Buying back shares in close companies
When someone wants to retire or leave a family business and step down as a director/shareholder of a family business for whatever reason, he or she and the other shareholders or directors need to think how this can be achieved. And can it be achieved in a tax efficient manner?
Of course, a Shareholders’ Agreement (if there is one) or the Articles may provide for shares to be offered to the remaining shareholders. But what if none of them has the available cash to buy the shares and/or they just don’t want to buy the shares?
Often, the obvious solution, if the Company itself has the money to do this, will be for Company to buyback its own shares. This will mean that the exiting shareholder (let’s call him the Seller) receives consideration for his or shares and cash is extracted from the business. The Seller’s shares are cancelled which means that the remaining shareholders post buy back will own a larger share of the cake.
The Seller will probably expect to pay capital gains tax on the gain in value since he or she acquired them (so capital gains tax at 20% on the gain, after taking into account any available annual CGT allowance – currently £12,300). And the Seller may also want to claim Business Asset Disposal Relief (previously Entrepreneur’s Relief) (BADR), assuming the requirements for this are satisfied reducing the rate to 10% for the first £1m.
But beware! The transactions in securities rules may mean that the consideration received may be subject to income tax at up to 45% for a higher rate taxpayer. And, if that is the case, there will be no Business Asset Disposal Relief to reduce the tax liability.
Example of how a buy back works
Imagine there are 4 shareholders each owning 20 shares – 20% each. The company has cash reserves built up of £1 million. One shareholder who has held his shares for 10 years retires – Seller. The Seller’s shares are bought back for £600,000 and cancelled. The Company’s issued shares will reduce from 80 shares to 60 shares of which the 3 remaining shareholders will each hold 20%. Providing the transaction in securities (TIS) rules do not bite the Seller will pay capital gains tax on the £600,000 payment to buy back his shares.
Transactions in Securities Rules (TIS)
The transactions in securities rules (known as the TIS Rules) are intended to prevent tax avoidance. In particular, they are intended to prevent taxpayers from obtaining a more favourable tax treatment for example by paying CGT rather than income tax.
Do the transactions in securities TIS Rules always apply on a buyback of shares in a family company? The answer is no not always – but the rules as to when they will and won’t apply upon a share buy back is not straightforward.
When the transactions in securities rules (TIS) will apply
The circumstances where taxpayers need to watch out for the transactions in securities rules biting are explained briefly below. The key points to remember are:
- TIS rules only apply to close companies;
- HMRC have to show that the main purpose of the transaction was to obtain a tax advantage
The TIS Rules may apply where a company is for tax purposes a “close company”, that is where the company:
is UK resident; AND
it either has five or fewer “participators” (let’s call them shareholders) OR any number of shareholders all of whom are directors; AND
the shareholders either “control” the Company (as defined in the relevant legislation – so the meaning could be wider than you expect) OR are entitled to acquire or receive to receive the greater part of the assets available for distribution among shareholders if the company were to be wound up.
So, in fact, most family run companies and small companies are “close companies”.
Obtaining a tax advantage
The second test for the transaction in securities rules to apply is where the main purpose, or one of the main purposes, of the transaction is “to obtain a tax advantage”. For these purposes the advantage is paying CGT rather than income tax and benefiting from the much lower rates of tax and in some circumstances you be able to reduce your liability further if you qualify for Business Asset Disposal Relief (formally called entreprenuers’ relief).
Does this mean that a buyback of the Seller’s shares in a close company (family or small company) will always be caught? Fortunately, this is not the case. There are some exemptions which may save the day.
Cash outside of the TIS Rules
The transaction in securities TIS Rules will not apply if it can be shown that the following circumstances apply:
1. There has not been a fundamental change of ownership
A transaction which leaves the Seller and any of the Seller’s “associates” (see the very broad definition of associates) controlling less than 25% either directly or indirectly of share capital, dividends or votes in a close company will fall outside of the TIS rules.
For these purposes “associates” means broadly speaking, spouses, parents, children, siblings, business partners, trustees of a settlement where the participator was the settlor or a beneficiary, companies controlled by the Seller or any associates etc.
2. If there are genuine commercial reasons for the transaction
Essentially, this means if HMRC wanted to challenge the transaction and assess consideration to income tax rather than capital gains tax HMRC would need to establish there was no genuine commercial reason for the transaction. We do see the HMRC accept as genuine transactions as a result of a dispute, divorce, retirement, a change in direction of the business so that the input of the relevant shareholder/director are no longer required.
3. If the transaction is carried out in the ordinary course of making o managing investments
Again, this aim is to show that there is a reason for the doing the transaction which is not primarily to get a tax advantage.
Are your reasons good enough for HMRC
To get certainty as to whether HMRC accepts that your reasons for buying back the Seller’s shares in a close company are genuine commercial reasons, it is possible to apply to advance clearance from HMRC. HMRC will want to see the paperwork. Tempting as it is to cut corners paperwork such as board minutes and evidence of the background reasons for the transaction should be kept.
Blue box – Getting caught under the transactions in security rules (TIS) is nasty for close company shareholders. Tax assessments of up to 45% plus in some case national insurance can be raised instead of the expected assessment to capital gains tax at 10% or 20%. The safest option is to apply to HMRC for advance clearance before entering into the transaction. We do deal with these applications so please do get in touch.