Individual shareholders selling their shares back to the company normally prefer the proceeds from the share disposal to be treated as a capital receipt, where possible. This is because the capital gains tax (CGT) rate is 10% if business asset disposal relief is available, or 20% in most other cases.
Income or capital gain?
However, CGT treatment is subject to several conditions. The default position is that the proceeds from a company purchase of own shares is an income receipt and is liable at income tax rates. If the proceeds are treated as an income distribution (i.e. like a dividend), those tax rates are typically 32.5% and/or 38.1%.
If the taxpayer carries on a trade of dealing in shares, any profits would be liable to income tax, at possible rates of 20%, 40% and/or 45%. However, trading treatment may be appealing if (say) the taxpayer has trading losses available to offset against a profit from the transaction. Trading receipts take precedence over income distributions for tax purposes (ITTOIA 2005, s 366).
Is it a ‘trade’?
Unfortunately, there is little guidance on the meaning of ‘trade’ in the tax legislation (see ITA 2007, s 989). This lack of statutory guidance has resulted in extensive case law over the years.
The ‘badges of trade’ can sometimes be helpful. These were first established by the Royal Commission for the Taxation of Profits and Income in 1955, using previous case law about what constitutes a trade. Subsequently, in Marson v Morton Ch D 1986, 59 TC 381, nine badges were identified. HM Revenue and Customs (HMRC) guidance (in its Business Income manual at BIM20205) lists these badges as follows:
- Profit-seeking motive;
- The number of transactions;
- The nature of the asset;
- Existence of similar trading transactions or interests;
- Changes to the asset;
- The way the sale was carried out;
- The source of finance;
- Interval of time between purchase and sale; and
- Method of acquisition
Not trading
Taxpayers seeking trading treatment on a company purchase of own shares run the risk that the proceeds will be taxed as a distribution if their contention is unsuccessful.
For example, in Khan v Revenue and Customs [2020] UKUT 168 (TCC), the proceeds of a company purchase of own shares (i.e. 98 out of 99 shares) from its sole shareholder almost immediately after his acquisition of the company’s entire share capital from its previous owners was held to be a distribution for income tax purposes, not a trading transaction representing the disposal of trading stock as the taxpayer argued.
Had the taxpayer been successful, he would have made a very small profit on proceeds of £1.95 million. Unfortunately, he was instead faced with a large tax bill on a distribution based on that amount.
Practical point
The First-tier Tribunal in Khan ([2019] UKFTT 204 (TC)) found the summary of the badges of trade in Marson v Morton helpful. However, the badges should not be used as a checklist to conclude whether a trade exists. HMRC’s guidance at BIM20205 also urges caution about relying too heavily on the badges.
The above article was first published in Business Tax Insider (October 2019) (www.taxinsider.co.uk).