Share buy-backs are a useful and potentially tax efficient method to restructure the shareholdings of a private company. However, it is all too easy to get the procedure wrong meaning the transaction could be void or adverse tax consequences arise.
The two most common situations we encounter where a share buy-back is used are the retirement of a director and the removal of a dissident shareholder. The other shareholders may not be able to afford to acquire the leaving member’s shares, and so the only practical alternative is for the company to undertake a share buy-back.
Companies Act 2006
Under the Companies Act 2006 (“CA 2006”) there are three routes for a company purchase of own shares:
- Out of capital in accordance with Part 18, Chapter 5, CA 2006.
- Out of distributable profits (or the proceeds of a fresh issue of shares) under Part 18, Chapter 4, CA 2006.
- Small purchases of shares from capital (up to £15,000 or no more than 5% of the nominal value of the share capital) under s.692 (1ZA), Part 18, Chapter 4, CA 2006.
- Purchases out of capital under Chapter 5 are complex, requiring a special resolution, a directors’ statement of solvency, auditor’s report, and a public notice. Owing to this complexity and the availability of other simpler options, such as performing a capital reduction, this procedure is not often used.
Purchase of own shares out of distributable profits
A purchase of own shares out of distributable profits is the most commonly used method and the procedure is as follows:
- The company’s Articles of Association must not prohibit the purchase of own shares.
- The terms of the purchase contract must be authorised by members by ordinary resolution; members holding shares to be repurchased are not entitled to vote.
- Either the purchase contract, or a memorandum of its terms, must be available for 15 days prior to the ordinary resolution being passed at a meeting, or sent to members in the case of a written resolution.
- Where there is more than one class of shares, class consent may be required from shareholders that have priority rights.
- The shares to be repurchased must be fully paid up.
- The consideration for the purchase must be paid in full on purchase – deferred payments are not permitted.
- The repurchased shares must be cancelled on acquisition or held in Treasury.
- Stamp Duty is payable on the share repurchase.
- Within 28 days of the share buy-back, a stamped return (Form SH03) must be sent to the Registrar of Companies.
- The company must keep the purchase contract for 10 years.
- If the correct procedure is not followed the share repurchase is void and an offence is committed by the company and every officer in default, with a potential penalty of up to two years in prison or an unlimited fine.
Where the share buy-back is for the purpose of an employee share scheme there are some minor differences to the procedure outlined above, notably that deferred payments are allowed.
One of the most common issues we encounter with share buy-backs is the payment of the consideration. Often the company may not have sufficient funds to pay in full for the shares of the exiting shareholder. As noted above, deferred payments are generally not permitted and so there are two other options that can be considered:
- the selling shareholder loans back funds to the company after the share repurchase; or
- the company acquires the shares in a series of instalments.
The potential problem with both options is that they may mean the share repurchase fails to qualify for capital gains tax treatment because the seller either remains connected with the company or has not achieved a sufficient reduction in their interest in the company.
Tax treatment
There is an assumption that a company purchase of own shares automatically entitles the selling shareholder to benefit from capital treatment, which means any gain could be taxed at just 10% if the individual is entitled to Entrepreneur’s Relief. However, the default position is that amounts received by sellers will be taxed like a dividend unless specific conditions are met.
In most circumstances, in order to secure capital treatment for the share repurchase the following conditions apply:
- The company must be an unquoted trading company, or holding company of a trading group.
- The shareholder must have held the shares for at least five years (or three years if the shares were acquired under the will of a former shareholder).
- The share repurchase is wholly or mainly for the benefit of the trade of the company.
- The interest of the seller and their associates in the company must be substantially reduced.
- The seller and their associates must not be connected with the company after the share repurchase.
Alternatively, where the proceeds from the share repurchase are used by the seller to discharge an Inheritance Tax liability capital treatment may apply subject to compliance with a separate, more limited set of conditions.
Substantial reduction test
For the purpose of the tax assessment, the “substantial reduction” condition is met if the seller’s interest in the company after the share buy-back is less than 75% of the seller’s interest before the repurchase. Interest is defined by reference to ownership of the issued share capital and entitlement to profits. The shareholdings of associates needs to be included in this test, who include spouses, civil partners, children under 18, connected companies, and persons who act under the directions of the seller.
Connection test
The seller will be treated as still connected with the company after the share repurchase if they:
- own more than 30% of the issued share capital, loan capital, or voting power; or
- are entitled to more than 30% of the assets on a winding up of the company.
In addition, a former shareholder will usually be treated as still being connected with the company if they remain as a director, employee, or consultant to the company.
Trade benefit test
Demonstrating that the share repurchase is for the benefit of the trade (rather than the benefit of the exiting shareholder) can be tricky. The main commercial reasons that HM Revenue & Customs (“HMRC”) usually accept are:
- Disagreement between shareholders over the management of the company which is expected to have an adverse effect on the trade.
- Acquiring shares that a member might otherwise sell to a party that would be unacceptable to the other shareholders
- An external shareholder who provided equity finance that now wishes to withdraw that finance.
- A controlling shareholder who is retiring as director and wishes to make way for new management.
- Personal representative of a deceased shareholder where they wish to realise the value of the shares.
A company can make a clearance application to HMRC in advance of the share buy-back to confirm that capital treatment would apply.
Market value
It is important that the price paid for the shares represents market value. If the consideration paid exceeds market value HMRC may treat any excess either as a distribution or employment income, which will be taxed accordingly. If the consideration is less than market value, HMRC may substitute market value resulting in a higher taxable gain than might have been expected. In the event of any uncertainty as to the shave valuation an expert opinion should be obtained.
For further information about share buy-backs and valuations please contact:
Simon Chapman E: simon.chapman@burgisbullock.com
T: 07831 255302