Buyback bliss: realising share value tax efficiently

A company purchase of its shares or 'share buyback' provides a tax-efficient mechanism for shareholders to realise capital value, for example where a shareholding employee ceases to be employed, without the need for a third party to acquire the shares and possibly disturb the equilibrium of the remaining shareholders. The continuing disparity between the tax rates applicable to income and gains for individuals makes the availability of capital treatment on such a transaction a valuable tool in tax planning.

Allowable under the Companies Acts, company articles are no longer required to specifically permit a buyback but a check should be made in case of any restrictions. For tax purposes the default position where a company purchases its own shares is to treat the payment as a distribution in the hands of an individual, subjecting the receipt to dividend rates of income tax of up to 38.1%. This compares very unfavourably with capital gains tax where, if Entrepreneurs Relief is available, the rate applicable is currently just 10%.

For the capital treatment to operate, both quantitative and qualitative conditions must apply. The quantitative conditions are as follows:

  • The vendor must be UK resident;
  • The shares must have been owned by the vendor throughout the period of five years ending with the date of purchase;
  • There must be a 'substantial reduction' in the shareholder's interest meaning that the vendor's proportional interest in the company after the buyback must be 75% or less of that prior to the transaction
  • The vendor must not immediately after the purchase be 'connected' with the company. There is normally considered to be no connection if after the transaction the vendor has less than a 30% interest in the company. Interest is measured in a number of ways including votes, share and loan capital so care must be taken.

The qualitative conditions state that he purchase must be made wholly or mainly for the purpose of benefiting a trade carried on by the company. In addition the purchase must not form part of a scheme or arrangement the main purpose or one of the main purposes of which is:

  • To enable the owner of the shares to participate in the profits of the company without receiving a dividend, or;
  • The avoidance of tax.

Of all the conditions, the 'trade benefit' test above can be the most difficult to satisfy. HMRC have provided examples of a purchase of own shares by a company in circumstances likely to be regarded as for the benefit of the company's trade, including:

  • Removal of a dissenting shareholder where there is disagreement between shareholders over the management of the company;
  • A controlling shareholder who is retiring as shareholder and wishes to make way for new management;
  • An outside shareholder who has provided equity finance and now wishes to withdraw that finance.

There is further commentary to be found interpreting the above which indicates that where there is a shareholder who simply wishes to exit the company, then the sale of his entire holding will normally be sufficient for the trade benefit test to be satisfied.

It is important to remember the Companies Act requirements that there should be sufficient distributable reserves out of which the payment is to be made and that the payment is made wholly in cash at the time of the buyback, i.e. no amounts maybe deferred or paid by instalment.

Comfort on the gains qualification can be obtained by entering into a clearance procedure with BAI branch of HMRC. Guidance on the content and form of the clearance can be found in HMRC Statement of Practice SP2/82.

For further advice on share buybacks or any other aspect of corporate reorganisation, please contact Mike on 01273 480480.

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