A company purchase of own shares has for many years been a useful tool to enable a shareholder to exit from a company. Provided the company has sufficient cash and distributable reserves, the company can purchase the shares. This is often a useful alternative to the continuing shareholders acquiring the shares which may pose funding or other issues.
Dividend income v capital gains treatment
Where a company purchases its own shares the consideration over and above the subscription price of the shares is ordinarily subject to tax as a distribution (dividend) in the hands of the vendor shareholder. For an individual shareholder this is not an attractive outcome with income tax rates on dividends of up to 38.1%. Fortunately, however, the tax legislation provides that in certain circumstances a purchase of own shares is not treated as an income distribution for tax purposes. In those cases the share sale consideration is instead treated as a capital gains receipt in the hands of the vendor shareholder, with the applicable CGT rate being as low as 10% where a valid claim for CGT Entrepreneurs Relief can be made (see further below).
There are numerous conditions for capital gains treatment to apply and these have to be reviewed carefully. In essence, the vendor shareholder must have owned the shares for at least five years and the purchase by the company must be made for the benefit of the company’s trade and not as a part of a tax avoidance scheme or arrangement. The vendor shareholder must not be connected with the company after the purchase – in practice this usually involves severing all ties with the company as shareholder, employee, director or consultant. An advance tax clearance application procedure is available whereby details of a proposed purchase of own shares transactions can be provided to HMRC for confirmation that capital gains treatment will apply and we would normally recommend that a company makes use of this. Capital gains treatment only applies where an unquoted trading company purchases its own shares – investment companies do not qualify.
Capital gains tax rates
Where the purchase of own shares benefits from capital gains treatment which rate of CGT will the vendor shareholder be liable for on the gain he or she makes?
If the departing shareholder was an officer or employee of the company for at least 12 months prior to the sale, and the shares being sold back to the company represented at least a 5% ordinary voting shareholding, then CGT Entrepreneurs Relief should be claimable and CGT liability should only be at the 10% rate (subject to a lifetime limit of £10m of gains).
Where CGT Entrepreneurs Relief is not in point, perhaps because the vendor shareholder held a sub 5% ordinary shareholding or was a passive shareholder with no employment or office with the company, then the applicable CGT rate is 20% (for a higher rate income taxpayer).
As will be appreciated these CGT rates compare very favourably with dividend income tax rates of up to 38.1%.
Multiple completion contracts
In some cases, a company will not have sufficient cash and distributable reserves to complete the purchase of all shares at the same time. As the Companies Act does not permit payment for the purchase of own shares to be made by instalments, a company will sometimes enter into what is known as a multiple completion contract with the vendor shareholder. In broad terms the contract will provide that the company will complete the purchase of some of the shares at the contract date, but will complete on the purchase of the remaining shares often in tranches on specified future dates, subject to the company having sufficient cash and reserves.
Historically, HMRC have accepted that such contracts can benefit from capital gains treatment and that the vendor shareholder makes a single CGT disposal of all the shares at the contract date, notwithstanding the later completions.
Recent change of stance by HMRC
It is our understanding that HMRC have recently begun to challenge claims to CGT Entrepreneurs' Relief by director shareholders who have sold shares back to the company under a multiple completion contract.
HMRC's technical argument, we are led to believe, is that the later completions of shares under the multiple completion contract amount to additional and separate disposals for CGT purposes. The potential problem here for the vendor shareholder is that, if HMRC are correct, these disposals will take place at a time when he or she will already have ceased to be an officer or employee of the company. In such circumstances, the gains arising on the later completion dates will not qualify for CGT Entrepreneurs Relief and the 10% CGT rate, but would attract CGT liability at the main rate of 20%. As will be appreciated, where the shares being sold back to the company have a substantial value, the differential in CGT liability will be significant. If HMRC are successful in their arguments, a shareholder could be liable for interest on late paid tax and a penalty in addition to the underpaid CGT.
HMRC's reported stance appears to be at odds with their longstanding practice and the technical position as understood by most tax commentators. It will be interesting to see if a Tribunal case is taken on this point over the forthcoming months.
Action to be taken
Companies and shareholders contemplating a purchase of own shares transaction are strongly recommended to take advice on the tax structuring aspects particularly where the shareholder is keen to access capital gains tax treatment and be in a position to claim CGT Entrepreneurs Relief and the 10% CGT rate. Alternative transaction structures may need to be considered, for example, the exiting shareholder might instead sell his or her shareholding to a new company incorporated by the continuing shareholders who would undertake a share for share exchange.
For further information on this area please contact Sheldon Cole or your usual Thomas Westcott tax contact.
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