For example: A client is a director and shareholder of a civil engineering company. He would like to retire from the business and hand over to his son who is currently a minority shareholder. His son does not have the cash to buy his father’s shares directly, however, the company is cash rich. Is it possible to use the cash in the company? What are the tax consequences?
In this situation where the company has sufficient cash, it would be appropriate to consider the rules for purchase of own shares. The Companies Act 2006 provides authority for a company to buy back its own shares, subject to various conditions. Such a purchase would normally be classified as a distribution for an individual shareholder however provided specific conditions are fulfilled, certain payments on the redemption or repurchase by a company of its own shares will not be treated as distributions for individuals. Most buybacks will, therefore, result in an income tax charge arising on the distribution, and to the extent that the proceeds exceed the repayment of share capital an income tax charge will arise at the shareholder’s marginal dividend rate.
Where relevant conditions are met, the company purchase of own shares would not be considered an income distribution and capital treatment would apply. Therefore, the client would be realising a capital disposal and potentially be able to take advantage of a claim to entrepreneur’s relief and as such reduce the tax charge to 10%.
Capital treatment can only apply to unquoted trading companies (or unquoted holding companies of trading groups). The buy-back must also be for the benefit of the trade and it must not be for the avoidance of tax. The ‘benefit of a trade’ requirement can be particularly subjective and HMRC have offered guidance on this point. A shareholder looking to exit a business may fall within the definition of ‘for the benefit of the trade’.
There are further conditions to be met and all of these conditions must be met for capital treatment to apply.
The first condition is that the individual selling his shares must be UK resident in the tax year of the buyback.
The shareholder must also have held his shares for five years prior to the buy back. If the shares were received from a spouse or civil partner the length in ownership is the aggregate. This period is reduced to three years if the shares were acquired by will or intestacy.
The purchase of the shares must substantially reduce the seller’s interest in the company. An interest is taken to be substantially reduced if it is not more than 75% of the seller’s interest prior to the transaction taking place.
Immediately after the transaction, the seller must not be connected with the company making the purchase. A person is connected with the company where they, together with their associates, hold 30% or more of the issued ordinary share or loan capital, including 30% of the voting rights or rights to assets on a winding up.
Where all of the above conditions are satisfied, the receipt is not an income distribution. Instead, the price paid by the company for the shares will be the proceeds for capital gains tax purposes. Should entrepreneur’s relief apply, the gain will be taxed at the reduced rate of 10%.