Catch 22: Company purchase of own shares – Multiple buy-backs and Entrepreneurs’ Relief
Company purchase of own shares – introduction
In this article we look at a potential issue – the availability of entrepreneurs’ relief (ER) where there is a multiple completion company purchase (buy back) of own shares. Before exploring the specific issue in detail, we look at the general rules relating to a company purchase of own shares.
There are a number of reasons why a company may wish to buy shares from a shareholder and a shareholder may wish to sell to the company. In the typical SME environment, the company may give a market place for the shares where non would otherwise exist, the remaining shareholders may not want the shares to go to a third party or it is more tax efficient for the company to buy the shares and cancel them than it is for the existing shareholders to buy the shares out of personal post taxed income. A further often important consequence is that as the purchased shares are cancelled (other than where they are taken into treasury) the shareholding ratio between the remaining shareholders does not change although their percentage shareholding does.
From a tax perspective the default position for a company purchase of own shares is that the excess of the capital element (generally the nominal value plus any premium) is treated in the hands of the shareholder as an income distribution, broadly treated as a dividend. Provided, however, that the relevant provisions are complied with the purchase in totality can be treated as giving rise to a capital gain.
Obtaining Capital Treatment
Although the focus of this article is upon multiple buy backs and the availability of ER, to set the scene it might be worthwhile briefly looking at the relevant conditions for capital treatment. The legislation is found in ss1033 -1048 Corporation Tax Act 2010 and covers a purchase in two circumstances;
- To discharge an IHT liability, this is seldom seen in practice and is not considered further.
- The redemption, repayment or purchase is made wholly or mainly for the purposes of benefiting a trade carried on by the company and is broadly not motivated by tax avoidance.
A distinction has to be made between benefitting the company’s trade and for the benefit of the shareholder. In many cases obtaining capital treatment will benefit the shareholder. HMRC acknowledge this and do not normally take the point if it can be clearly established that the buyback is mainly for the benefit of the company’s trade and the benefit to the shareholder is as a consequence of the benefit to the company and not the key motivation. HMRC have given guidance as to circumstances where they will accept a trade benefit, these include;
- A disagreement between the shareholders over the management of the company which is having an adverse effect on the company’s trade.
- A controlling shareholder who is retiring as a director wishes to make way for new management.
The other key requirements of the legislation are;
- The sellers interest (taking into account the interests of associates) must be substantially reduced. The test will be satisfied if his interest is not more than 75% of his pre-sale interest. The calculation calls for the reduction of the issued share capital, as a result of the buy back, to be taken into account in the pre and post-sale position.
- There is a second leg to this test which relates to profits. And assuming that the company distributes all of its profits available for distribution the sellers interest in those profits post disposal must be less than 75% of the pre-sale fraction.
- Immediately after the sale the seller must not be connected with the company. A person is connected with a company if directly or indirectly he possesses or is entitled to acquire more than 30% of the issued ordinary share capital and share capital and loan stock combined, voting power or assets available for distribution on winding up.
- The company must be an unquoted trading company.
- The shareholder must be resident in the year of sale and have owned the shares for at least five years.
Company Law Requirements
It is beyond the scope of this article to consider the Company Law requirements in detail, however, it is necessary to consider those which impact directly on the tax treatment or HMRC’s approach to this matter;
- The shares must be fully paid up
- Are paid for on purchase, this means that a company cannot stagger payment for the shares. A possible work round would be for the company to buy back the shares over a period of time, however, this is often impractical and typically causes tax issues. Providing the purchase is for cash the former shareholder can lend a proportion of the funds back to the company but again this is not always practical.
- The payment must be in cash
- The buy back must be out of distributable profits, the calculation is similar to that applying to interim dividends and the company’s in year trading performance can be considered.
- The company’s articles must allow for the purchase and any pre- emption rights must be disapplied; any issues here can usually be dealt with by a special resolution as an initial step.
As a company cannot defer the consideration for the share purchase and where cash is restricted a commonly used approach is a multiple completion contract.
In essence the shareholder enters into a single, unconditional and binding contract to sell his shares with completion taking place in tranches. In other words the company is able to finance the purchase over a number of years out of its surplus trading cash flows.
To obtain HMRC clearance for the transaction it is normally necessary for the departing shareholder to;
- Acknowledge that he has no beneficial interest in the shares and holds the uncancelled shares as nominee on bare trust for the company
- Confirm that he will transfer the shares as directed by the company on payment of the relevant tranches of the sale price
- Acknowledge that he is not entitled to any rights attaching to the uncancelled shares (dividend waivers)
- To avoid potential issues with the connection test it may be felt appropriate to change the uncancelled shares into a new class of non-voting ordinary shares.
As already noted HMRC have a clearance procedure and providing that the relevant facts and considerations for adopting a multiple completion contract are explained HMRC are normally willing to give clearance (subject to the normal criteria being met).
The basic requirements for ER is that the disposing shareholder held 5% of the share and voting power for at least 12 months and is a director or employee at the point of sale.
Until relatively recently the received wisdom is that the date of disposal is the entering into of the multiple completion contract. The contract is at that time unconditional and the seller disposes of his beneficial interest in the shares. HMRC confirmed to the ICAEW that this was their position in 1989 (ICAEW technical release 745).
There is now some suggestion that HMRC are taking a very literal reading of the relevant legislation (s28 TCGA) which fixes the CGT disposal date. In summary HMRC’s argument appears to be that in a multiple completion there is strictly no acquisition by the company.
If there is no disposal and acquisition for the purposes of s28 then it is necessary to look at s22 – capital sums derived from an asset. Both provisions give the date of disposal, however, under s22 this will be when each tranche of shares are purchased. At which time it is unlikely that the departing shareholder will be a director and hence the basic requirements for ER will not apply.
HMRC will give clearance under s1044 CTA and will confirm that capital treatment will apply to the buy back and interestingly even if asked will not express an opinion on the availability of ER. It is only when the return is submitted and after the closure period that there can be any certainty as to the availability of ER and of course the clearance application has told HMRC everything they need to know to challenge the availability of ER.
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This article was in published in our May 2018 enewsletter. To be added to our mailing list, click here and submit your contact details on our sign up form.