A company purchase of own shares is a useful way of exiting shareholders from the company and is preferable in many instances to a new holding company as there is no increase in the number of companies. However, if CGT treatment is expected the adviser should methodically work through all the tests and consider the pitfalls to ensure that there are no nasty surprises.
A company purchase of own shares (POS) can be a useful planning tool for an owner-managed company.
It can be used to facilitate the exit of a shareholder or to carry out a management buyout; the latter can be particularly efficient if combined with an approved share scheme such as Enterprise Management Incentives (EMI).
Take the situation where there is a successful private company owned by a husband and wife.
They are both in their late fifties and are thinking about an exit strategy.
There are three employees who they believe would be capable of taking the business forward.
The directors could put an EMI plan in place with the intention that each of these employees get, say 10% of the shares in the company.
The employees would pay whatever market value is agreed with HMRC.
When the options are exercised the husband and wife would now have 70% of the company and the management could carry out a management buyout (MBO) by using a POS, subject to the company having sufficient reserves.
The benefits are:
Generally a POS is treated as a distribution, as defined in CTA 2010 s 1000(1)B:
‘Any … distribution out of assets of the company in respect of shares in the company except however much (if any) of the distribution:
(a) represents repayment of capital on the shares, or
(b) is (when it is made) equal in amount or value to any new consideration received by the company for the distribution.
For the purposes of this paragraph it does not matter whether the distribution is in cash or not.’
However this does not override the fact that there is a disposal for CGT purposes.
So there are two parts to the disposal for an individual shareholder.
First, there is a capital gains transaction in respect of the shares, the proceeds being the total amount of the consideration received from the company less any amount that is subject to income tax (TCGA 1992 s 37), which will usually be equal to the capital subscribed for the shares including any share premium attaching to the shares.
Second, there is a distribution in respect of any excess which will be taxed as dividend income under ITTOIA 2005 s 383. See Example 1.
The basic treatment above is set aside where the POS is carried out by an unquoted trading company and one of the following conditions is met:
The conditions in CTA 2010 ss 1034–1043 are:
Residence: the vendor must be resident and ordinarily resident in the tax year in which the repurchase is made. This test is largely irrelevant now that there is no advance corporation tax (ACT) on dividends.
Period of ownership: the shares must have been owned by the vendor throughout the five years ending with the disposal. Where the shares were acquired by the vendor at different times they are treated as being disposed of on a first in first out (FIFO) basis.
If at any time during the five-year period the shares were transferred between spouses or civil partners and they were living together at the date of transfer, the periods of ownership of both spouses or civil partners are aggregated.
Where the vendor has acquired the shares under will or intestacy the period of ownership is aggregated with the deceased or personal representatives and the required period is reduced from five years to three years.
Reduction of interest as a shareholder: where shares are held by the vendor after the POS his interest must be substantially reduced. Substantially reduced is a reduction of more than 25%. See Example 2.
Practical tip
Where there are more than two shareholders the process of calculating the correct number of shares to repurchase is very often done by trial and error which can be tedious.
Practitioners can use the formula below to calculate the minimum number of shares to repurchase so the substantial reduction test is met.
(The answer should always be rounded up!)
S x C
4C – 3S
where
S = the shareholding of the vendor before the repurchase; and
C = the issued share capital before the repurchase.
In Example 2 the formula would have given a minimum of 119 shares to repurchase.
350 x 1,000= 118.64
4,000-1,050
Entitlement to profits: the vendor’s entitlement to profits must also be substantially reduced.
The purpose of this test is to prevent a shareholder selling his shares back to the company and continuing to benefit from a disproportionate amount of profits.
It is often assumed that once the nominal value test above is met then this test is also met. This test can be a trap for the unwary.
In applying the test the profits are increased by £100 and if any person is entitled to periodic distributions the profits are also increased by that amount. See Example 3.
Group conditions: if the company is part of a group the substantial reduction test must be met in connection with the group as a whole. A group in these circumstances is defined as a 75% group.
Connection: following the POS the vendor cannot be connected with the company. Connected for these purposes is an entitlement to more than 30% of the issued ordinary share capital of the company; the loan capital and the issued share capital of the company; or the voting power of the company.
In considering this test the nominal value of the shares and loan capital is used.
This means that if a company has issued share capital of 10,000 £1 ordinary shares, and a shareholder has 1,000 shares and has also made a loan to the company of £20,000, his total interest in the company amounts to 70% of the combined loan capital and issued share capital of the company (21,000/30,000).
If the loan cannot be repaid this situation could be dealt with by issuing further share capital so as to swamp the loan capital.
This of course depends on the company either having sufficient reserves to create further share capital, or on the shareholders being willing to inject some further funds into the company by way of a share subscription.
In the above example, the company would have to issue a further 40,000 £1 ordinary shares, so that the total share capital is £50,000 and the loan capital is £20,000.
CGT treatment is mandatory where the conditions are met.
If CGT treatment is not required the transaction should be structured to ensure that the conditions are not met.
This could include repurchasing the shares in tranches or presenting a repurchase which has as its main purpose the provision of funds to the shareholder.
1 The assumption that the vendor wants CGT treatment. Always do the maths. It is more tax efficient for a basic rate taxpayer to have the proceeds taxed as a distribution. Also the vendor may have income tax losses to relieve the tax.
2 Meeting the substantial reduction test and not meeting the connection test or vice versa.
3 Loss of entrepreneurs’ relief where the director resigns first. Resignation should always be after the repurchase.
4 Not having a benefit to the trade; this is not the same as a good commercial reason.
5 Repurchasing the shares in instalments but not getting the sequence of events correct.
6 Other tax issues may arise if the purchase price does not reflect market value, for example employment related securities.
7 Do not forget stamp duty at ½%.
In Moody v Tyler ([2000] STC 296) it was found that the purchase was simply a means to facilitate the repayment of a loan made by the company to the individual so CGT treatment was denied.
In Allum and Another v Marsh ([2005] STC(SCD) 191) a husband and wife owned almost all the shares in a trading company, with their son having a very small minority interest. The company’s premises had development potential.
The main shareholders wished to retire from the business and saw the sale of the property as a means of providing funds for their retirement, but wanted their son to carry on the trade.
The property was sold without the company securing alternative premises and the company purchased all the shares held by the main shareholders, leaving the son as sole shareholder.
The company only managed to secure limited access to premises which were shared with another company and the company’s trade reduced substantially.
It was found that these transactions had not benefited the trade in any way so the disposal by the shareholders could not be treated as capital.
Advance clearance can be obtained in respect of the transaction.
As regards the various conditions set out in ss 1034–1043 it will be a matter of fact whether these tests are met.
However the practitioner and the clients may want assurances that the benefit to the trade test is met.
Following the POS the company must make a return to HMRC within 60 days giving details of the payment.
Paula Tallon, Managing Director, Gabelle LLP
