Company Purchase Of Own Shares: Problem Areas

A company purchase of own shares (PoS) enables a shareholder to realise their investment in the company, financed in effect out of the company’s own profits. However, the process is not without difficulty. 

 

Companies Act 2006, s 690 allows a limited company to purchase its own shares, subject to any restriction in the company’s articles (this therefore needs to be checked). The company must normally have sufficient distributable reserves of profits for this purpose, although s 709 allows a private company to purchase or redeem shares out of capital.

 

However, s 691 requires that the shares must be fully paid, and must be paid for on purchase, that is to say on completion of the buyback contract. This is a somewhat controversial topic. A popular company law guide states that payment may be made in cash or in specie, citing the case BDG Roof-Bond Ltd v Douglas [2000] 1 BCLC 401, where Park J had stated that the word ‘payment’ in s 691 was not limited to payment in money, but also included payment by a transfer of assets, being akin to a dividend in specie. However, those remarks were ‘obiter’ and are contradicted by the House of Lords decision in IRC v Littlewoods Mail Order Stores [1965] AC 135, which held that the words ‘sale’ and ‘purchase’ in ordinary legislative usage require an exchange of property for cash and not for any other form of property.

 

HMRC’s view is given in its Company Taxation manual at CTM17505: ‘To effect a valid purchase, the company must make full cash payment on purchase. The transfer of any other asset or the creation of a loan account because, say, the company does not have sufficient cash available does not represent payment.’

 

A payment under a PoS is a distribution out of the assets of a company within CTA 2010, s 1000(1)(B), except so much of it as represents a return of capital. As such, it is liable to income tax unless the provisions of s 1033 onwards apply, in which case it may be treated as a capital distribution. In theory, capital treatment is mandatory if the requirements of ss 1034-1042 are met, but it will usually, although not always, be desirable anyway, especially where the conditions for capital gains tax entrepreneurs’ relief are met.

 

The fundamental tests in s 1033 are that the company is an unquoted trading company (or holding company of a trading group) and the PoS is for the purpose of benefiting the trade of the company or group. 

 

It is not intended to consider the requirements of ss 1034-1042 in detail here, but to flag-up some potential problems.

 

The first is the requirement as to the period of ownership (s 1034). The shares must be owned for five years ending with the date of purchase. The exception is where the shares were transferred from a spouse or civil partner, and provided the spouse was living with the seller when the shares were transferred and at the date of the PoS. In that case, the spouse’s/partner’s period of ownership may be added to the seller’s.

 

The seller’s interest must be substantially reduced after the PoS to not more than 75% of their prior interest (s 1037). 

 

For example, suppose that a director owns 600 ordinary shares in a private company out of 1,000 issued share capital. At first sight, it might seem that if the company buys back 150 of those shares, he can hold on to 450. Not so, because the test must be applied both before and after the PoS. To calculate the number of shares which need to be sold the following formula may be used:

 

S x C 

4C – 3S

 

Where:

S = the shareholding of the vendor before the repurchase; and

C = the issued share capital before the repurchase.

The minimum number of shares which must be sold is therefore:

600 x 1,000 = 273 (fractions are rounded up).

4,000 – 1,800

 

However, while a sale of 273 shares might satisfy the requirements of s 1037, this would still not meet other requirements of the legislation and HMRC practice.

 

The connection test means that the seller cannot remain connected with the company after the PoS (s 1042). A person is ‘connected’ with a company if they own or are entitled to over 30% of the company’s share/loan capital and voting power (s 1063). 

 

So, while in the above example the reduction test may be met by a sale of 273 shares, leaving a holding of 327 shares out of a reduced capital of 727, this is well over 30% of 727 (727 x 30% = 219). The seller therefore remains connected with the company. For the purposes of the connection test the rights of associates are taken into account. Spouses and civil partners are ‘associates’ for this purpose, but no other relatives (except for children under 18). 

 

Any credit balances on directors’ loan account may need to be repaid before the PoS, because this counts as loan capital, and since the issued share capital of most private companies is nominal, even a small credit balance may mean that the seller remains connected with the company (and similarly if their spouse or civil partner is a loan creditor).

 

HMRC practice regarding a PoS was set out long ago in Statement of Practice SP2/82. This focusses mainly on the ‘trade benefit test’ and the form of clearance applications. HMRC regard the trade benefit test as having been met in a number of familiar situations, such as a shareholder wishing to retire and make way for new management, or where there is a disagreement between the shareholders over the management of the company. Other examples of unwilling shareholders are also given. 

 

However, HMRC would not normally regard the test as being met unless the seller completely severs their connection with the company, so even if the seller in the above example had sold (say) 400 of their shares and therefore met both the substantial reduction and connection tests, HMRC are unlikely to accept that the trade benefit test is met if the seller retains in excess of a token holding of no more than 5% of the issued capital (for sentimental reasons). HMRC are also unlikely to accept that the trade benefit test is met where the seller retains a directorship or consultancy. 

 

The one circumstance where it might be accepted that the test is met is where the company does not have sufficient resources to completely buy out the shareholder at one go and buys as many shares as it can afford, with the intention of buying the remainder as soon as possible (although the particular requirements of the legislation would need to be met in respect of each buy-back). 

 

In these circumstances, though, it may be possible to use a ‘multiple completion’ route, whereby the seller enters into an unconditional contract to sell their entire holding for completion in stages as the company’s reserves permit (although they would need to waive dividend and voting rights in the interim). Professional advice is highly recommended in these circumstances, since the multiple completion route is not without difficulty, and HMRC may be expected to take a sceptical approach to the arrangement. 

 

A clearance procedure is provided (by s 1044), and it would be ill-advised to proceed with a PoS without HMRC clearance. HMRC also give some helpful notes (link here), which contain some helpful guidance and checklists concerning clearance applications.

 

Shares held by directors or employees are almost always ‘employment related securities’ by definition (see ITEPA 2003, s 421B). Various consequences potentially flow from this on a PoS. Again, professional advice may be required (e.g. where Ch 2 (restricted securities) or Ch 3D (sale of securities for more than market value), ITEPA 2003, Pt 7 may apply). 

 

The company law requirements for a PoS must be met to the letter, or the buyback may be legally void, with the result that the seller may claim to be still entitled to the shares.

 

A return must be made of the payment within 60 days of the buyback (s 1046). The clearance itself is not sufficient.