Shareholder exits via a company purchase of own shares
Whether it is moving towards retirement, taking a step back from the business for family reasons or shareholder disagreements, the exit from a company by a shareholder can be a challenging time. The mechanics of the shareholder departure and resulting tax implications require careful consideration to ensure there are no unexpected tax liabilities.
How does a company purchase of own shares work?
A company purchase of own shares (or ‘share buyback’) is a popular route for shareholder exits, particularly where there is no willing external buyer or the remaining shareholders do not want to bring in another shareholder.
Companies Act 2006 allows a company to repurchase its own issued share capital, provided certain conditions are met. Commonly, the repurchased shares are then immediately cancelled.
The purchase price for the shares must be agreed between the company and the exiting shareholder. This should reflect market value for the shares.
Key aspects for the company:
- Distributable reserves – the company must have sufficient distributable reserves to carry out the buyback.
- Cash reserves ― cash reserves would also need to be carefully reviewed to ensure there is sufficient cash to carry out the buyback, while also leaving adequate cash for the company’s working capital requirements.
- The company’s power to undertake the share buyback ― it is important to check the company’s articles of association and shareholders’ agreement for any restrictions or prohibitions on share buybacks.
Tax implications for the exiting shareholder
The proceeds received by the shareholders on a purchase of own shares will either be treated as an income distribution (taxed at dividend tax rates) or capital (taxed at capital gains tax rates). Business Asset Disposal relief may be available if the conditions are met.
Where share buybacks are made by unquoted trading companies and, provided certain conditions are met, the seller is treated as making a capital disposal. Capital treatment is often preferable for the shareholder due to the capital gains tax rates currently being lower than dividend tax rates.
The key conditions for capital treatment are as follows:
| Test | Condition to be met |
| Trade benefit test | The buyback of shares must be made wholly or mainly for the purposes of benefiting a trade carried on by the company or any of its 75% subsidiaries. |
| Period of ownership | The shares must have been held by the seller for five years prior to the purchase. If the shares were received from a spouse or civil partner, look through provisions allow for the length of ownership to be considered in aggregate. This period is reduced to three years if the shares were acquired by will or intestacy. |
| Substantial reduction test | The seller’s shareholding must be ‘substantially reduced’ following the share buyback, which means that their interest in the company must be 75% or less than it was before the buyback. The combined interests of the seller and any ‘associates’ are considered for the purpose of the substantial reduction test. |
| Residency |
The seller must be UK resident in the tax year of the purchase by the company. |
| Connection test | The seller must not be connected with the company following the share buyback. A person is considered to be connected with the company where they, together with their associates, hold 30% or more of the issued ordinary share or loan capital, including 30% of the voting rights or rights to assets on a winding up. |
If any of the above conditions are not met, the proceeds received by the exiting shareholder will be treated as an income distribution rather than a capital distribution.
There may also be implications under the employment related securities legislation e.g. where the shares being disposed are ‘restricted securities’ or are sold for more than their market value.
Tax implications for the company making the buyback
Stamp duty will be payable at 0.5% of the consideration paid by the company to the shareholder, unless the purchase price is £1,000 or less.
The company will need to report the transaction to HMRC within 60 days of the share buyback. In addition, the company will be required to notify Companies House of the purchase or own shares.
The costs of implementing a share buyback will not be treated as a trading expense. Therefore, any legal, tax advice, etc fees connected with the share buyback should be disallowed in the company’s tax computation.
What if the company does not have sufficient cash reserves?
There are potential routes of carrying out a valid company purchase of own shares for companies with a cash shortage (such as a ‘multiple completion contracts’). These can be complex and must be structured carefully in order for the capital conditions to be met, in particular the connection test.
A multiple completion share buyback enables the exiting shareholder to enter into a contract to sell all their shares back to the company (with beneficial ownership in all shares being given up at the date of contract) but the legal completion of the share buyback subsequently taking place in tranches spread over a number of years (usually two – five years). The company would then pay the relevant consideration at each tranche date using cash flow generated since the contract date.
However, despite the payment being made in tranches, the seller will still be subject to capital gains tax on the total consideration (including the deferred elements) in the year the purchase of own shares contract is signed. Therefore, the seller will need to ensure they have sufficient funds to settle their capital gains tax liability on both the initial consideration and deferred elements.
HMRC’s view on multiple completion contracts has been tightened over the past couple of years particularly around meeting the connection test for the exiting shareholder. HMRC will refuse clearances in cases where the seller retains legal ownership of more than 30% of the company’s issued ordinary share capital after the multiple completion contract is made, even though beneficial ownership in the entire shareholding is given up at the date of contract.
Therefore, the legal ownership of shares given up at the date of the contract will be extremely important under a multiple completion share buyback.
Advance clearance procedure
An advance clearance procedure is available to obtain certainty on HMRC’s view of the tax treatment of the buyback.
We recommend that HMRC clearance is sought prior to any share buyback to ensure that HMRC are satisfied that the key conditions (e.g. trade benefit test, substantial reduction test and connect test) are met and capital treatment can be obtained.
Legal aspects
There are strict legal requirements in the Companies Act regarding the purchase by a company of its own shares.
In addition, legal documents, such as a share buyback agreement, board minutes, written resolution to approve the buyback, will need to be drawn up and agreed between the company and the exiting shareholder.
A lawyer will be required when carrying out a company purchase of own shares.
How we can help
The mechanics of a share buyback need to be considered carefully. A detailed analysis of the conditions, including from a company law perspective, will be required prior to undertaking the transaction. It is important to ensure a company purchase of own shares is valid. A void purchase of own shares can result in implications for the company, the directors and unexpected tax charges for the vendor.
To discuss your particular challenges and the possible solutions available, please speak to Simon Crookston or your usual Crowe contact.
