There are several reasons why a shareholder may want to exit a business, including retirement, dispute, or a requirement to settle an inheritance tax (IHT) bill. When this is done via the share buyback method (also known as the company purchase of own shares route), there are points which need to be considered, and tax rules to meet.
What is share buyback?
A share buyback is where a limited company repurchases some of its issued share capital from one of its shareholders. It takes advantage of rules within the Companies Act 2006 and special provisions within the tax legislation (Corporation Tax Act 2010 [CTA10] to be specific).
The transaction is such that a distribution is made by the limited company, in return for the shareholder transferring shares to the company. After the transaction has been completed, the shareholder will have a reduced number of shares (usually none) and instead have cash in their hands.
Distributions to shareholders and the tax treatment
You may be asking: “If a distribution is being paid, why not declare a dividend and let the shareholder retain their shares?”. This is a valid question as the default tax position for distributions made to shareholders by a company is that the distribution will be a dividend and therefore subject to income tax at dividend rates.
There are, however, provisions in CTA10 s1033 onwards which enable the distribution to be treated as a capital receipt in the hands of the shareholder. This means that the shareholder, if the relevant conditions are met, could be taxed at 20% in a worst case scenario or taxed at 10% on the first £1m of gain in a best case scenario where the Business Asset Disposal Relief (BADR) rules are met. Compared to the income tax rates on dividends, there could be some significant tax savings!
Purchase of own shares – capital treatment of distribution
The initial condition for the distribution to be capital in nature is that the company or group making the buyback is unquoted and that its activities are wholly or mainly (i.e. as to more than 50%) trading. Unlike BADR, ‘substantial’ non-trading activity is permitted, provided it accounts for less than 50% of the activities.
There are then two routes through which the distribution will qualify:
Condition A: trade benefit
The first hurdle in Condition A is ensuring that the buyback is for the benefit of the trade carried on by the company (or group).
A trading company means a company whose business consists wholly or mainly of carrying on a trade. However, for these purposes, a trade does not include dealing in shares, securities, land or futures.
Reasons which may constitute the buyback being for the benefit of the trade are outlined in Statement of Practice 2 (1982). They include a retiring director-shareholder, withdrawal of financing and shareholder disagreements over company management.
If this ‘benefit of the trade’ condition is met, there are then four further conditions which must all be met.
- Residency – the seller must be UK tax resident in the year of the buyback.
- Period of ownership – the shares must have been held by the seller for a period of five years before the sale (this is reduced to three years if they were acquired through a will).
- Substantial reduction in interest – there must be at least a 75% reduction in the sellers’ interest in the nominal value of the shares and the entitlement to profits. We recommend that before and after calculations are performed to ensure this condition is met.
- No connection – immediately after the repurchase, the seller must not be connected with the company or group. They or their associates cannot hold more than 30% of: the issued share capital (by nominal value), the loan capital or voting power.
Condition B: IHT bill payment
This is met where the whole or substantially the whole of the payment (apart from any sum applied in paying capital gains tax on the redemption, repayment or purchase) is used to pay an IHT bill. Secondary conditions include:
- The payment is made to a person who needs to discharge an IHT liability on a death.
- The payment is applied for within two years of the death.
- The liability could not have been discharged other than through the redemption (etc) of shares in the company or in another unquoted trading company (or holding company of a trading group).
HMRC clearance
It is possible to apply to HMRC for clearance (under CTA10 s1044). Where we have clients using this route with the aim of the distribution being capital in nature for the shareholder, we will always recommend seeking clearance from HMRC. This will determine if the distribution will be an income or capital distribution.
At the start of 2021, it was increasingly difficult to get even the most straightforward and uncontroversial clearances through HMRC. However, HMRC’s stance has softened. We are now finding that, where the facts are not uncontroversial, HMRC is giving clearances to transactions which we would expect clearance to be given for.
Post-transaction notification requirement
Where a “capital” payment has been made, HMRC must be notified within 60 days of the payment. This notification must be made regardless of whether clearance was sought.
Where there is a late submission of the notification, a maximum penalty of £300 can be applied. If the wrong treatment was adopted, a maximum penalty of £3,000 can be applied.
A limited company is allowed to undertake a share buyback under the Companies Act s690. The company can make the repurchase out of either the company’s retained profits, or out of capital.
As alluded to at the start of this article, the exiting shareholder will be left with cash in their hands (or bank account). The reason for this is found in Companies Act s691(2): “Where a limited company purchases its own shares, the shares must be paid for on purchase.” It is therefore not possible to leave the amounts due to the shareholder on loan account for them to draw down in the future.
The case of BDG Roof-Bond Ltd v Douglas (2000) suggests that the ‘payment’ does not have to be in cash, but can be settled in the transfer of assets (similar to a dividend in specie). However, this was defined in obiter and is therefore not binding: we await another case which concludes on this point.
The implication is that if the company does not have sufficient cash to settle the agreed consideration amount, the company will not be able to undertake a share buyback. This is when the holding company method comes to the fore as an alternative. We will explore this in a future article.
For more information on the tax implications of share buybacks, please get in touch with your usual BKL contact or use our enquiry form.
You can also watch our 2019 tax webinar on share buybacks.