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TaxationWeb by Burges Salmon LLP

Burges Salmon LLP point out a flaw in the tax system concerning tax on a company repurchase of its own shares from trustees, and the tax relief potentially available in respect of it.The taxation of companies repurchasing their own shares – while deceptively straightforward - is often fraught with difficulties. Most such problems seem to be caused by an incomplete understanding of the company law issues involved in a share repurchase and the effect that this can have on the tax treatment.

However, company law is not solely to blame. Whilst it has clearly escaped the attention of most practitioners and commentators, deep within the workings of ICTA 1988 and TCGA 1992 themselves there has been lurking a potentially serious flaw. That flaw concerns tax on a company repurchasing its own shares from trustees. The potential ramifications of this anomaly were that a trust could suffer a double tax hit on a share buy-back, paying income tax and capital gains tax on receipts from the same share sale.

It doesn't seem that the technical loophole in the legislation has ever been exploited by HM Revenue & Customs, or indeed brought before the courts, and largely before most people knew it existed, the problem has been solved. For an explanation of how and why, read on.

Taxation of a share buy-back

When a company chooses to repurchase (buy-back) its own shares, the starting point of the tax analysis is TA 1988, s 219. This provides a limited number of circumstances in which the purchase will not qualify as a 'distribution' for the purposes of the Act. If the transaction fulfils these conditions and falls into one of the exceptions, the payments will not be treated as distributions and therefore will give rise solely to capital gains tax liability.

In practice, in the majority of circumstances the complex conditions of section 219 are not fulfilled. In these instances, the payment to the seller, to the extent it exceeds the nominal value of the shares, is treated as a distribution. It is therefore subject to tax as income in the hands of the seller. In most transactions, the tax story ends there. However, it is important to note that the vendor still makes a disposal of his shares for capital gains tax purposes.

In the vast majority of instances this does not lead to a 'double' income tax and capital gains tax liability. This is due to the provisions of TCGA 1992, s 37. This provides that any proceeds of a disposal which are charged to income tax or taken into account in computing the income of the seller will not be taken into consideration when calculating the chargeable gain (or loss) on the seller's disposal of the shares. Because the excess over nominal value is treated as a distribution for income tax purposes, the CGT base-cost is updated and this invariably serves to cancel out any CGT liability on the disposal. In some cases, indeed, it creates a capital loss.

The presence of a trust

However, where the seller of the shares is a trust, the particular wording of section 37 poses a problem. The legislation allows for the proceeds of a disposal to be excluded from a chargeable gain calculation where they are ‘charged to income tax as income of, or taken into account as a receipt in computing income of, the person making the disposal’.

In non-trust circumstances, it will always be the same person that disposes of the shares for capital purposes as receives the proceeds for income purposes.

But in the case of a settlor interested trust, while the person making the disposal will be the trustees, the person on whom the income liability will arise will actually be the settlor of the trust. This is therefore a different person making the disposal under the legislation, and therefore the relief of s 37 is unavailable.

The consequences of this are that a charge to capital gains tax on the net difference between the purchase price of the shares and the sale price will arise in the trust, but an income tax charge will also be levied on the settlor. In effect, the same transaction will be taxed twice. This will be particularly detrimental to the settlor of a settlor interested trust, where the income tax rules will impute the income itself to the settlor and the CGT rules will also impute an amount equal to the capital gain to the settlor. The settlor will therefore be personally liable to CGT and income tax on the same receipt.

Relief

It is clear that the inconsistency in treatment here is merely down to an unfortunate piece of drafting. To this end we approached H M Revenue & Customs for their view on this question.

The response was that in these circumstances, relief would be provided by section 32 of the Taxes Management Act 1970. This provides that in a situation of possible double assessment, if the Board are satisfied:

that a person has been assessed to tax more than once for the same cause and for the same chargeable period, they shall direct the whole or such part of any assessment as appears to be an overcharge, to be vacated, and thereupon the same shall be vacated accordingly.

HMRC have confirmed that in the case of a settlor-interested trust whose shares are repurchased, they will apply the provisions of section 32 to vacate the CGT assessment.

Life-interest trusts

A similar point to the above might be thought to apply to life-interest trusts as well. Typically with a life-interest trust the capital gain is that of the trustees whereas the income tax liability is that of the life-tenant.

On putting this point to HMRC, they pointed out that while a repurchase of shares may be a distribution for tax purposes, it generally remains capital for trust purposes. As such it will not usually belong to the life-tenant and therefore the income tax liability will actually be that of the trustees. The normal protection of TCGA 1992, s 37 can then apply.

Care should be taken that the trust deed is not drafted in such a way that the life-tenant's entitlement to income is defined by reference to ‘taxable income’. HMRC have declined to comment upon this type of situation. Fortunately, such trust-drafting is rare so an answer to this point will have to wait for another day.

August 2005

Burges Salmon LLP

About Burges Salmon LLP

Burges Salmon is one of the UK's leading commercial law firms. With some 550 partners and staff based in Bristol, and with a presence in London, the firm provides national and international organisations and individuals with a full service through the core practice areas of corporate, commercial, finance, litigation, property and tax.
Burges Salmon's Tax and Trusts department is one of the largest in the country. Its tax services are understood to be among the most comprehensive of any law firm in the UK.