers use the same legal documentation for fractional shares as for “normal” shares (with minor tweaks); the nature of the ownership is the same. ¹⁷A further point: if I was HMRC I’d be wary about putting any of the above arguments to a tribunal/court. If HMRC somehow won, and established the principle that you can transform an asset to another type of asset via nominee arrangements and fractional ownership, that would create considerable uncertainty and potentially enable new forms of avoidance.

A final point to note: we understand that the FCA accepts that fractional shares are fractional interests in shares, and considers them covered by CASS 6.

2. Do the transfer mechanics breach the ISA Regulations?

The ISA Regulations say providers must, at a client’s request, move their account to another provider. Regulation 4(6)(f) says that the provider’s T&Cs must secure:

Ideally all the shares in the account would move with it, and technically that means the shares have to be transferred from the old provider to the new. However any fraction can’t move; instead it will be sold, and the cash proceeds moved with the account to the new provider.

We understand HMRC have suggested this means Regulation 4 is failed.

We don’t agree. As we noted above, it’s fairly common right now with ISA transfers that “awkward” securities can’t be transferred, and have to be sold, with the cash proceeds moved with the account to the new provider.

It’s the same with fractional interests in shares.

Why is that okay under the Regulations? Probably because “all the rights and obligations of the parties” mean the basic terms of the account (and critically the aggregate value in cash/securities in the account). It doesn’t mean that every security in the account has to transfer; but if it did, many providers existing/non-fractional arrangements would be breaking the Regulations. Regulation 4(6)(f) shouldn’t be read too literally – from a literal legal point of view an account cannot be transferred, and will not be transferred… rather a new account will be created by the new provider with similar characteristics. Regulation 4(6)(f) necessarily operates in a pragmatic commercial world, not a literal one.

So we don’t think fractional ownership arrangements break the transfer requirement in the Regulations.

Nor do we think it’s relevant that customers can’t request in specie transfers of fractional shares. Plenty of providers don’t offer in specie transfers at all, and it’s not a requirement of the ISA Regulations that they do.

3. Do voting and meeting restrictions make a difference?

Now we come to HMRC’s best argument. Regulation 4(6)(d) says that the provider’s T&Cs must secure:

As we note above, the investor will sometimes not be able to vote, and (if their fraction is less than one) will never be able to attend a meeting. So is this a breach of the Regulations?

We think probably not. The provider just uses its standard terms, which includes the right to vote and attend meetings. That itself may be enough – Regulation 4(6)(d) doesn’t explode an ISA if voting can’t happen in a particular case; it merely says what the terms should contain.

Clearly the terms saying an investor can attend a meeting doesn’t mean the investor will always be able to attend a meeting. Why? Because UK company law doesn’t permit a vote to be cast on a fraction of a vote, or a fractional shareholder to attend meetings. But that is a “provision under an enactment”, and therefore there is probably no breach of regulation 4.

That is, however, not entirely clear, and this is why we say at the top of this article that HMRC are “probably” wrong.

Conclusion

We hope that, on a full consideration of the legal and tax analysis, they agree that the better view is that fractional shares are permitted by the existing ISA rules. We don’t see a public interest in HMRC pursuing a point that is (at best) marginal.

This article is our legal and tax analysis of the fractional share dispute, prepared to assist public debate. It is not legal advice and cannot be relied on by investors, providers, or any other party.

Thanks to A for his in-depth knowledge of omnibus account and custody/dealing mechanics, F and K for their ISA regulations expertise, T for regulatory insight, and the industry contacts who kindly provided us with the background to the dispute.

And, finally, thanks to Rafe Uddin and Claer Barrett for the story that piqued our interest in this.

Photo by Tech Daily on Unsplash.

• 1
  We are still considerably simplifying the underlying plumbing, but we believe the additional complexity doesn’t change the analysis. If you disagre, please write to us, or comment below.
• 2
  We’re using Hargreaves Lansdown as an example; they don’t actually offer fractional shares
• 3
  Simplification alert – it’s much more complicated than this. In particular, Hargreaves Lansdown will have numerous buy and sell trades on the same security, and only trades out its net position in the market (so you may actually be buying your shares from another Hargreaves Lansdown customer, albeit at the market price). For the purposes of this article “the market” will do.
• 4
  I am simplifying; the precise arrangements with CREST etc are more complicated than this.
• 5
  To be more pedantic: you don’t have legal ownership of any shares; Hargreaves Lansdown does. You have an undivided beneficial interest of 0.01% in their pool of 100,000 shares.
• 6
  Again, it’s more complicated than that, and HL are trading the net position, but we’ll ignore that to keep this article under 10,000 words
• 7
  Possibly there is an additional disadvantage that a pooled omnibus account is more susceptible to losses from fraud/error than if you had your own “segregated” account. However, it’s not clear if this is really the case in practice. A good test here is whether veteran regulatory and insolvency lawyers insist that their own investments are held in segregated accounts – in the authors’ experience they don’t.
• 8
  These days, that’s not quite right, as some providers have systems and arrangements that let ISA investors attend meetings, but the important point is that Hargreaves Lansdown has to facilitate this; otherwise AstraZeneca won’t treat you as a shareholder.
• 9
  The exemplar of this is Berkshire Hathaway, whose Class A shares currently trade at over $500,000 – but the company created a much smaller denomination Class B shares twenty years ago which now trade at around $350.
• 10
  There is no contradiction here; it’s common for beneficial ownership of an asset to be split between different parties when legal ownership cannot be split.
• 11
  Because it isn’t legally “shares” even if it economically behaves like shares
• 12
  In particular, it may not exactly track the value of the share, and it may leave the investor exposed if the provider goes bust
• 13
  Again, in the interests of simplicity, we’re ignoring the fact that brokers only trade their net position. The more accurate way to put this is “if the net position includes a fraction then Hargreaves Lansdown tops up/down the trade to the nearest whole number of shares”.
• 14
  Or perhaps they’ve already done this for another customer, in which case Hargreaves Lansdown are selling 0.1 of “their” share to you. And again there’s the complication that Hargreaves Lansdown only trade the market for their net position
• 15
  Again, in the interests of simplicity, we’re ignoring the fact that brokers only trade their net position. The more accurate way to put this is “if the net position includes a fraction then Hargreaves Lansdown rounds up/down the trade to the nearest number of whole shares, and if there’s an excess then Hargreaves Lansdown holds the residual fraction of the excess share themselves”.
• 16
  The rule in Saunders v Vautier is not that any one beneficiary can call for the trust property; it’s that the beneficiaries together can call for the trust property.
• 17
  A further point: if I was HMRC I’d be wary about putting any of the above arguments to a tribunal/court. If HMRC somehow won, and established the principle that you can transform an asset to another type of asset via nominee arrangements and fractional ownership, that would create considerable uncertainty and potentially enable new forms of avoidance.