Let Me Tell You a Story

Did you hear the one about … the accountant who dabbled in company law? MARTIN DAWSON provides an insight into current buy-back procedures, the tax planning implications and looks at how far tax practitioners should stray in the legal aspects of company buy-backs.

CHRIS AND DARREN were brothers, running and owning their market stall company in equal shares with Matthew. Matthew was not actively involved in the business, but enjoyed sharing in its success. After being made an offer he could not refuse, he agreed to let Chris and Darren go their own way. A deal was agreed. Matthew was given his £50,000 by the company, and duly gave Chris and Darren a signed stock transfer in favour of the company buying his shares back.

Chris and Darren passed the stock transfer form across to Stephen, their accountant, who filed the appropriate paperwork at Companies House (form 169) being careful to file the paperwork within the statutory 28-day filing period. He also ensured that the form was stamped with the appropriate duty payment of £250 before filing it.

Stephen confirmed to Chris and Darren that Matthew's buy-out was now completed and that everything was in order.

Twelve months later, they received a surprise offer from S plc, a large chain of marker traders, to buy the company for £1 million. They were more surprised, however, to hear from Matthew, who having read about the proposed sale in the local newspaper, approached them asking for his share of the £1 million.

It couldn't happen to me

Could this scenario happen in real life? The answer is that it could, so the above should act as a warning to those practitioners who dabble in company law and find themselves in Stephen's position.

The Companies Act 1985 lays down a specific procedure that a company buy-back of shares must be properly effected, the details of which are laid out in section 164. Key points to be aware of, although by no means the only points, are:

• the company's articles of association must give it the authority to effect the purchase. If they do not (and this would generally be companies incorporated under Companies Act 1948), then the shareholders will have to pass an appropriate special resolution enabling it to do so;
• a written resolution must be prepared confirming the company's authority to effect the buy-back;
• the company's proposed buy-back 'contract' must be filed at its registered office for 15 days prior to the resolution being passed/contract being entered into;
• the shares must be fully paid-up;
• payment for the shares must be made in cash and in full at completion, and out of distributable reserves or the proceeds of a fresh issue. Less frequently undertaken in practice, the purchase may also be made out of capital.

Deviation from the above procedures will make the buy-back void and legally unenforceable. Additionally the company could find itself liable to a fine, and the company's officers liable to both a fine and imprisonment.

Legal advice

It could be inferred that the fictitious tax practitioner, Stephen, has indirectly given legal advice, and as a result he may be visiting his professional indemnity insurers sooner than he anticipated.

His legal advisers should tell him that non-compliance with the statutory requirements of the Companies Act is unlikely to save him, even using the defence argument that Chris, Darren and Matthew had all agreed to the buy-back, and that they simply wished to dispense with the formalities.

As such, it is not possible for Stephen to ratify breaches in respect of the buy-back with further documentation.

The recent case of R W Peake (Kings Lynn) Ltd [1998] BCLC 193, considered the argument that the procedural requirements of the Companies Act are exclusively for the members' benefit, and hence can be waived by them and therefore (in the above scenario) must have been waived. The courts, however, took the opposite view, holding that section 164, Companies Act was not simply procedural and thus for the benefit of the members only.

This leads to the inference that breaches are not merely 'procedural irregularities', and hence the provisions of the Companies Act must be properly followed.

It follows that the original payment (and buy-back) in favour of Matthew is invalid. As payment has already been made to Matthew, Stephen's lawyer is likely to confirm to him that Matthew holds the £50,000 as a constructive trustee for the company.

If Matthew has not in fact made a disposal, what is his position?

The company will be deemed to have made a £50,000 loan to him and naturally the attendant issues of benefits in kind, overdrawn loan accounts, the legality of the loan in accordance with the Companies Act will follow.

The only proviso is that before he receives his share of the S plc offer, the company should request repayment of the £50,000.

The statutory rules laid down regulating the buy-back by a private limited company of its own shares are tortuous and, cynics may say, deliberately so.

The moral of the story is therefore to leave the legal advice to the lawyer.

Tax implications

Having considered the legalities of a company buy-back, it will be useful to consider the tax implications of the transaction.

Readers may be forgiven for thinking that with the 'trolley dash' of 5 April 2002 now a distant memory, there are no viable alternatives for those shareholders not entitled to business asset taper relief.

This article will recap the tax provisions relating to the company buy-back of its own shares and look at where a buy-back may still provide a tax saving.

The legislation generally operates to allow the share premium arising on the buy-back, i.e. the difference between the amount originally subscribed for those shares and the proceeds received from the buy-back, to be treated as a capital transaction (liable to capital gains tax) in two situations. These are where the buy-back is for the benefit of the company's trade, and the less well known scenario of where the cash proceeds are required to fund an inheritance tax liability (see section 219(1)(b), Taxes Act 1988).

Advance clearance can be sought from the Revenue that a capital treatment will indeed be available to the vendor shareholder. A negative clearance that the transaction is a distribution is also available.

It follows that this technique may still offer a vendor shareholder a more beneficial exit route (by treating the aforementioned 'premium' as income) than via a capital treatment, where, for example:

• the company concerned is not a trading company, in accordance with Schedule A1 to Taxation of Chargeable Gains Act 1992;
• the exiting shareholder does not qualify for business asset taper relief.

Income or capital transaction

While many other factors can influence a decision (such as retirement relief, annual capital gains exemption, capital losses, re-investment relief, March 1982 value (where relevant)), for the purposes of this article it is assumed that an income transaction would be a more beneficial route.

It is not intended to restate the extensive rules of when a buy-back shall be treated as a capital transaction for tax purposes, suffice to say that these are contained within the legislation in sections 220 to 224, Taxes Act 1988. In summary, these are:

• the exiting shareholder must be both United Kingdom resident and ordinarily resident and have held the shares for at least five years (reduced to three years if acquired by will or on an intestacy), but care should be exercised as different share acquisitions will be dealt with under the 'matching' rules of section 106A, Taxation of Chargeable Gains Act 1992;
• the buy-back must be for bona fide commercial reasons;
• the exiting shareholder must not be 'connected' with the company after the buy-back;
• there must be a 'substantial reduction' in the vendor's shareholding.

It follows that a deliberate breach of one of the above should lead to the desired 'income' treatment, and hence an effective tax rate of 25 per cent for a higher rate taxpayer, which should generally lead to a lower tax rate than can currently be achieved for the non-business asset rate of capital gains tax.

It should be possible to engineer an income tax treatment, and hence the desired reduction in tax by any of the following, some more practical, and indeed realistic, than others:

• leave the buy-back proceeds outstanding on loan account;
• gift shares to a non resident nominee or perhaps into a settlor interested life interest settlement;
• put the tax avoidance argument to the Revenue, which by definition should disapply the capital treatment; it may, however, be sensible to obtain also a negative clearance at the same time.

Connection test

Practitioners should be aware that the 'connection test' not only applies to the vendor shareholder but also the rights of his associates (as defined by sections 227 to 228, Taxes Act 1988), and hence includes the rights of the spouse, minor children, various trust and corporate connections, etc.

Interestingly, and perhaps unfairly, a family buy-back transaction where the husband and wife own a company can never effect a capital transaction due to the exiting shareholder always being connected through the remaining spouse's interest.

However, this could also offer opportunities over a capital transaction in companies that are either non-trading companies or do not satisfy the requirements of being a trading company for taper relief purposes.

Other costs

It is also worth considering two further areas that nearly always feature in most transactions: VAT, and the professional costs of effecting the transaction.

The argument is often put forward in securing a capital treatment that the exiting shareholder is being bought out because he is a dissident shareholder, at odds with the company, and whose departure is necessary to secure the continued success and trading benefit of the company. It follows by definition that the professional costs of the transaction are a trading expense, since they secure the continued trading success of the company.

Looked at objectively, this assumption is unlikely to be correct, especially if the shareholder has no active role in the day-to-day running of the company, i.e. in its trading. It is tempting to believe that where there is a real active involvement, a deduction may be available, but the company may struggle to show that the buy-back was 'wholly and exclusively' (as required by section 74, Taxes Act 1988). This is highlighted by the Revenue in its Company Taxation Manual at paragraph CT1760.

Additionally, it must also be shown that the purchase is not a capital transaction. This may prove difficult as the Revenue has said that in its view, the costs are usually connected with the restructuring of the share capital of the company, and are likely to be capital in nature.

Each situation must be viewed on its merits, and practitioners should give due consideration, when raising a note of their charges, in highlighting the different services they (may) have supplied during the course of the transaction.

From a VAT perspective, an exemption applies to services central to the co-ordination of the transaction or negotiation. These are known as intermediary services. Other parties providing specialist services (for example, reporting accountants and legal advisers) are providing support to the suppliers of the intermediary services, but are not regarded as acting in an intermediary capacity for the issue of shares. Their supplies are therefore standard rated.

Company's point of view?

A straightforward buy-back out of reserves should not be an issue, unless the company is exempt. However, (partial) recovery problems could well ensue in the case of a buy-back funded out of the proceeds of a fresh issue. The raising of funds by the company is not a taxable transaction and hence that proportion of any fees related directly to this aspect is unlikely to be recoverable.

Two final interesting tax situations arise for the following profile: a corporate shareholder and an exempt shareholder, e.g. charity, approved pension scheme, and a brief review may be beneficial.

At first, it might seem that a corporate could be in a distinctly better position than its unincorporated counterpart. After all, would an 'income' buy-back not be classed as 'franked investment income' and hence be free from corporation tax by virtue of section 208, Taxes Act 1988?

The Revenue does not accept this argument, and has confirmed this to be so in Statement of Practice SP 4/89. In essence, it believes that any income received, while possibly exempt by virtue of the above argument, should be brought into account in the calculation of the chargeable gain liable to corporation tax. It does, however, accept that different considerations apply to a redemption of redeemable shares.

As long as this view is adopted, practitioners would be advised to follow it unless they wish to test its validity. For practitioners interested, technical analyses have been put forward in the past by leading tax counsel testing the Revenue's view (see the sixth edition of Taxation of Companies and Company Reconstructions).

In the light of this year's Budget pronouncements in respect of substantial shareholdings, subject to Royal Assent, corporates may well be advised where possible to effect an equivalent disposal that would bring it within these provisions, thereby exempting any gains from tax.

Historically, positions regarding exempt shareholders have also generated their fair share of activity with the Revenue. The cases heard, including Commissioners of Inland Revenue v Universities Superannuation Scheme [1997] STC 1, Sheppard and another (trustees of the Woodland Trust) v Commissioners of Inland Revenue (No 2) [1993] STC 240, and even Commissioners of Inland Revenue v Sema Group Pension Scheme have concerned the ability of the shareholder to recover previously the associated tax credit where the buy-back was structured as a distribution.

It is not surprising that companies have structured such buy-backs in this manner, and these cases have no doubt contributed to the Revenue introducing legislation in late 1996 restricting the ability of the exempt shareholder to recover the tax credit.

Finally

It is logical that due care and attention should always be given to section 703, Taxes Act 1988 which concerns cancellation of a tax advantage.

This may be more likely where a buy-back follows a previous acquisition/subscription by a related vehicle such as an employee benefit trust, small self administered pension scheme, funded unapproved retirement benefit scheme, and where this could lead the Revenue, rightly or wrongly, to contend that an overall tax advantage has been obtained.

The above article does not profess to be an extensive résumé of the area involving a company buy-back of its own shares, which has been and will continue to be the source of many books and articles in the future.

Martin Dawson is a tax partner at Baker Tilly's Manchester office. He welcomes practitioners' comments at martin.dawson@bakertilly.co.uk, and recommends that readers take their own professional advice on the subject matter discussed here.

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