Q: My client is a director and shareholder of a civil engineering company. Having reached his late 50s he would like to retire from his business and hand the reins over to his son, who is currently a minority shareholder. His son does not have the cash to buy his father’s shares directly; however, the company is cash rich. Is it possible to use the cash in the company? What are the tax consequences?
A: In this situation, where the company has sufficient cash, it would be appropriate to consider the rules for the purchase of a company's own shares. The Companies Act 2006 gives authority for a company to buy back its own shares, subject to some conditions.
Such a purchase would normally be classified as a distribution for an individual shareholder. However, provided specific conditions are fulfilled, certain payments on the redemption, or repurchase by a company of its own shares, will not be treated as distributions for individuals.
Most buybacks will therefore result in an income tax charge arising on the distribution, and to the extent that the proceeds exceed the repayment of share capital an income tax charge will arise at the shareholder’s marginal dividend rate.
Where relevant conditions are met, the company buying its own shares would not be considered an income distribution, so capital treatment would apply. That means your client would be realising a capital disposal and potentially be able to take advantage of a claim to entrepreneur’s relief and as such reduce the tax charge to 10 per cent.
Capital treatment can only apply to unquoted trading companies, or unquoted holding companies of trading groups. The buyback must also be for the benefit of the trade and it must not be for the avoidance of tax.
The benefit of a trade requirement can be particularly subjective and HMRC has offered guidance on this point. A shareholder wanting to exit a business might fall within the definition of "for the benefit of the trade".
There are further conditions – and all of these must be met for capital treatment to apply.
The first condition is that the individual selling his shares must be UK resident in the tax year of the buyback.
The shareholder must also have held his shares for five years prior to the buyback. If the shares were received from a spouse or civil partner, the length in ownership is the aggregate. This period is reduced to three years if the shares were acquired by will or intestacy.
The purchase of the shares must substantially reduce the seller’s interest in the company. An interest is taken to be substantially reduced if it is not more than 75 per cent of the seller’s interest before the transaction took place.
Ben Chaplin is managing director of Croner Taxwise