Tax Bite - Share buybacks - Update

Tax Bite – Share buybacks – Update

A company purchase of own shares, or buyback, is a popular way of implementing corporate succession, but is not without tax challenges and risks.

Corporate lawyers will be familiar with the company law rule that a buyback cannot include deferred consideration. Most will also be aware of the basic tax rule that the proceeds of a buyback from an individual (above the amount originally subscribed for the shares) are taxed as an income dividend (39.35% for top rate tax payers), unless a series of conditions are met to enable the gain to be subject to capital gains tax (and possibly business asset disposal relief) instead (either 20% or 10%). So CGT treatment typically gives the seller a much better tax outcome.

HMRC’s “clarified” position on connection

Due to the company law prohibition on deferred consideration, it is common to see buybacks structured as multiple completion contracts, under which the departing shareholder will agree to sell all of his or her shares back to the company, but with completion in tranches over time. This allows the company to finance the purchase out of profits over time in a way that doesn’t fall foul of the Companies Act.

One of the requirements for CGT treatment is that the seller can’t be connected with the company after the sale. This means the seller can’t possess more than 30% of the share capital (or share and loan capital) or votes in the company. Previously, HMRC appeared to grant clearances for CGT treatment on this point based on beneficial ownership. So if a departing seller entered into a multiple-completion contract to sell (over time) all of his shares, at the point of entering into the contract he would have lost beneficial ownership of all the shares and would therefore not fail the connection test and could qualify for CGT treatment.

Recently however HMRC have confirmed that they interpret “possess” in this context as meaning legal title. So if, on a multiple completion buyback deal, the seller still has legal title to more than 30% after (say) the first completion, the conditions for CGT treatment won’t be met and all proceeds will be taxed as dividends.

HMRC has at least confirmed that it will not disturb clearances already given where this point may have been in issue, but HMRC will apply the new interpretation for any clearance and challenges now.

Minority discounts, and other purchase price issues

A point that is often overlooked on a buyback is that if what is being sold is not a controlling stake in the company, the shares will be susceptible to a minority discount when valuing them for tax purposes.

If the shares are employment-related, which the vast majority of shares held by employees or directors (or their relatives) will be, then if the shares are sold for more than market value, the excess over market value will be subject to income tax (PAYE and NICs) (at up to 48.25% for income tax and employee NICs and 15.05% for employer NICs). This would be the case even if the sale otherwise qualified for CGT treatment (as opposed to being taxed as a dividend).

Whilst historically we think there was some uncertainty over whether HMRC would take the minority discount point on a buyback, we understand the latest position is that HMRC indeed do take the point.

Further, in a recent case HMRC initially granted clearance that a buyback was subject to CGT, but then discovered that the price paid for the shares was, in HMRC’s eyes, clearly well above the market value of the shares. The tax tribunal found that HMRC was entitled to revoke the clearance (on the grounds that, in the circumstances, the buyback could not have been wholly or mainly for the purpose of benefiting the company’s trade, which is another of the CGT treatment conditions) so that the proceeds were taxed partly as a dividend and partly as “above market value” employment income.

Alternative – Newco structure

If, whether due to the connection issue, minority discount risks or other factors, CGT treatment is not available (or certain) on a share buyback, an alternative we very frequently see implemented in practice is a purchase of the entire share capital of the target company by a Newco, with the departing seller receiving cash and the other sellers exchanging their target company shares for Newco shares. This makes CGT treatment much more likely and significantly reduces the risk of any of the proceeds for the departing shareholder from being taxed as dividend income or employment income.

If a Newco route is to be pursued for the sake of the tax position of the departing seller, the parties need to understand that there will be an increased stamp duty cost (i.e. on 100% of the value of the target company) compared to a purchase of own shares, plus the continuing shareholders will most likely want to obtain prior clearance from HMRC that the share for share exchange will qualify as a tax-neutral rollover.

A final warning

Whatever route is adopted, careful planning and implementation will always be key.

In one recent case, the owners of a failing company wanted to receive the historically-accumulated profits then have the company wound up. The company’s accountant agreed to take out a loan and buy all of the shares in the company, then almost immediately had the company buy back all but one of the shares, with the proceeds discharging the loan. The selling shareholders achieved the desired CGT treatment on their exit as they sold to a third party (i.e. the accountant). The accountant expected the transactions he entered into to be a “nothing” (as he didn’t make any profit), but HMRC successfully asserted that the proceeds of the buy-back were to be subject to income tax as a dividend in his hands. This was because the income treatment on a buyback applies to the amount above the amount originally subscribed for the shares, i.e. by the original subscribers. The fact the accountant had paid more than that did not help him, and he ended up with a dividend income tax charge of around £600,000 and a large capital loss (which, even if he was able to use, would not give enough tax saving to neutralise the dividend tax charge).

If you have clients who are considering a share buyback or similar arrangements and would like any assistance with the tax structuring or implications, please do get in contact.

Posted on 26/05/2022 in Tax News


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