By Mike Chapman, Tax Partner
Share buy-backs in tax planning
A company purchase of its shares or 'share buy-back' 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.
Share buy-backs are allowable under the Companies Acts, and company articles are no longer required to specifically permit a buy-back 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%, rising to 39.35% from 2022/23. This compares very unfavourably with capital gains tax where, if Business Asset Disposal Relief is available, the rate applicable to the first £1m of lifetime gains is currently just 10%.
Buy-back conditions
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 buy-back 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 possesses 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 the purchase must be made wholly or mainly for the purpose of benefiting a trade carried on by the company. In addition the purchase must
- To enable the owner of the shares to participate in the profits of the company without receiving a dividend, or;
- The avoidance of tax.
Out 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 buy-back, i.e. no amounts maybe deferred or paid by instalment. There exists other Companies Act obligations so it is always sensible that there be a legal review of the proposals.
Recent Developments
One method traditionally used by practitioners to overcome the Companies Act requirement, that there should be no consideration payable by instalment or deferment (normally where there are insufficient cash reserves within the company) is to effect the sale via a 'multiple completion contract'. In short, this process involves the shareholder entering into an unconditional contract for the disposal of the beneficial ownership of the shares at the contract date while retaining legal ownership which in turn passes on a succession of completion dates.
HMRC had confirmed (via ICAEW Technical Release 745) that a multiple completion approach is possible, provided the beneficial ownership passed at the contract date.
However, in a note received from HMRC and shared by the Chartered Institute of Taxation (CIoT) on 21 February 2022, HMRC appear to have backtracked on their absolute acceptance of multiple completion contracts. HMRC now take the view that in determining whether a shareholder remains 'connected' with a company (the 30% test outlined above), 'possession' relates to legal as opposed to beneficial ownership. HMRC state that this is the case even if the shares retained have been converted to 'deferred shares' status, without voting or dividend rights.
The net result therefore is that as long as the seller remains the legal owner of sufficient 'non-completed' shares that breaks the 30% limit HMRC believe they will remain connected with the company and will not qualify for capital treatment on the buy-back.
Clearance procedure
HMRC's view is of course an interpretation of the law, which will be included within the HMRC manuals, and has happened too recently to yet be challenged in law.
Tax practitioners normally advise that comfort on the gains qualification of a buy-back can be obtained by entering into a clearance procedure with the BAI branch of HMRC. HMRC were never entirely comfortable with multiple completion transactions and given the recent publication we would expect that any clearance applications describing multiple completion arrangements, where the new interpretation of connection may be breached, are likely to be rejected.
This doesn't mean that the taxpayer can't claim the relief via the tax return but it does mean that the return is more like to be the subject of enquiry.