In these challenging times, we are increasingly finding that certain shareholders of a private company want to exit and the remaining shareholders are both unable to buy the outgoing shareholder’s shares personally and unwilling to risk the outgoing shareholder's shares being bought by an external party. Consideration invariably then focuses on whether the company can buy back those shares to facilitate the exit. Even if they have sufficient distributable profits to allow it to contemplate a buyback, increasingly companies are looking to spread the buyback cost by having a single contract incorporating multiple completion dates typically spread over up to 5 years (a “multiple completion buyback”) and so keep a cash buffer to meet contingencies.
In this not uncommon situation, the company and the exiting shareholder need to be mindful of various tax and company law considerations which, if ignored, may make the buyback both legally ineffective and tax inefficient. To illustrate the point, let us suppose that there are 3 founder shareholders (A, B and C) each owning 100 ordinary shares with a £1 par value. As C is nearing retirement age, he wants to exit and has agreed with A and B a price of £1 million for his 100 shares. The company could fund the share buyback out of distributable profits in one go but, for cash flow reasons either self imposed or by the bank, it wants to stagger the purchase in five equal instalments, £200,000 payable now and the other £800,000 payable in four equal instalments on successive anniversaries of the date of the buyback agreement.
The typical questions we receive from clients in this situation include the following:
Question 1: Can the company buy all the 100 shares now, pay £200,000 now and the other £800,000 in equal instalments over the next 4 years?
Unfortunately not. The Companies Act 2006 is very clear that the 100 buyback shares must be paid for in full at the time of purchase. There is plenty of case law confirming that instalment payment arrangements are not lawful and that payment must be made in cash (i.e. the transfer of a non cash asset or set off against a liability are not permitted forms of payment). The consequences of breaching this Companies Act 2006 requirement are that the buyback is void and the Company and the responsible officers criminally liable. The legal effect is that the 100 shares would not be cancelled but continue to be held by C. This is an unsatisfactory state of affairs particularly if the remaining shareholders, A and B, only realise this when they come to exit the company themselves and, for example, have to warrant to a buyer that their combined 200 shares constitute the whole of the company’s issued share capital. At that point remedying the defect could be time consuming and expensive or, worse, derail their own exit.
Question 2: Can the company buyback all the 100 shares, pay £1million now with the seller, C, lending back £800,000 of the buyback proceeds to the company?
In theory yes but there may be significant adverse tax consequences for the seller if he continues to be “connected” to the company after the buyback because he holds a significant amount of the Company’s debt. See connection test in Question 4.
Question 3: Does the buyback have to be fully funded out of the company’s distributable profits?
Yes, unless the company funds the buyback out of a reduction of capital or the proceeds of a fresh issue of shares to the remaining or new shareholders.
Question 4: Will the sale proceeds be taxed as income or capital for the seller?
The starting point is that the buyback proceeds over the capital element (i.e. the nominal value plus any premium paid at the time of subscription) are treated as an income distribution in the hands of the selling shareholder. For a 50% taxpayer this means an effective tax rate of 36.1%.
For the buyback proceeds to be taxed in the hands of the seller as a capital receipt (meaning a 10% effective rate of capital gains tax if the seller is entitled to entrepreneurs’ relief), a number of complex conditions must be met. It is advisable to obtain clearance from HMRC before signing the buyback agreement that these conditions have been satisfied and the more tax beneficial capital treatment thus applies.
These conditions include:
- Trade benefit test - the purchase must be wholly or mainly in order to benefit the trade carried on by the company or a 75% subsidiary. HMRC have, for example, indicated that the trade benefit test is satisfied if the purpose of the buyback is to facilitate the exit of a shareholder who disagrees with the management direction of the company and that disagreement is having an adverse effect on its trade. The trade benefit test is less likely to be satisfied if the selling shareholder retains a connection with the company although there may be circumstances where HMRC can be persuaded otherwise.
- Substantial reduction test - the seller’s interest as a shareholder in the company must be substantially reduced. In a multiple completion buyback structure, this means that after each tranche of shares is bought back, the seller’s fractional interest must not exceed 75% of his pre buyback fractional interest. In calculating the post sale fractional interest, the reduction of the issued share capital as a result of the buyback must be taken into account.
- Connection test - immediately after the sale, the seller must not be connected with the company or any group company (i.e. he cannot have more than 30% of either the issued ordinary shares or voting power or loan capital and issued ordinary shares).
Question 5: So how can I ensure in a multiple completion buyback situation my sale proceeds are taxed as a capital receipt rather than as an income distribution?
It is easy to see how a series of smaller buybacks would not satisfy the above substantial reduction and connection tests and the seller’s proceeds not qualifying for capital tax treatment. The solution involves preparing a single unconditional contract where C transfers the beneficial interest in his 100 shares to the company from the date the agreement is entered into. By doing so, there ought to be a disposal of all the 100 shares for capital gains purposes at the date of the agreement thus satisfying the substantial reduction test. On that date 20 shares will be purchased for £200,000 and those shares cancelled. Payment for the remaining 80 shares will take place on the next 4 anniversaries of the date of the agreement provided there is at least £200,000 of distributable profits on each relevant anniversary.
Provided C is a director on the date of the buyback agreement and the other conditions for entrepreneurs’ relief are satisfied, he should pay capital gains tax at 10% on his £1million proceeds. Despite remaining the legal owner of the remaining 80 shares subject to uncompleted tranches until they are completed, the substantial reduction test will be applied. The connection test ought to be satisfied, particularly if the uncompleted tranche shares are converted into non voting and non dividend participating shares from the date of the agreement.
To avoid the perils described in Question 1, careful drafting of the buyback agreement is required to ensure that the seller’s proceeds in a multiple completion buyback situation are taxed as capital whilst at the same time ensuring that the Company does not commit contractually to more than it can do under the Companies Act 2006. In some cases there may be an unavoidable trade off between the seller’s tax efficiency and his contractual protections in the buyback agreement as regards his uncompleted tranches. In addition, the seller’s chances of receiving a favourable tax clearance for this less straight forward buyback structure may depend on the ability of his tax adviser to persuade HMRC that the capital treatment conditions have been satisfied.
