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Share buybacks and deferred consideration

How to structure a share buyback that is both affordable to the Company and allows favourable tax treatment for the seller.

Why a share buyback?

Share buybacks can be a great way for a company to return capital to its shareholders thereby increasing earnings per share. Alternatively and most usually they are a way of buying out a retiring or recalcitrant shareholder.

There are tax advantages in structuring a deal as a share buyback. This isn’t a tax scheme, there is no commission or marketing fees payable, instead it’s a method well recognised and accepted by HMRC. The remaining shareholders don’t have to use their own funds to buy out the leaver. In other words the funds have not already been subject to tax.

Whilst remaining shareholders have the opportunity to save tax, the seller can ensure he benefits from entrepreneurs’ relief, which reduces tax to 10% on the first £10m of consideration for qualifying persons.

Structuring the deal in the most tax efficient way for both sides.

Gaining a preferable rate of tax on both sides is important for all parties trying to negotiate the exit of a shareholder.

Deferred consideration is not permitted in share buybacks under the Companies Act 2006, therefore, the ambition of both sides to find an equitable tax efficient deal can often be frustrated where the Company does not have enough cash to pay the departing shareholder in one go.

However, it is not often appreciated that it is possible to structure a deal where monies are paid in tranches in-spite of the above rule and other provisions set out below.

Making sure the buyback consideration is treated as Capital not income.

Making sure the buyback consideration is treated as Capital not income means the seller (if he is a higher rate tax payer) is likely to pay tax at a 10% rate instead of up to 38.1%. Unless the conditions in CTA 2010 ss1033-1034 are satisfied, a seller of shares back to the Company will not be eligible for capital tax treatment. In essence the requirements are:

The company must be an unquoted trading company or the unquoted holding company of a trading group;

  • The buyback must be made wholly or mainly for the purpose of benefiting a trade carried on by the Company (for more on the trade benefit test see below);
  • The selling shareholder must have held his shares for at least 5 years and be a UK resident in the year the shares are sold;
  • The sellers post sale interest as a shareholder and his entitlement to a share of the profits must not be more than 75% of the pre-sale entitlement (the Substantial Reduction Test);
  • Immediately after the purchase the seller must not be connected to the Company or any other group company (a person will be connected if he has or is entitled to acquire 30% or more in the issued ordinary share capital or voting rights).

The “Trade Benefit” Test

HMRC has offered guidance in respect of the trade benefit test.  The test is not as restrictive as it might initially appear. HMRC have given the following examples of where the trade benefit test will be deemed satisfied:

  • If there is a disagreement between shareholders which is having an adverse effect on trade and the effect of the buyback would be to remove a shareholder (and therefore the dispute) entirely;
  • An unwilling shareholder (such as an investor or retiree) wishes to sell his shares and the other shareholders wish to prevent him from selling to a third party who may not be desirable to the ongoing business.

Avoiding the effects of the Substantial Reduction Test

Buyers and Sellers must ensure there is a single unconditional contract entered into by the Company and the Seller. In it the Seller must ‘dispose’ of his entire beneficial interest in the shares on the date the contract is entered into. The payment as regards the buyback of the shares may then take place on a series of successive dates.

The downside

The Seller will have to account for tax at the 10% rate on all the consideration in the year the deal is done. The date for payment of the tax can be greatly extended if the deal is completed at the start of a tax year.

Peace of mind HMRC Clearance.

A carefully drafted advance clearance should always be submitted to HMRC in advance of any payment being made in respect of any buyback, to give the parties that crucial comfort that the buyback will not be treated as a distribution.

ORJ Solicitors work closely with tax experts to ensure that any transaction is structured in the most tax efficient way.  We believe in providing answers not problems to getting you and your business where it needs to be.

If you would like to speak to someone concerning share buybacks or any other company matter, please contact Lorraine Smith on 01785 223 440 or email Lorraine.smith@orj.co.uk