13 January 2020
This note covers main tax issues on proceeds from off-market share buybacks that generally, unless otherwise stated, includes share redemption and pays a special attention to property companies.
One of the main issues for an investor when acquiring a target company or business is how to finance the acquisition. Equity finance, which involves issuing new shares to existing shareholders and/or third party investors, is one of the main sources of funding. For example, a company may issue redeemable shares, i.e. shares that are to be redeemed or are liable to be redeemed by the issuing company either at its option or option of the holder.
Companies may also use redeemable shares as a mechanism for returning surplus capital to shareholders, as an alternative to a share buyback. The advantage of a redemption over a share buyback is that the company will not have to pay stamp duty on the value of the redeemed shares.
Generally, if the company redeems the shares without liquidation the accumulated interest would be taxed as income, i.e. subject to income tax for individual shareholders and corporate tax for corporates. However, if the certain conditions are met the conversion of income to capital may be possible whereas the latter is subject to capital gains tax. Care should also be given to the tax reliefs.
Distributions in case of the solvent liquidation of the company are treated as gains, i.e. subject to capital gains tax. Due to this treatment in certain cases equity financing structured through the issue of redeemable shares may be viewed as a beneficial substitution of loan financing (see below).
Taxation: overview
General tax treatment
For tax purposes the purchase price in case of share buyback is divided into a capital and a distribution elements.
As a general principle, the capital element is represented by the par value paid for the shares and any premium payable on their purchase (1003 CTA 2010, Part 4 of the Income Tax (Trading and Other Income) Act 2005 ). Once the capital element has been identified it is taxed as a capital, i.e. subject to capital gains tax (CGT).
Any excess of the buyback price paid to a shareholder is recognised as a distribution and treated as income for tax purposes, i.e. subject to income tax for individual shareholders and corporate tax for corporates.
Comparison of distribution and capital treatment
Individual shareholders. Generally, individual shareholders prefer capital treatment as the rate of CGT chargeable on gains is 10% for basic rate taxpayers and 20% for the rest subject to possible reliefs if the conditions are met. Carried interest gains and residential property gains that do not qualify for principal private residence relief are recognized as "upper rate gains" and falls under 18% and 28% tax rates.
Income tax rates are significantly higher and dividend tax rate may reach up to 38,1% although subject to possible tax reliefs provided the conditions are met.
Corporate shareholders. The situation is different with corporate shareholders as they usually prefer distribution treatment. Gains obtained by a UK company is subject to corporation tax whereas distributions are recognized as dividends and fall within a number of exemptions. The exemptions are broadly drafted and the general effect of the rules is to exempt all dividends from corporation tax unless they fall within certain anti-avoidance rules.
Exemptions
Capital treatment
In case of purchase by the company of its own shares capital treatment is available on the distribution, i.e. the excess over the par value paid falls under CGT, when the company that purchases its own shares satisfy the following conditions:
Unquoted status. The company is recognized as quoted if its shares (or any class of the shares), including stock, are listed in the official list of a stock exchange. The company also should not be a 51% subsidiary of a quoted company.
Trading status. The company has a trading status when its business consists wholly or mainly of carrying on a trade. Care should be given as HRMC states) that a trade does not include dealing in shares, securities, land or futures.
Purpose test. The purpose test is satisfied when any one of the next condition is met:
the redemption must be made wholly or mainly for the purpose of benefiting the trade carried on by the company or any of its 75 % subsidiaries and it should not form part of a scheme where the main purpose or one of the main purposes is either to enable the UK shareholder to participate in the profits without receiving a dividend or the avoidance of tax; or
the whole, or nearly all, of the purchase money are to be applied by the shareholder in paying a liability for inheritance tax charged on a death, within two years after the death, where the tax so paid could not otherwise have been paid without undue hardship.
Distribution treatment: shares in property company
If a company derives its value directly or indirectly from land the shares in such company can be recognized as “property deriving its value from land” (Section 356OR(2), CTA 2010) and covered by the transactions in land rules. The rules do not apply to a profit or gain so far as it is brought into account as income in calculating profits (of any person) for corporation or income tax purposes.
Where a person realizes a profit or gain from a disposal of the property which (at the time of the disposal) derives at least 50% of its value from UK land then the proportion of income attributable to the land is treated as trading profits of the beneficiary company. This condition does not make a distinction between land held as an investment and trading stock. Account is to be taken of any method, however indirect, by which any property or right is transferred or transmitted, or the value of any property or right is enhanced or diminished. References to "profits or gain" include a loss (section 356OF, CTA 2010).
The corporation tax is chargeable if both of the following conditions are met:
the person is a party to, or concerned in, an arrangement concerning some or all of the UK land
the main purpose, or one of the main purposes, of the arrangement is to deal in or develop the project land and realise a profit or gain from a disposal of the property deriving its value from that land.
If it is necessary to determine the extent to which the value of any property or right is derived from land the value may be traced through any number of companies, partnerships, trusts and other entities or arrangements (section 356OM(1), (2) and (4), CTA 2010). The property of a company, partnership or trust are attributed to the shareholders, partners, beneficiaries or other participants.
It does not matter whether the person (“P”) realising the income realises it for P or another person. If, for example by a premature sale, a person (“A”) directly or indirectly transmits the opportunity of realizing a profit or gain to another person (“B”), A realises B's profit or gain for B (section 356OS, CTA 2010).
Reliefs relevant in case of capital treatment
Substantial Shareholding Exemption (SSE)
The effect of the substantial shareholding exemption (SSE), is that any gain of a corporate seller on the disposal of shares is not chargeable to tax and any loss is not available to be set off against gains. There are, in fact, four exemptions – one main and three additional exemptions that together constitute SSE.
The main exemption provides that the exemption is applicable if both of the following conditions are satisfied:
The seller has owned a "substantial shareholding" (broadly speaking, a minimum of 10%) in the company. Notice should be given to the time requirement that is generally a continuous 12-month period beginning not more than six years before the day on which the disposal takes place.[1]
It is a trading company or a holding company of either a trading group or a trading sub-group throughout the period beginning with the start of the latest 12-month period by reference to which the substantial shareholding requirement is satisfied and ending with the time of disposal.
It is recognized by HMRC that a company engaged in property development is capable of being a trading company. However, in case of purchase by the company of its own shares care should be given to the fact that HMRC do not recognized as a trade dealing in shares, securities, land or futures.
The first (1) additional exemption applies where the requirements for the main exemption are met and a company disposes of an asset related to shares in the company in which the substantial shareholding is owned. For example, this would cover options over, or securities convertible into, shares in the investee company.
The second (2) additional exemption relates to the disposal of both shares and related assets where the condition for the main exemption is not met at the time of the disposal, but a disposal within the previous six years (for disposals before 1 April 2017, two years) would have qualified for the main exemption and all of the following conditions are satisfied:
The seller meets the "substantial shareholding requirement" at the time it disposes of shares in the purchaser.
A gain on the disposal would be a chargeable gain or an allowable loss.
At the time of the disposal, the seller is UK resident or any gain arising on the disposal would form part of its chargeable profits for UK corporation tax purposes.
A gain on a hypothetical disposal of shares in the purchaser by the seller or a company in the same group would not have been a chargeable gain (Paragraph 3, Schedule 7AC, TCGA 1992).
The third (3) additional exemption (Section 28, Finance (No. 2) Act 2017) applies in relation to investing companies (A) that are wholly or partly owned by Qualifying Institutional Investors (QIIs). QIIs include pension schemes, life assurance businesses, sovereign wealth funds, charities, investment trusts, authorised investment funds, and exempt unauthorised unit trusts.
If the investing company is not a "disqualified listed company" and QIIs own 80% or more of its shares, then the whole of the gain that the company (A) realises on the sale of shares in the investee company (B) is exempt. If QIIs own at least 25% but less than 80% of its shares, the gain that company (A) realises on the sale of (B) shares is reduced by the percentage of the QII shareholding in (A), for example: a gain accruing to a seller that was 60% owned by a QII would be 40% chargeable. Application of the exemption may be more complicated if the QII has an indirect shareholding in the investing company (A). There are also more beneficial conditions for large investments of at least £20 million.
Entrepreneurs' relief (ER)
The result of the entrepreneurs’ relief[1] is the reduction of the tax rate to 10%. Provided that certain conditions are met the relief applies to qualifying gains (after deduction of any related losses) up to a lifetime limit (currently £10 million). The gains are recognised as qualifying if they are made on disposals of the following assets ("qualifying business disposals"):
Shares in or securities of a trading company.
It is also necessary to check that the company’s non-trading activities are not substantial. Care should be given to shareholding – it is generally required at least 5% of the company's ordinary shares and voting powers to be held for at least a year (two years with effect from 6 April 2019) - and the employment (either full time or part time) requirements are satisfied.
The transfer of the whole or part of a business as a going concern provided that the business has been owned by the individual for at least one year ending with the date of the disposal. A business is any trade, profession or vocation conducted on a commercial basis and with a view to the realisation of profits. Shares held for investment purposes or assets not used for the purposes of the business, will not qualify for relief (section 169L (4),TCGA 1992).
Assets in use on the cessation of a business, i.e. disposal of (or of interests in) one or more qualifying assets used for the purposes of a business at the time when it ceased to be carried on, provided both of the following conditions are met (1) the business has been owned by the individual (whether as a sole trader or in partnership) throughout the period of one year ending with the date on which the business ceases to be carried on, and (2) that business ceased to be carried on three years before the date of the disposal (Section 169I (2)(b) and (4) and section 169L, TCGA 1992).
Associated disposals of personal assets.
Capital Gains Tax may be charged on a disposal when a person sells an asset or gives it away. Provided that certain requirements are met a disposal by a partner or a shareholder of a personally-owned asset that is used by the partnership or by the company may also benefit from relief. There are also rules that restrict relief if (*) the asset was used in the business for only part of the period the asset was owned by the individual; (*) the individual was involved in the business for only part of the period during which the asset being disposed of was used in the business; and (*) the asset being disposed of was used in the business in return for the payment of rent. In these circumstances ER will only be given to the extent that the rent charged was less than market value.
Investors’ relief
Investors’ relief[1] (also known as entrepreneurs’ relief for long-term investors) (sections 169VA to 169VY, TCGA 1992) reduces the applicable tax rate to 10%. This is a separate lifetime allowance that enables shareholders to benefit from the same reduced rate of CGT as in entrepreneurs' relief. Provided that certain conditions are met the relief applies to chargeable gains (after deduction of any allowable losses) on the disposal of qualifying shares or of an interest in shares up to a lifetime limit (currently £10 million). The shares are recognized as qualifying when all of the following conditions are met:
The shares are fully paid (at the time of an issue) ordinary shares that were issued to the investor in return for cash on or after 17 March 2016.
The company is, and has been since the date the shares were issued, a trading company or the holding company of a trading group.
At the time the shares were issued, none of the shares in the company were listed on a recognised stock exchange.
The shares have been held by the investor continuously from the date of issue and for at least three years from 6 April 2016.
The investor subscribed for the shares for commercial reasons by way of a bargain at arms' length, and not as part of any scheme or arrangement the main purpose, or one of the main purposes, of which was the avoidance of tax.
Neither the investor, nor any person connected with the investor is, or has at any time from the date the shares were issued been, a "relevant employee" (broadly, includes all officers and employees other than business angels).
Relevant investments schemes
Seed Enterprise Investment Scheme (SEIS)
The scheme provides income tax and CGT reliefs to individual investors who buy new shares in the company. A company (or group of companies in case of a parent company) can receive a maximum of £150,000 through SEIS investments and may qualify if it is less than 2 years old, and at the time of investment has:
no more than £200,000 in gross assets
less than 25 employees
not previously carried out a different trade
no investments through EIS (enterprise investment scheme) or a VCT (venture capital trust).
The company can use the scheme if it:
carries out a new qualifying trade
is established in the UK
is not trading on a recognized stock exchange at the time of the share issue
has no arrangements to become a quoted company or a subsidiary of one at the time of the share issue
does not control another company unless that company is a qualifying subsidiary
has not been controlled by another company since the date of your company being incorporated.
Enterprise Investment Scheme (EIS)
The scheme makes available the benefit from unlimited deferral relief on CGT. It is applicable where gains (including gains on shares) are reinvested in newly issued eligible shares (section 150C and Schedule 5B, TCGA 1992) within the period beginning one year before and ending three years after a gain is realized. A company's shares will be eligible for the EIS if it is an unquoted trading company and meets various other conditions. Notice: no redemption rights should be attached to the shares.
The gain is then postponed and becomes chargeable only on the occurrence of one of several specified events, e.g. the disposal of the EIS shares or the shares ceasing to be eligible EIS shares. EIS also provides relief from income tax on investment in EIS shares: the deduction is given at the rate of 30% on the amount invested, up to a maximum annual investment of £1 million (from 6 April 2012), provided that the shares are held for at least 3 years. If income tax relief is granted and the EIS shares held for 3 years, the disposal is exempt from CGT.
Taxation in case of liquidation
General principles of taxation
Distributions in respect of shares on a solvent winding-up are possible. These distributions are not recognized as distributions for the purposes of income or corporation tax and usually treated as capital distributions within the scope of chargeable gains taxation.
Certain CGT reliefs are possible provided the relevant conditions are satisfied. For example, entrepreneurs' relief is available if the trading condition was satisfied throughout the period of one year ending with the date on which the company ceased trading, and the trading ceased within the period of three years ending with the date of the disposal.
The SSE can also exempt gains arising when an investing company is in liquidation. For disposals on or after 1 April 2017, there is no requirement for the investee company to be a trading company or the holding company of a trading group or trading sub-group after the disposal (unless the disposal is to a connected party). The SSE may also be available on disposal of an investee company in liquidation, but it means that the investing company cannot realise an allowable capital loss in the context of an insolvent liquidation.
If a company is in insolvent liquidation, it is unlikely that any surplus will remain for distributions to shareholders, its shares are usually worthless. The shareholders can make a "negligible value" claim to HMRC (section 24 of TCGA 1992) to realise the loss on the shares. Alternatively, if the shares are shares in certain types of trading company, the shareholders can set their allowable capital loss against their income under the share loss relief rules.
Anti-avoidance regulations
In order to receive favorable CGT treatment some taxpayers used voluntary liquidation to extract cash from a company. Then they continue to carry on the same trading activities through another vehicle. This is often known as "phoenixism".
To prevent gaining a tax advantage through the winding up of companies the government implemented the new Target anti-avoidance rule (TAAR). This rule aims to restrict the opportunities for shareholders to convert to capital what, absent the voluntary liquidation, might otherwise be paid as an income distribution.
As per these rules, distributions from a winding up is treated as an income distribution where three conditions are met. Broadly, these conditions are:
there is a distribution from the winding up of a close company;
the person that receives the distribution continues to be involved, directly or indirectly, in the trade activities that are identical or similar to that of the wound up company;
the main purpose, or one of the main purposes, of the arrangements as a whole is to obtain a tax advantage.
If the amount of distributions does not exceed the cost of the shares for chargeable gains purposes and distributions of shares (other than redeemable shares) are excluded from the TAAR.
Care should be given to the fact that HMRC states in the Spotlight 47 that where TAAR does not cover the arrangements, HMRC will consider whether the general anti-abuse rule (GAAR) is applicable.
For further information or to arrange a consultation please contact
Yuliya Shved at yuliya@lexefiscal.com, or
Dr. Frank at clifford.frank@lexefiscal.com.