Jennifer Adams considers the main reasons why some shareholders of a family-owned company may consider a purchase of its shares and the tax implications of doing so.
Retirement for a family company member can be an emotive event. Someone who has spent much of their working life building up that business now has to hand over the reins to another.
Exit routes
A more practical problem is finding a tax-efficient method of extracting monies. The realistic option is via the capital route, as any capital gains tax (CGT) charged will be less than taking a salary, bonus or dividend. Withdrawals as capital can be effective either as a capital distribution on winding up (difficult and impractical if the company is continuing to trade) or by the sale of shares - either to an individual (external or not) or by a company share buy-back.
The sale of shares to an individual may not be easy to arrange; other shareholders may not be happy about shares going out of the family, or no-one may be interested in buying. If there is interest, the purchaser is more likely to be linked to the company in some way, such as a family member or a management team; this produces another problem if the prospective purchaser is unable to finance the purchase. Borrowing funds may not be an option, and in any event cash borrowings will have to be repaid out of additional taxed income derived from the company, making the whole event an expensive exercise.
A better solution may be for the company to buy back the retiring shareholder’s shares.
Income or capital?
The consideration on a company purchase of own shares will be satisfied by the company, any additional borrowing being within the company, repaid out of trading cashflows. CGT treatment is automatic if the share buy-back conditions are satisfied and this may be a tax-efficient departure, especially if business asset disposal relief (formerly entrepreneurs’ relief) is available, reducing the tax rate from 28% to 10% (for 2021/22) on gains of up to £1 million. The conditions for CGT treatment include that the purchase must be for the benefit of the company’s trade, and the seller must have owned the shares for at least five years, being resident and ordinarily resident in the UK. In addition, after the purchase by the company, the vendor (and any associates) must have reduced their interest to 75% or less of their share before the sale. Afterwards, the vendor must retain less than a 30% share in the company (or any other company in the same 51% group).
If income treatment is advantageous, the shareholder must break at least one of the above conditions to apply. For example, the company could buy the shares in stages so that initially, the ‘substantial reduction’ and the ‘connection’ tests are not met, or the proceeds could be left outstanding as a loan to the company. It may be possible to argue that the purchase was not made wholly or mainly for the benefit of the company’s trade (e.g. if the reason for the buy-back was the shareholder’s urgent need of funds for a divorce settlement) or that the avoidance of tax was one of the primary purposes for the buy-back. The payment of an ex-gratia lump sum to the vendor in consideration of his leaving the company could also break the conditions.
For the company, stamp duty is payable should total consideration exceeds £1,000.
On buy-back, the shares are cancelled, thereby increasing the relative percentage ownership for the remaining shareholders and their percentage claim on distributable profits.
Practical tip
Care should be taken to ensure that the vendor receives consideration approximate to the market value; otherwise, HMRC may say that part of the monies received include an element of gift and that in itself could produce CGT and inheritance tax (IHT) problems. The share buy-back rules are complex and are not always successful unless planned in detail.
