The default tax position where an unquoted trading company buys back its shares from an individual shareholder is broadly that the shareholder who sells his or her shares is treated as receiving a distribution for income tax purposes, similar to a dividend. The amount of the distribution is normally the sale proceeds for the shares, less the amount of capital originally subscribed for them (CTA 2010, s 1000(1)).
However, there are special rules which can apply to a purchase of own shares by an unquoted trading company, where certain conditions are satisfied (CTA 2010, Pt 23, Ch 3). If those special rules apply, the shareholder whose shares are bought back is treated as receiving a capital payment for the shares, as opposed to an income distribution. The capital payment will normally be subject to CGT if a capital gain arises. This treatment will generally be beneficial if the shareholder is entitled to entrepreneurs’ relief at 10% on the shares, where the individual would otherwise be liable to the dividend higher rate of 32.5%, or the dividend additional rate of 37.5% if the purchase of own shares was treated as an income distribution.
Regardless of whether the purchase of own shares would otherwise be treated as an income or a capital distribution, the transaction has to satisfy certain company law requirements for it to be a valid purchase of own shares. If the company fails to comply with those requirements, the transaction is treated as void, and an offence is committed which could result in a fine for the company, and possibly imprisonment for its officers (CA 2006, s 658(2), (3)).
The law dealing with the acquisition by limited company of its own shares is in Companies Act 2006, Pt 18. There is a specific chapter in that legislation dealing with a purchase of own shares (Pt 18, Ch 4). The company law requirements are fairly detailed, but the main ones are as follows:
- Power to purchase own shares – A company is not required to have the power in its Articles of Association to purchase its own shares. However, the members may restrict or prohibit a purchase of own shares through the company’s Articles if they wish (CA 2006, s 690).
- Payment for purchase of shares – The shares purchased must be fully paid, and the company must pay for the shares on completion (CA 2006, s 691). However, there is an exception from the requirement for payment upon completion in the case of private companies purchasing shares for the purposes of, or pursuant to, employee share schemes by instalments, with effect from 30 April 2013 (SI 2013/999, reg 3).
- Funding for the purchase – Subject to an exception (below), a company is required to purchase its own shares out of distributable profits, or out of the proceeds of a fresh share issue to finance the purchase (CA 2006, s 692(2)). However, a private company may purchase its own shares out of capital, and using cash without having to identify it as distributable reserves, from 30 April 2013 (following SI 2013/999), subject to certain limits and conditions (CA 2006, ss 692(1); 709–723), e.g. the cash limit must not exceed the lower of £15,000 or 5% of the value of the company’s share capital in each financial year.
- Authority for purchase – A contract for an ‘off-market’ company purchase of own shares must be approved in advance. However, separate conditions apply if the purchase is for the purposes of, or pursuant, to an employee share scheme, with effect from 30 April 2013 (CA 2006, ss 693, 693A). A company may enter into a contract to purchase its own shares if (inter alia) the shareholders approve the contract terms by an ordinary resolution (CA 2006, s 694(2)). Prior to the changes introduced by SI 2013/999, a special resolution was required.
- Disclosure – A copy of any written contract or a memorandum of its terms must be made available to the members. For resolutions at meetings, it must be available for inspection at the company’s registered office for at least 15 days prior to the meeting, and also at the meeting itself (CA 2006, s 696(2)).
- Cancellation of shares – Following the company share repurchase, the relevant shares are treated as cancelled. The company’s share capital is reduced by the nominal value of the cancelled shares (CA 2006, s 706). However, this rule does not apply to treasury shares.
- Inspection of contract – The company must keep a copy of the contract, or a memorandum of its terms, available for inspection for a period of at least ten years from conclusion of the contract (CA 2006, s 702). Alternatively, a copy of the contract (or any variation) may be kept for inspection at an alternative location in the UK to be notified to the registrar (Companies (Company Records) Regulations, SI 2008/3006). The company must notify the registrar of the place where the contract is available for inspection.
- Reporting requirements – A return must be made to Companies House within 28 days, stating the number of shares purchased, their nominal value and the date of purchase (CA 2006, s 707). Other than treasury shares which are not cancelled, the company must also give notification of the cancellation of the shares within 28 days, together with a statement of the company’s share capital (CA 2006, s 708).
As indicated above, a number of changes in the law dealing with share buybacks were introduced with effect from 30 April 2013, by The Companies Act 2006 (Amendment of Part 18) Regulations 2013, SI 2013/999. These changes were made to ease the statutory requirements for purchases of own shares when an employee leaves the company, in relation to ‘employee shareholder shares’, which were introduced in Finance Act 2013, and became available from 1 September 2013. A number of the changes relate to employee share schemes. However, some of them have a wider application to company purchases of own shares generally, including the following:
- There are special company law provisions allowing a private limited company to purchase its own shares out of capital, if certain conditions are satisfied (CA 2006, Pt 18, Ch 5). Subject to those provisions, a company can only purchase its own shares out of distributable profits, or out of the proceeds of a fresh issue of shares. In addition, any premium payable by the company on the purchase (i.e. effectively the shareholder’s profit) must be paid out of distributable profits, with certain restrictions applying to the premium which may be paid out of a fresh issue of shares (CA 2006, s 692). However, from 30 April 2013, a private company can use cash to finance the purchase of own shares, without having to identify the cash as distributable reserves. There is an upper limit on the amount of cash which can be used in this way, which is the lower of £15,000 or the value of 5% of the company’s share capital in each financial year. This change will obviously help companies which would otherwise have insufficient distributable reserves to finance purchases of own shares.
- There are certain company law requirements for shareholders to authorise contracts for share buybacks (e.g. in CA 2006, s 694). Prior to 30 April 2013, the authorisation needed to be passed by a special resolution, which required a majority of 75% of shareholders. However, from 30 April 2013, the authorisation may be given by an ordinary resolution instead. An ordinary resolution only requires a simple majority, i.e. over 50% of the shareholders. There are also special rules for share buybacks in relation to employee share schemes, which provide a further relaxation in the normal rules (CA 2006, s 693A).
Void company purchases
Despite such relaxations, the company law requirements on a share buyback can be difficult to comply with. The rules that the smaller, owner managed companies seem to have particular difficulties with in practice are the requirement for the company to pay for the shares on completion (CA 2006, s 691(2)), and the need for the company to have sufficient distributable reserves, as mentioned above. Sometimes, the rules may be broken because the company, or its professional advisers, were simply unaware of the company law requirements.
What happens for tax purposes if the company law requirements are not met on a purchase of own shares? The answer depends to a large degree on whether the individual whose shares were being bought back is allowed to keep the consideration paid by the company for his or her shares.
In Baker v Revenue & Customs  UKFTT 394 (TC), the appellant, Mr Baker, was a director and shareholder of a manufacturing company, which was incorporated in January 2002. Following a falling out between Mr Baker and his fellow director shareholder, it was decided that the company would buy back Mr Baker’s shares for a total payment (in cash and in kind) of £120,000, that he would resign as a director, and that his employment would be terminated. The company’s purchase of Mr Baker’s shares took place in January 2006. Various cash payments and asset transfers were made during 2005-06.
The latest company accounts available at the time were for the year ended 31 October 2004. Those accounts showed distributable reserves of just over £47,000. The October 2005 accounts were not finalised until six months after Mr Baker left the company, and showed distributable reserves of nearly £51,200.
HMRC opened an enquiry into Mr Baker’s 2005-06 tax return, and subsequently concluded that Mr Baker had received an income distribution of £120,000 from the company. An appeal was lodged, after which Mr Baker’s accountants wrote to HMRC pointing out that the purchase of own shares was in breach of company law, and was therefore void. HMRC refused to be drawn into an argument about company law, and confirmed their assessment of £120,000 as an income distribution. The case therefore proceeded to the First-tier Tribunal.
The Tribunal’s view was that the share buyback breached company law, for two reasons. First, the agreement provided for the payments of deferred consideration, whereas company law requires that the company must pay for the shares on completion (CA 2006, s 691(1)). Secondly, the company had insufficient distributable profits for the transaction. So the question arose how the company’s payment of £120,000 to Mr Baker should be dealt with. Should it be an income distribution as HMRC contended? The Tribunal concluded that the purchase of own shares by the company, and the company’s obligation to pay for Mr Baker’s shares, were void due to the breaches in company law. Mr Baker was therefore under an obligation to return the cash and assets he received for his shares to the company. This meant that there was no income distribution for tax purposes. Mr Baker’s appeal was allowed.
Proceeds not recoverable
An interesting point in this case is that in reaching its decision, the Tribunal considered an earlier (non-tax) case involving a company purchase of own shares in which there had also been a breach of company law, where it was held that although the purchase was void, the sale proceeds were not recoverable from the departing shareholder.
In that case, Kinlan and anor v Crimmin & Anor  EWHC 779 (Ch), the company had gone into liquidation, and the liquidators made a claim against a Mr and Mrs Crimmin for monies paid by the company on a share buyback. The liquidators claimed that the share buyback breached company law. The terms of the transaction were that the company would make a lump sum payment to Mr Crimmin, with the balance payable over eight years by way of consultancy fees. Following the agreement, Mr Crimmin had no further role in the company as a shareholder, and no involvement in the company’s affairs.
In the High Court, it was held that the share buyback was void. The company did have sufficient distributable reserves for the share buyback. However, company law also required that on a company purchase of own shares, the terms of the agreement must provide for payment on completion. In this case, part of the consideration was payable by instalments, which breached company law. However, the Court also held that the liquidator could not recover the payments for Mr Crimmins’ shares. This was due to two “important and unusual features” in this case. First, if the parties had been aware of the company law requirements, they could have changed the terms of the agreement so that the company paid for the shares in full on completion. Secondly, Mr Crimmin had given up his rights as a shareholder and director on the basis that the share buyback was valid. Had he realised that the money was recoverable, Mr Crimmin would have wanted to consider how to protect his interest in the company. The claims against Mr and Mrs Crimmin were dismissed, and the proceeds for the shares were not recoverable.
Why did the Tribunal in Mr Baker’s case decide that he had to repay the company for his shares, instead of following the High Court decision in Mr Crimmin’s case? The reason was broadly because of differences in the facts of the two cases. For example, the company in Mr Baker’s case had insufficient distributable reserves to buy back the shares, whereas in Mr Crimmin’s case the company did have sufficient reserves. The breaches of company law in Mr Baker’s case were therefore more material. In addition, the tribunal in Mr Baker’s case held that even if the parties had been aware of the company law requirements, they would not have been able to alter the agreement to comply with those requirements, mainly because of the insufficient distributable reserves.
So the end result in Mr Baker’s case was that he had to repay the proceeds for his shares back to the company, whereas in Mr Crimmin’s case, he could keep the money despite the share buyback being void under company law. How would HMRC treat these different situations for tax purposes? HMRC guidance on a company purchase of own shares is included in the company taxation manual. CTM17505 simply states that if a purchase is invalid, the shares are not treated as cancelled and legal ownership remains with the vendors. It also states that the tax treatment following from an invalid purchase of own shares depends upon the actions taken (if any) to rectify matters.
There is some general HMRC guidance on distributions and company law at CTM15205. In the context of unlawful dividends, it points out that a recipient who knows or has reasonable grounds to believe that a distribution is unlawful is liable to repay it to the company. The shareholder in those circumstances holds the dividend as constructive trustee for the company. This means that there is no distribution for tax purposes, because the company has not parted with the funds. If the company is a close company, HMRC would treat the company as having made a loan to a participator, and a tax charge may arise under CTA 2010, s 455, subject to possible relief if the funds are repaid to the company. In addition, although not mentioned in HMRC’s guidance, if the recipient is also a director or employee of the company, there would probably also be a benefit in kind as a beneficial loan under ITEPA 2003, s 175.
In the Baker case, the tribunal confirmed that Mr Baker became a constructive trustee in respect of the cash and assets paid to him on the void purchase of own shares, so the potential tax treatment would seem to fall in line with HMRC’s guidance at CTM15205.
That guidance also indicates that there is no liability to repay the company if the shareholder is an innocent recipient of the funds. In that case, there will be no constructive trust, and HMRC will treat the individual as having received a distribution for tax purposes under CTA 2010, s 1000(1)(B). This would be the likely tax treatment for Mr Crimmin in the case mentioned earlier. If the shareholder then decided to repay the company, in HMRC’s view the shareholder would simply be making a voluntary transfer of funds, which would not affect the tax position.