Share Buybacks When Directors/Shareholders Exit: Legal Requirements, Funding Options and Tax Implications
Consider this: You own a private limited company and one of your director/shareholders wants to leave. The exiting director wants to sell their shares in the company and realise their value. However, none of the other shareholders wish to purchase them, or if one of them did wish to do so, then this would have an impact on the balance of power within the company in respect of the remaining shareholders.
In these circumstances the exiting shareholder looks to the company to buy back its shares. The process for a private limited company buying back its own shares is tightly regulated under the Companies Act 2006.
The most commonly used method of funding such a share buyback is the company purchasing the shares out of distributable profits. These are profits available for distribution by the company and are not the same as net profits.
Where sufficient distributable profits are not available to cover the cost of purchasing the shares, a company can reduce its capital or use the proceeds of a new share issue.
There is also an exemption available to companies to make payment out of ordinary funds provided that payment does not exceed the lower of £15,000 or 5% of the share capital.
Once purchased, in most cases, the company will immediately cancel the shares, but in some instances they may then be held ‘in treasury’ so that they can be issued to a new shareholder at some point in the future.
HMRC will usually classify the payment received by the exiting shareholder as a ‘distribution’ in the same way that it would classify a dividend payment. This means that any such payment will be taxed in the hands of the recipient as income, so the usual tax rates would apply.
It is likely that the level of payment will take the seller into a high rate tax band. The alternative is that the company can apply to HMRC for ‘advanced clearance’ so that the transaction is treated as a capital transaction. This would mean that the seller would be taxed in respect of a capital gain only (so after deducting the original amount paid for the shares) and the tax rate is likely to be significantly lower. However, certain criteria are applied by HMRC as to whether the transaction would qualify as a capital transaction.
These include:
- That the share buyback is for the benefit of the company’s trade; and
- That the selling shareholder had held the shares for a minimum period of 5 years.
So the option to apply for capital treatment may not be available to all sellers.
The process for undertaking a share buyback is not as straight forward as the process for selling shares generally. If the formalities are not complied with then any buy back will be void. The consequences of this are:
- Potential personal liability for all officers of the company at the time of the buyback which could result in either an unlimited fine or up to 2 years in prison; and
- The funds paid by the company to the selling shareholder for the shares have only created a debt on the part of the shareholder to the company.
If you would like to carry out a share buyback but wish to avoid the pitfalls or you want to check whether any share buyback you have carried out previously is compliant, please contact me.
