Mark McLaughlin CTA (Fellow) ATT TEP considers potential obstacles to obtaining capital treatment on a company purchase of own shares and reviews company law issues.
Capital or distribution?
When a company buys back its own shares from a shareholder, a payment in excess of the capital originally subscribed for the shares generally falls to be treated as an income distribution. For unquoted trading companies, if certain conditions are satisfied, the transaction is automatically excepted from income distribution treatment and the shareholder is generally treated as receiving a capital payment instead. Capital treatment provides individual shareholders with a potentially tax-efficient exit route from the company, particularly if full business asset taper relief is available to reduce the effective capital gains tax rate to 10% or less for a higher-rate taxpayer, comparing favourably with an effective tax rate of 25% for an income distribution.
The legislation on company distributions (TA 1988, Part VI) contains provisions specifically dealing with the purchase (or redemption or repayment) of own shares by an unquoted trading company. This article outlines those rules in the context of individual vendor shareholders of a single unquoted trading company (all statutory references are to TA 1988, unless otherwise stated).
In addition to the taxation requirements, a purchase of own shares must also comply with Companies Act requirements to be valid. However, in practice the company law aspects are often an after-thought. The implications for 'getting it wrong' can be unfortunate, to say the least. This article therefore also considers various company law requirements, particularly in the context of changes to be introduced in Companies Act 2006.
Conditions for capital treatment
The requirements for a company purchase of its own shares to be excluded from income distribution treatment and treated as a capital payment (within s 219(1)(a)) are broadly summarised below.
Company status - the purchasing company must be an unquoted trading company (s 219(1)).
Purpose of the payment - either the 'trade benefit' and 'no scheme or arrangements' tests are met, or the recipient applies the payment towards discharging an inheritance tax liability within two years after a death (in the latter case, the further conditions below do not need to be satisfied) (s 219(1)(a)).
Residence - the vendor must be UK resident and (for individuals) ordinarily resident for the tax year in which the purchase takes place (s 220(1)-(4)).
Period of ownership - the shares must generally be owned for a minimum of five years (or, if acquired by will or intestacy, three years) (s 220(7)).
'Substantial reduction' - the vendor shareholder's interest in the company (i.e. if the vendor retains an interest after the purchase) must be substantially reduced (s 221).
No 'continuing connection' - the vendor must not be connected with the company immediately after the purchase (ss 223, 224, 228).
The interests of 'associated persons' (as defined in s 227) are added to those of the vendor for these purposes.
Company status
The 'trading company' test requires that the company is 'wholly or mainly' (i.e. more than 50%) trading. This is a less stringent test of trading status than for capital gains tax taper relief purposes, whereby the company's activities must not include non-trading activities to a substantial extent (TCGA 1992, Sch A1 para 22A(1)), with HMRC considering 'substantial' to mean more than 20% (Capital Gains Manual at CG17953p). Hence it is possible for a company to satisfy the 'wholly or mainly' test of trading status on a purchase of its own shares, but for a gain on the disposal of those shares to be denied business asset taper relief in the hands of an individual shareholder because the company's non-trading activities are substantial.
'Purpose' tests
This condition contains two separate requirements, both of which must be satisfied.
The 'trade benefit' test
First, the share repurchase must be wholly or mainly for the purpose of benefiting a trade carried on by the company. Unfortunately, 'benefiting a trade' is not defined in the legislation. The resulting uncertainty culminated in the Inland Revenue (as was) issuing Statement of Practice 2/82, containing examples of situations in which the trade benefit test would normally be regarded as satisfied. However, it should be remembered that statements of practice do not carry the force of law. Despite this non-statutory nature basis for the 'trade benefit' test, case law offers little guidance on its meaning. However, the decisions in Moody v Tyler (Inspector of Taxes) [2000] STC 296 and Allum and anor v Marsh [2005] STC(SCD) 191 suggest that the test can be problematic for the taxpayer.
The 'scheme or arrangement' test
The second test is that the purchase of own shares must not form part of a scheme or arrangement, a main purpose of which is either to enable the share owner to participate in the company's profits without receiving a dividend, or the avoidance of tax. Unfortunately, 'scheme' or 'arrangement' is not defined. However, both terms require consideration of the motive for the transaction, which will largely be a matter of fact.
Retained interest
Two computational tests must be satisfied for capital treatment to apply, which are relevant if the vendor (and/or any associates) retain an interest in the company following the share sale. These are that there must be a 'substantial reduction' in the shareholding and that there must be 'no continuing connection'.
Substantial reduction
The vendor's interest as a shareholder must be substantially reduced. The interests of any associates are also taken into account. The term 'substantially reduced' broadly means that the nominal value of shares owned immediately after the purchase, expressed as a fraction of the company's share capital at that time, does not exceed 75% of the corresponding fraction immediately before the purchase (s 221(4)). This is illustrated in Example 1 below.
Example 1
Suppose that Martin owns 4,000 shares in Express Retail Ltd, an unquoted trading company. Its issued share capital is 10,000 ordinary £1 shares. Express Retail Ltd agrees to purchase 2,000 of Martin’s shares. The relevant fractions are as follows:
Before the purchase: 4,000/10,000 (40%).
After the purchase: 2,000/8,000 (25%).
75% (i.e. the substantial reduction threshold) x 40% = 30%. Martin holds 25% of the company’s shares following the purchase.
Martin’s remaining holding of 2,000 therefore represents a substantial reduction based on his original holding. Note that although his interest in the company has actually been reduced by 37.5% (i.e. (40% - 25%)/40%), Martin’s shareholding has reduced by 50%.
Even if the substantial reduction test is met in terms of share capital, it is not regarded as satisfied if the vendor shareholder's interest in the company's profits available for distribution exceeds 75% of the corresponding fraction immediately before the purchase (s 221(5)). (This was illustrated by Example 2 in Paula Tallon's article, 'Ooohs and aaahs', Taxation, 5 July 2007, page 15.)
No continuing connection
The second arithmetical test requires that the vendor must not be connected with the company immediately after the purchase. 'Connection' is defined broadly in terms of direct or indirect ownership or entitlement to acquire (i.e. now and in the future) more than 30% of the company's ordinary share capital, loan capital, voting power or the entitlement of equity holders to assets available for distribution on a winding up. The rights of any associates are again taken into account. The vendor is also connected with the company if he controls it. 'Control' in this context has the meaning given in ITA 2007, s 995 (previously TA 1988, s 840). There are anti-avoidance provisions to prevent the 'substantial reduction' and 'no continuing connection' tests being circumvented (s 223(2), (3)).
Loan backs
What if the company wants to purchase all the vendor's shares, but cannot afford them? HMRC accept that there is no reason why the vendor should not lend part of the consideration back to the company immediately after the purchase. Clearly, the 'substantial reduction' requirement is satisfied. However, the 'no continuing connection' test must also be considered. A loan back to the company may breach this requirement, particularly if the market value of the shares is relatively high and the remaining issued share capital is relatively small. However, HMRC accept that the company can satisfy the connection test by making a bonus issue before the purchase of own shares takes place in order to increase its issued share capital, and in Tax Bulletin 21 (www.hmrc.gov.uk/bulletins/tb21.htm) they illustrate how this is achievable.
'Phased' purchases
An alternative to a loan back following the purchase of the vendor's entire shareholding is a 'phased' purchase (i.e. the purchase of shares in tranches). Clearance applications are appropriate in respect of each purchase. HMRC accept (subject to the 'trade benefit' test being satisfied) that it is possible for the vendor to make a series of disposals phased over a period (ICAEW Technical Release 745). However, for the transactions to be eligible for capital treatment, the above arithmetic tests must be satisfied on each occasion.
Contracts with multiple completion
A purchase by instalments is generally prohibited under company law (see below). However, the company may enter into a single, unconditional share sale contract with the vendor, with completion taking place on different dates in respect of separate tranches of shares within the agreement. The effect is that the 'substantial reduction' test need only be considered once; i.e. at the contract date. The vendor must also satisfy the 'no continuing connection' test. However, as the vendor loses beneficial ownership of the shares at the contract date, he will only remain connected with the company if there is ongoing ownership of, or entitlement to, more than 30% of its issued ordinary shares, loan capital, voting rights and/or assets on a winding up. Completion of the contract in stages does not create a debt for connection purposes.
HMRC accept that a multiple completion contract is possible, provided that beneficial ownership passes at the contract date (TR 745). The disposal date for capital gains tax purposes is when the unconditional contract is made (TCGA 1992, s 28(1)), notwithstanding that payments are made at later dates. This means that the tax liability arising from the disposal could fall due before the consideration is fully received. This may not be a significant problem if, for example, full business asset taper relief is available to the vendor shareholder. However, loss of beneficial ownership of the shares effectively means that the vendor is unable to participate in dividends paid after the contract date, or to exercise voting rights in relation to the shares. A single contract with multiple completion normally only requires a single clearance application to HMRC.
Hitting the jackpot
Capital treatment presents an opportunity for individual shareholders to claim capital gains tax reliefs, allowances and exemptions, if applicable. For example, the liability may be reduced or extinguished by a March 1982 value for the shares, indexation allowance (up to April 1998), capital losses, taper relief, and the annual exemption.
As Example 2 illustrates, the effective capital gains tax rate can therefore be considerably lower than the often-publicised 10% headline rate, and is reduced further to the extent that the gain is taxable at lower rates.
Example 2
Suppose that Martin subscribed for 100 ordinary £1 shares in Express Retail Ltd in 1980. The company’s trade is successful, and Martin’s shares are worth £200,000 as at 31 March 1982. On 31 March 2007, Express Retail Ltd purchases Martin’s shares for £800,000. The conditions for business asset taper relief (BATR) were satisfied throughout Martin’s relevant ownership period. His capital gains tax position for 2006-07 is as follows (Martin is a higher rate taxpayer on his entire gain).
| £ | |
| Proceeds | 800,000 |
| Less: Value at 31 March 1983 | 200,000 |
| 600,000 | |
| Less: Indexation (to April 1998 @104.7%) | 209,400 |
| 390,600 | |
| Less: BATR (75%) | 292,950 |
| 97,650 | |
| Less: Annual exemption | 8,800 |
| Chargeable Gain | 88,850 |
| CGT at 40% | £35,540 |
The effective CGT rate is 4.44%.
The 'all-clear'
Two points on clearance applications under s 225 are worth making.
First, a clearance application is not necessarily required for capital treatment to apply, as application of the rules is mandatory. The conditions are either satisfied, or they are not.
Secondly, clearance applications can either be 'positive' that s 219 applies, or 'negative' that it does not. There is a negative advance clearance facility available to the company (s 225(1)(b)). The Annex to SP 2/82 helpfully includes pro-forma applications for clearance on the purchase of own shares.
In practice, a joint clearance application is normally made under s 225, and ITA 2007, s 701 (previously s 707) that the transactions in securities rules in ITA 2007, s 684 (previously s 703) do not apply. Anti-avoidance provisions aimed at close companies will affect most owner-managed businesses, and broadly apply to company distributions not otherwise taxable as income (ITA 2007, s 689, previously s 704D) unless HMRC are satisfied that the transaction was for bona fide commercial reasons, and that obtaining a tax advantage was not a main objective.
Other points
Two other points are worth making.
(a) Companies must submit a return to HMRC within 60 days of making a payment for the purchase of own shares to which capital treatment is considered to apply (s 226), irrespective of whether clearance was requested and obtained for the payment. In practice, if a clearance application was made, this requirement can often be satisfied in a short letter to HMRC drawing the inspector's attention to the previous clearance, and outlining any changes between the proposed transactions in the letter and the actual transactions that took place.
(b) The purchasing company is liable to stamp duty of 0.5% on the consideration for the shares (rounded up to the nearest multiple of £5) on returns under CA 1985, s 169 (FA 1986, s 66). The return (form G169) provides details of the share buyback. The return itself is stampable, rather than the share transfer form. The company must deliver the return to Companies House within 28 days from the first date on which the shares were delivered to the company.
Company law
A company share repurchase must comply with certain Companies Act requirements. HMRC can only consider a clearance application for a transaction which appears to be a valid purchase of own shares (Tax Bulletin, Issue 21). Professional advisers who are unfamiliar with company law should obtain appropriate legal advice. Failure to satisfy the relevant requirements could make the transaction void and legally unenforceable. The company and its officers could be liable to sanctions - and the adviser to a professional indemnity claim!
Shares purchased by an unquoted company are treated as cancelled. However, if the company law requirements are not satisfied, the shares are not cancelled and legal ownership remains with the vendor. HMRC would then consider the tax implications of the company's payment to the shareholder (Company Taxation Manual, para CTM17505). For most owner-managed companies, this could include a potential liability under the loans to participators provisions (s 419).
Companies Act 2006 was given the Royal Assent on 8 November 2006, and is being introduced in stages until October 2008. Part 18 ('Acquisition by limited company of its own shares') takes effect from 1 October 2008. Companies Act 1985 specifies a procedure for share buy-backs. CA 2006 restates some provisions of its predecessor, and changes others. A detailed consideration of company law issues is outside the scope of this article. However, the main company law considerations for an unquoted (or 'off market') purchase are summarised below.
Power to purchase own shares
CA 1985 gives a company the power to purchase its own shares if authorised to do so by the articles of association (CA 1985, s 162(1)). Otherwise, it may be necessary for the shareholders to pass a special resolution to allow the company to make the purchase. CA 2006 does not include a requirement in the company's articles to purchase its own shares, although the members may restrict or prohibit a purchase of own shares through the company's articles if they wish. The share purchase must not leave the company with only redeemable or treasury shares (CA 1985,
s 162(3); CA 2006, s 690).
Authority for purchase
CA 1985 requires the share purchase contract to be agreed by the company's members through a special resolution beforehand (CA 1985, s 164(5)). The contract (or a detailed memorandum of its terms) must be available for inspection for at least 15 days before the meeting, and also at the meeting. CA 2006 also requires a contract for an 'off-market' company purchase of own shares to be approved in advance (CA 2006, s 693). However, the company may enter into a contract to purchase its own shares, on condition that the shareholders authorise the contract terms by a special resolution (CA 2006, s 694(2)). If the contract is not approved, the company may not purchase the relevant shares and the contract lapses. A copy of any written contract (or a memorandum of terms) must similarly be made available to the members (CA 2006, s 696(2)).
Payment for the shares
The shares repurchased must be fully-paid, and the company must pay for the shares on completion (CA 1985, ss 159(3), 162(2); CA 2006, s 691).
Distributable profits
A company must purchase its own shares out of distributable profits, or out of the proceeds of a fresh share issue to finance the purchase. An amount equal to the par value of the shares bought back must be transferred to a capital redemption reserve account. However, a private company may purchase its own shares out of capital, if certain conditions are satisfied (CA 1985, ss 160(1), 162(2), 171 to 177; CA 2006, ss 692(2), 709 to 723).
Cancellation of shares
Following the share repurchase, the relevant shares are treated as cancelled. The company's share capital is reduced by the nominal value of the cancelled shares (see CA 1985, ss 160(4), 162(2); CA 2006, s 706).
Returns to Companies House
A return must be made to the Registrar of Companies within 28 days, stating the number of shares purchased, their nominal value and the date of purchase (CA 1985, s 169(1); CA 2006, s 707). The company must also notify the Registrar of the cancellation of the shares within that period, and provide a statement of the company's share capital (CA 2006, s 708). CA 1985 imposes a notification requirement only in relation to treasury shares which are cancelled (CA 1985, s 169(1A)).
Inspection of contract
CA 1985 requires that the share purchase contract (or a memorandum of its terms) must be retained at the company's registered office for at least ten years from completion of the contract (CA 1985, s 169(4)). CA 2006 also stipulates a ten-year retention period, but provides that a copy of the contract (or any variation) may alternatively be kept for inspection at a specified place (in regulations to be made under CA 2006, s 1136). The company must notify Companies House of the place where the contract is available for inspection. A contract (or memorandum of terms) relating to private companies must be made available for inspection by any of its members (CA 2006, s 702).
All change!
Having spent most of the morning carefully researching and explaining the tax and company law implications of the proposed transaction, Bob was confident of charging a significant fee. Unfortunately, Martin and Jason decided that it wasn't worth all the hassle, and eventually resolved their differences! Bob was left yearning for a peaceful rest away from clients ... in a nice, quiet padded cell.
The above article was first published in 'Taxation' on 12 July 2007.
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