Mark McLaughlin highlights some practical issues and potential pitfalls on a company purchase of an individual’s shares in an owner-managed trading company.
For some shareholders of small, owner-managed companies in particular, a company purchase of own shares can be a useful ‘exit’ strategy in the right circumstances. For example, one of the company owners may be about to retire; or there may be a falling out between shareholders over how the business is run, resulting in one of the shareholders deciding to wash his hands of the company.
This article looks at the purchase by an unquoted trading company of its own shares from an individual shareholder of a family or owner-managed company. As a general rule, when a company buys back its own shares from such a shareholder, any ‘premium’ (i.e. payment in excess of the capital originally subscribed for the shares) constitutes a distribution of income, similar to the dividend.
However, there is an exception in the case of unquoted trading companies (CTA 2010, s 1033). If certain conditions are satisfied, the vendor is normally treated as receiving a capital payment instead. This can provide shareholders with a tax-efficient exit route from the company, particularly if the capital gains tax (CGT) entrepreneurs’ relief conditions are satisfied, resulting in a CGT rate of 10% (on gains of up to £10 million).
A number of conditions must generally be satisfied in order to qualify for capital gains treatment on a company purchase of own shares (in CTA 2010, Pt 23, Ch 3). These include a ‘trade benefit’ test and various requirements as to the vendor shareholder’s residence, length of ownership of the shares and the extent (if any) to which he or she remains connected with the company. This article does not cover these conditions (nb I have written a chapter on company purchases of own shares in ‘Tax Planning’ published by Bloomsbury Professional, which discusses them), but instead highlights some potential pitfalls and planning points if a company purchase of own shares is being considered.
1. Don’t forget company law!
There is much more to a company purchase of own shares than tax rules. Company law requirements (in Companies Act 2006) must also be satisfied. These requirements are beyond the scope of this article. Company owners and professional advisers who are unfamiliar with company law should obtain the necessary legal advice.
Compliance with company law is essential. Failure to comply with the legal requirements could result in the transaction void and legally unenforceable, and render the company and its advisers liable to sanctions (CA 2006, s 658(2), (3)).
For tax purposes, a void company purchase of own shares under company law will have its own implications, depending on whether or not the shareholder is required to repay the proceeds to the company (e.g. see Baker v Revenue & Customs [2013] UKFTT 394 (TC)). HM Revenue & Customs (HMRC) may seek to treat any funds retained by the shareholder as liable to income tax as a distribution.
2. Where’s the benefit?
One of the conditions for a company purchase of its own shares to be treated as resulting in a capital receipt rather than income is that the transaction must be wholly or mainly for the purpose of benefitting a trade carried on by the company (or a 75% subsidiary) (CTA 2010, s 1033(2)(a)).
This ‘trade benefit’ test is sometimes overlooked by the parties to the transaction. A purchase of own shares may provide a convenient exit route for the vendor shareholder, but it may not necessarily be helpful to the company’s trade.
HMRC has published some useful guidance on the trade benefit test (Statement of Practice 2/82). Examples given by HMRC of situations in which the trade benefit test would normally be regarded as satisfied include disagreements between the shareholders over the company’s management, which has (or could) have an adverse effect on the company’s trade, and an ‘unwilling shareholder’ who wants to end their association with the company (e.g. a retiring controlling director shareholder).
3. The ‘right’ company
The purchasing company must be an unquoted trading company, or the holding company of a trading group (CTA 2010, s 1033(1)(a)). The terms ‘unquoted company’, ‘trading company’ and ‘trading group’ (among others) are specifically defined for the purposes of the purchase of own shares rules (CTA 2010, s 1048).
It is important to note that the definition of ‘trading company’ under the company purchase of own shares rules differs from the meaning for entrepreneurs’ relief purposes. A trading company under the purchase of own shares rules is a company whose business consists ‘wholly or mainly’ (i.e. more than 50%) of carrying on one or more trades (CTA 2010, s 1048(1)). By contrast, a trading company for entrepreneurs’ relief purposes requires that the company’s activities do not include to a substantial extent activities other than trading activities (TCGA 1992, s 165A(3)). HMRC treats ‘substantial’ in this context as being more than 20% of certain measures, such as non-trading income.
It is therefore possible that a company may satisfy the ‘wholly or mainly’ test of trading status on a purchase of own shares, but that a gain on disposal of those shares is ineligible for entrepreneurs’ relief in the hands of the individual shareholder because the company’s non-trading activities are substantial. This is obviously a point to watch out for if the vendor shareholder is relying on making a claim for entrepreneurs’ relief.
4. A bit at a time?
For a purchase of own shares to be valid under company law, the company must normally make full payment on purchase (CA 2006, s 691) (nb there is a limited relaxation to this rule for private company share purchases in relation to employee share schemes). This requirement is often problematic, particularly if the company is suffering cash flow difficulties.
However, it may be possible (but see below) for a company to enter into a single, unconditional share sale contract with the vendor, with completion taking place on different dates in respect of separate tranches of shares within the agreement. The purchase of own shares conditions must continue to be satisfied, including a ‘no continuing connection’ test between the vendor shareholder and the company. ‘Connection’ is broadly defined in terms of ownership and entitlement to acquire more than 30% of the company’s issued ordinary share capital, loan capital (except in certain limited circumstances involving money lending companies), voting power or the entitlement of equity holders to assets available for distribution on a winding up of the company (CTA 2010, s 1062(2)).
HMRC may be prepared to accept that the multiple completion contract is possible, provided that beneficial ownership of the shares passes at the contract date (ICAEW Technical Release 745). There is an advance clearance procedure on a company purchase of own shares (CTA 2010, s 1044), to seek HMRC’s confirmation that the conditions for capital treatment are (or are not) satisfied.
Multiple completion contracts are a difficult area. For example, HMRC may argue that until the purchase price is paid for the shares, the company law position is that the seller remains on the register and is entitled to vote in respect of the shares. HMRC may also argue that the seller cannot lawfully give up his voting rights under a multiple completion contract. Specialist professional advice should therefore be obtained if necessary.
Practical Tips:
There are two concluding points. First, take great care when dealing with the purchase of own shares rules, for both tax and company law purposes.
Secondly, consider whether capital gains treatment is really going to be more beneficial than if the disposal proceeds were subject to income tax. For example, if a shareholder (who is a 40% taxpayer for income tax purposes) is ineligible to claim entrepreneurs’ relief on the share disposal, an income distribution may be better. The effective income tax rate on distributions received by 40% taxpayers is 25%. This is clearly more attractive than the higher CGT rate of 28% (although the CGT annual exemption should also be taken into account, if available).
In other words, so the sums – circumstances (and tax rates) vary from case to case. If income tax treatment is better, it may be possible to breach the purchase of own shares conditions for capital gains treatment, depending on the circumstances.
