Business protection - Shareholder protection – Company buyback of own shares

A company buyback of shares is a popular route for shareholder exits. What are the legal and tax implications?
Key facts
  • Requires company owned plans on the lives of the shareholders. 
  • Premiums should be non-allowable and proceeds tax free. 
  • Companies Act legal requirement to be met before a valid buyback can be effected.
  • When the company pays out the proceeds to a critically ill shareholder or their estate, this may be treated as a dividend or as a capital amount. The specific circumstances will determine which treatment will apply. There are procedures for advance clearance.
  • No need for premium equalisation.
  • Option agreement usually needed.

Under this method, first permitted in 1981, the company will take out plans on each of the shareholders taking part. The company will be the owner and the shareholders will be the people covered. The plans are life of another and no trusts are needed. The Companies Act 2006 legal requirements must then be satisfied before the buyback can take place.

The company will pay the premiums and get the proceeds of the life and/or critical illness plans on the shareholders’ lives. The company can then use these proceeds to buy the shares from a shareholder who has died or become critically ill.

An appropriate cross option/single option type agreement should be in force between the company and the outgoing shareholder or their legal personal representatives. Given that various Companies Act requirements have to be met before the buyback can proceed, the option agreement will have less certainty than an agreement between individual shareholders.

Example

Five Engineering Ltd has an authorised share capital of 100 shares, issued as follows:

  Shares
Scott 20
Mark 20
Kris 20
Katie 20
Lorna 20
Total 100

The company takes out five Life or Critical Illness plans on each of the shareholders. Scott dies and the company buys back his shares from his estate and in the process cancels them. The situation is now as follows: 

The authorised share capital of Five Engineering Ltd remains 100. This now comprises: 

 Issued shares 80
Unissued shares 20
Total 100
  Shares
Mark 20
Kris 20
Katie 20
Lorna 20
Total 80

Before the scheme buyback, each shareholder had a one-fifth interest (20/100). This has now increased to one quarter (20/80). The 20 cancelled shares may be re-issued in the future if needed. This also highlights a potential problem with the company buyback solution where there is a shareholder, for example a private equity investor, who has a stake but doesn’t want to increase that shareholding.

In that case, if the plans were instead set up as own life under business trusts, that investor could be removed as a potential beneficiary of the trusts so that their shareholding remains constant while the others are involved in purchase/sale of shares.

Why is this potentially tax efficient?

If the company is the plan owner, then although the premiums won’t be eligible for corporation tax relief, they won’t be taxable as a benefit in kind on the person covered. This is in contrast to the situation where shareholders take out own life plans and the company pays those premiums. In this case, the premiums paid will constitute benefits in kind for the individual.

Will the proceeds be subject to corporation tax?

The proceeds should not be subject to corporation tax because the plan is being taken out for a capital rather than trading purpose. For more on the taxation of Life or Critical Illness Cover proceeds received by companies, see the key person section at the start of this guide. We recommend companies seek advice from their own legal advisers.

Legal requirements

The Companies Act 2006 sets out specific requirements to be met for a valid buyback of shares. The key points are summarised:

  • The company’s articles of association mustn’t prevent the purchase.
  • On purchase, the shares must be treated as cancelled and the company’s issued share capital (although not its authorised share capital) must be diminished by the nominal value of those shares.
  • Most purchases will be ‘off market’ (that is, broadly those not purchased on a recognised investment exchange). As such, any contract must be authorised or a proposed ‘contingent purchase’ must be approved in advance by a special resolution. A ‘contingent purchase’ contract is a contract under which the company may become entitled or obliged to purchase the shares. In other words, a type of option agreement.

    A special resolution requires a 75% majority by those entitled to vote who do so in person (or by proxy, if allowable) at a general meeting.
  • A private company must use distributable profits to purchase the shares before it can resort to capital.

Extra safeguards are needed if the purchase is to be made out of capital. For example, where the purchase is funded from protection plan proceeds. The company’s accountant should be able to confirm the correct treatment at the time of any purchase. If a purchase using the plan proceeds is to be treated as a capital payment, the requirements can be summarised as follows:

  • The directors must make a statement in accordance with section 714, specifying the amount of the capital payment for the shares in question and stating that the payment can be made without prejudice to the company’s creditors. In particular, they must confirm that they can see no grounds on which the company would be unable to pay its debts or continue as a going concern for a period of at least one year after the purchase. This statement must be accompanied by an auditors’ report backing it up.

    The statement should be delivered to the registrar of companies no later than the notice date specified below. This could be a significant issue to take into account when considering the company purchase route since he proceeds of any plan paid to the company on the death of a shareholder may be treated as a capital receipt.

    The requirement for a statutory statement could mean that when the sum assured is paid, it has to be used for purposes other than share purchase, thus thwarting the purpose for which the plan was set up.
  • A special resolution authorising the purchase of the shares out of capital with the approval of 75% of the remaining members present and voting should be passed within one week of the statement.
  • Within one week of the special resolution, a notice must be placed in the Gazette making creditors aware that the payment out of capital has been approved. The creditors may apply to the court to cancel the resolution. At the same time, a similar advertisement has to be put in a national newspaper or written notice given to each creditor and a copy of the statement and the auditors’ report must be delivered to the registrar of companies. Where a company has substantial debts, its creditors may well object to the company capital being spent on share purchase if this could, in their view, prejudice their interests.
  • The share purchase must take place between five and seven weeks from the date of the special resolution authorising it.
  • Form SH03 – Return of purchase of own shares – must be completed and delivered to the registrar of companies within 28 days from the date shares purchased by the company are delivered to it.

For full details of these requirements see part 18, chapters 4 and 5 of the Companies Act 2006.

Tax treatment of the sale and purchase of the shares

The tax treatment of buybacks is unusual as the rules treat the buyback payment as a distribution (that is, a dividend) unless the payment falls within s1033 Corporation Tax Act 2010  in which case the buyback will represent a disposal for CGT purposes.

If the dividend treatment applies, any excess proceeds received over the original subscription price will be treated as investment income. This means higher rate income tax liabilities could therefore arise on the critically ill shareholder or their beneficiaries in the event of their death.

However, if the conditions are met for the CGT treatment to apply, then the excess over the original subscription price will give rise to a capital gain. There are advantages to this:

  • If shares are bought back after death, then they will have been revalued which means that any capital gain is generally eliminated, unless the proceeds received exceed the market value at date of death.
  • If shares are bought back on critical illness, then the outgoing shareholder may mitigate the gain with any available entrepreneurs’ relief and any annual CGT exemption.

Conditions to be satisfied for capital treatment to apply.

  • The company must be an unquoted trading company or the unquoted holding company of a trading group. This must be the case when the purchase is taking place. Investment companies, including those dealing in shares, securities, land or futures are excluded.

  • The purchase is made wholly or mainly for the purpose of benefiting the trade carried on by the company or any of its 75% subsidiaries. HMRC guidance on the trade benefit test can be found in HMRC Statement of Practice 2/82. It includes the examples of when the test may be satisfied summarised below:
    • Resolution of a disagreement between the shareholders over management that’s having or is expected to have an adverse effect on trade.
    • Withdrawal of equity finance by an outside shareholder.
    • Retirement of a controlling shareholder who is retiring as a director and wants to make way for new management.
    • Death of a shareholder when the personal representatives want to sell the shares.

Or

  • The purchase is made wholly or mainly for the purpose of benefiting the trade carried on by the company or any of its 75% subsidiaries. HMRC guidance on the trade benefit test can be found in HMRC Statement of Practice 2/82.. It includes the examples of when the test may be satisfied summarised below: 

  • The company must be an unquoted trading company or the unquoted holding company of a trading group. This must be the case when the purchase is taking place. Investment companies, including those dealing in shares, securities, land or futures are excluded.
  • However, if the seller keeps a small holding (not exceeding 5% of the issued share capital),  say for sentimental reasons, this should not in itself cause the loss of the capital gains tax treatment.
  • The transaction shouldn’t be part of a scheme or arrangement made to avoid tax.
  • The seller must be resident and ordinarily resident in the UK in the year the purchase is made.
  • The seller must have held the shares for at least five years. If the personal representatives are selling the shares, the qualifying period is reduced from five to three years. This may be an important issue where shareholders of a newly started company are planning share purchase protection.
  • The seller’s shareholding must be substantially reduced. This test is satisfied if the fraction of the company’s issued share capital owned by the seller is reduced by more than 25% as a result of the sale. It’s not enough merely for the seller’s shareholding to be reduced by 25%.
  • After the sale, the seller mustn’t be connected with the company. This, together with the benefit of trade  requirement, generally means that the seller can’t merely sell off a few of their shares.

Under s1044 Corporation Tax Act 2010, there’s a procedure for getting advance clearance to be obtained from HMRC that the capital treatment will apply.

Following share purchase, the company must make a return to its inspector (under s1046 Corporation Tax Act 2010) if it has bought its shares back under the capital procedures. This must be done within 60 days of purchase regardless of whether clearance was requested.

Effect on share values

The plan proceeds and corresponding increase in the company’s assets could clearly increase the company’s share value.

However, it could be argued that losing a key person would have a downward effect. Whatever price may be specified by the option agreement, for inheritance tax purposes, the payment of a sum assured is a change occurring by reason of the death of the person covered.

The result is that the sum assured would be an asset of the company for the purposes of share valuation on the death of a shareholder (S171 IHTA 1984). Indeed, at any given time, the market value of the plans effected by the company would be included among its assets. Specimen option agreements should specify that the purchase price should be the value of the shares immediately before death. This means that only the market value of the plan would be included in the company’s assets.

This could be substantial if the person covered were in ill health at the time. Subject to any professional advice, the agreement should specify that the purchase takes place at market value as it’s possible that a sale at any other price could result in HMRC withholding clearance.

Any inheritance tax consequences would usually be minimised or completely avoided due to business property relief.

How do you make sure that the company will use the proceeds to buy back the shares or that the family will sell?

You could use some form of shareholder agreement (as with own life in trust and life of another plans).

What can you do to help?

Sample cross option agreements specifically drawn up for company share purchase are often offer by provider but they not intended for signature but instead should be used as a working document which the company solicitors can use to prepare an agreement specific to the clients’ particular circumstances.

Note 

The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.

All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.

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Last updated: 14 Jan 2019

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The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.