Why is it important?
• Sometimes companies find themselves with more share capital than they need
• Sometimes shareholders wish to dispose of their holdings and there is no available individual buyer
• Shareholders want to be able to dispose of shares in a tax-efficient manner
• Formal liquidation is expensive, and thus cheaper alternatives are attractive
• There is a problem with recovering share capital in an informal winding-up
Company purchase of own shares
• This option has been available to companies for a long time.
• You need to check with older companies (say those incorporated pre-1980) that the Articles allow the company to purchase its own shares.
• It can carry significant tax advantages for the shareholder.
Tax advantages of purchase of own shares
• As a general rule, a company purchase of own shares is treated as the payment of a dividend, subject to a 25% tax charge in the hands of a higher rate taxpayer.
• If certain conditions are met, the purchase is instead treated as giving rise to a capital gain, suffering tax at 18% or even 10% in some cases.
Conditions for capital gains tax treatment of purchase of own shares
• The company must be unquoted
• The company must be a trading company or the holding company of a trading group
• The purchase must be to benefit the company’s trade and not for tax avoidance OR
• The payment must be used to pay inheritance tax due on the shareholder’s death
• The shares must be sold for an immediate cash payment
• The vendor of the shares must be UK resident in the tax year of sale
• The vendor must have held the shares for 5 years
• The vendor’s shareholding must be eliminated or substantially reduced (to not more than 75% of previous holding)
• In a substantial reduction case, there must be a plan to achieve complete disinvestment, save for the retention of a small (less than 5%) holding for sentimental reasons in appropriate cases
When does a purchase benefit a company’s trade?
• An outside shareholder is withdrawing equity finance
• A proprietor is retiring to make way for new management
• The personal representatives or beneficiaries of a deceased shareholder do not wish to keep the shares
• There is disagreement over management of the company
When would I be eligible to pay 10% capital gains tax instead of 18% or 28%?
• If you are eligible for entrepreneurs’ relief
• Limited to first £1 million of relevant lifetime gains
• Must hold at least 5% of the shares and have done so for at least 1 year
• Company must be at least 80% a trading company
Can I make sure I qualify for capital gains tax treatment?
• There is an advance clearance procedure. If all of the facts are presented to HM Revenue & Customs, and the actual transaction takes place as presented, a clearance given by the tax authorities will bind them to treat the purchase as giving rise to a gain as opposed to a dividend.
What if I don’t want capital gains treatment?
• If you are a basic rate taxpayer, and dividend treatment would not push you into higher income tax rates, your effective tax rate on a dividend is 0%.
• In such a case you would wish to ensure that you fail one of the tests for capital gains treatment (perhaps by using a staged reduction that fails the ‘substantial reduction’ test.
What is in a purchase of own shares for the remaining shareholders?
• Although they are reducing the distributable reserves of the company (see next slide), the big advantage for the remaining shareholders is that they do not have to pay for the departing shareholder’s shares personally (out of taxed income). Instead they get an increase in their percentage holding simply as a result of the cancellation of the purchased shares.
Is it really that easy to do a purchase of own shares?
• Yes if you have available distributable reserves (i.e un-drawn profits) out of which to fund the purchase. Simply hold a meeting, resolve to make the purchase and do it.
• Not if you don’t have the distributable reserves. Then it gets more complicated, which brings me to the new share capital reduction legislation, introduced with effect from 1 October 2008.
The share capital reduction legislation
• This largely mirrors the procedure required where a purchase of own shares takes place without enough distributable reserves to cover the purchase price, thus requiring a reduction in the company’s capital.
• In such a case the directors are required to make a declaration of solvency prior to the purchase taking place. If it proves that this was made fraudulently or negligently, the directors may find themselves liable for company debts in an insolvency.
When would I want to use reduction of share capital instead of purchase of own shares?
• Where all shareholders want to reduce their share capital, typically where the company has too much share capital for its current and future financial needs. It is important to understand that the capital is repaid at par (i.e. the amount initially subscribed for the shares) so there is no question of any tax arising on a capital reduction.
How does this fit in with efficient winding up of companies?
• There has long been an informal HM Revenue & Customs procedure, whereby a company wishing to be wound up could apply to them for a clearance that distributions to shareholders in a winding up without a formal liquidation would give rise to capital gains rather than dividends, as would normally be the case. However……….
Tax-efficient informal winding up procedure
• The problem for companies with significant share capital was that, technically, that share capital could not be distributed in an informal winding up, and had to be left in the company and lost to the shareholders.
• The ability to reduce share capital means that this can be done immediately before an informal winding up, thus avoiding the loss of that capital. Signing a Declaration of Solvency the day before a company goes into a solvent winding up procedure is not a big risk for the directors!
Summary and Conclusion
If your company:
• Has excessive share capital
• Has a shareholder who wants to leave due to a disagreement, withdraw outside equity funding, retire or has died
• Needs to be wound up but you don’t fancy paying for a formal liquidation……….
• Contact Mark Simpson, Director of Tax Saving on 0161-886-8062 or email@example.com for a tax efficient solution to your problem.