Tax Doctor:
Mark McLaughlin
CTA (Fellow) ATT TEP

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September 2005

Q:

I am a director and 40% shareholder in a precision engineering company. There are two other director shareholders, who own 40% and 20% respectively. We formed the company together, which started trading in 1995, and has been fairly successful. Currently it is worth around £1.5 million. I no longer get on with the other director shareholders, and would walk away from the company if I could get a fair price for my shares. Should I ask the other shareholders to buy my shares? What if they don't have enough money?

A:

You could approach the other shareholders to buy your shares. Alternatively, you could discuss with the other director shareholders the possibility of the company backing back its shares from you. This would have the advantage that it would not be necessary for the other individuals to buy your shares if they were unwilling or unable to do so.

Company law

There are certain statutory requirements to consider when a company buys back its shares from a shareholder. For example, the company's Articles of Association must permit the purchase of its own shares, and the company must normally have sufficient distributable reserves to fund the repurchase (or the money may come from the proceeds of a fresh issue of shares). In addition, there are various company law procedures and documentation (e.g. resolutions, contracts etc) in connection with a company purchase of own shares. Professional advice and assistance is strongly recommended.

Income or capital?

For tax purposes, the sale proceeds for your shares will either be treated as a receipt of income or capital, depending on the circumstances, except for the repayment of share capital itself. If income treatment applies, the proceeds will be treated in the same way as a dividend. Assuming that you receive full market value for your shares, it seems likely that most of the sale proceeds will be liable to income tax at the higher rate of 32.5 per cent for dividends (i.e. on the excess over the amount subscribed for the shares, and inclusive of a 10% tax credit), less the 10% non-repayable tax credit, as for dividends. The vendor is also be treated as disposing of his shares for capital gains tax (CGT) purposes, although in your case no gain (or loss) should arise as virtually all of the proceeds have already been taxed.

However, if certain conditions are satisfied, the sale of your shares will be subject to CGT instead. Capital treatment is often more tax-efficient than the income treatment described above. For example, CGT taper relief will be available to reduce the gain. If the conditions for 'business asset' taper relief are satisfied (e.g. if the company has been a 'trading company' as defined for those purposes throughout), the gain may be reduced by 75%, giving an effective CGT rate of around 10% for a higher rate taxpayer. The annual CGT exemption (i.e. £8,500 for 2005/06) may further reduce the gain, assuming that it has not already been used elsewhere. It is generally advisable to calculate and compare the tax liability under both income and capital treatment to determine which is best, in case forward planning can secure the most tax-efficient treatment. However, in your case it seems likely that capital treatment will work out best.

Conditions

As mentioned, capital treatment for the sale of unquoted shares is subject to certain conditions. For example, you must be resident and ordinarily resident in the UK for tax purposes, and must normally have owned the shares for at least five years. In addition, the purchase must be made wholly or partly to benefit the company's trade, and not to enable you to participate in the company's profits without receiving a dividend or for tax avoidance purposes. The requirement that the purchase must benefit the company's trade sometimes causes difficulty and uncertainty. However, some guidance is available in a Statement of Practice (SP2/82) published by HM Revenue & Customs (in Booklet IR131 'Statements of Practice'), which includes examples of circumstances in which a company purchase of own shares may be considered to benefit the trade. For example, SP2/82 states the following:

'If there is a disagreement between the shareholders over the management of the company and that disagreement is having or is expected to have an adverse effect on the company's trade, then the purchase will be regarded as satisfying the trade benefit test provided the effect of the transaction is to remove the dissenting shareholder entirely.'

There is also a procedure for applying to the HM Revenue & Customs Business Tax Clearance Team for clearance in advance that the purchase will be treated as a capital (or income) distribution. A specimen form of application is contained as an annex to SP2/82. The company must also provide details to its tax office within 60 days of the transaction.

A company purchase of its own shares can be complex from both a tax and a company law perspective. Expert professional advice is strongly recommended.

Mark McLaughlin

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