– a clean break or a messy break-up?
A company share buy-back, or company purchase of own shares, is often seen by business owners and shareholders as an attractive method of facilitating an exit for a shareholder as an alternative to a more traditional management buy-out. However, a CPOS (my acronym of choice, rather than the alternative POOS), can be fraught with tax and legal complexities which need to be carefully navigated.
What is a CPOS and why undertake one?
On the face of it, a CPOS does exactly what it says on the tin. The company buys its own shares back from the departing shareholder. Shares which are bought back are then either held in a treasury reserve, from which they can be issued or sold to incoming shareholders, or are cancelled.
CPOS transactions can often be viewed by the uninitiated as simpler than an MBO. I’ve met plenty of lawyers who would disagree, and they can also be a tax minefield, but can certainly be appropriate in the right circumstances. Clients often explore a CPOS if there is a reluctance to alter the corporate structure by placing a new holding company above the existing Topco, and this can be of particular concern for those whose suppliers or customers would get nervous or raise eyebrows if they noticed a significant corporate reorganisation being disclosed at Companies House. There is also usually a Stamp Duty saving compared to alternative ‘Newco’ structures.
What is the tax treatment?
The default tax position is that proceeds received by the departing shareholder on a CPOS are treated as a distribution. In other words, the proceeds are subject to income tax at dividend rates (up to 39.35%). However, when specific conditions are satisfied, the CPOS is eligible for ‘capital treatment’ and is subject to capital gains tax at 20%, with the 10% Business Asset Disposal Relief rate available on the first £1m of lifetime gains if the conditions for the relief are also met. There is clearly a substantial difference in the tax liability if capital treatment is available, and so the conditions need to be carefully reviewed.
Capital treatment – the qualifying conditions
The requirements to be met to secure capital treatment on a CPOS are as follows:
- The seller must be UK resident for tax purposes in the tax year in which the CPOS takes place
- The shares must have been held by the seller for at least five years up to the date of the transaction
- The seller’s shareholding post-transaction must not be more than 75% of their shareholding pre-transaction (the “substantial reduction” test)
- Post-transaction the seller must not be entitled to more than 30% of the aggregate value of share capital and loan capital, or 30% of the voting power (the “connection” test)
- The transaction must be wholly or mainly undertaken for the benefit of the trade of the company and not for tax avoidance purposes
With the exception of the trade benefit test, all of these are objective. However, as is almost always the case in tax, most of these conditions need to be delved into deeper to fully understand the implications and risks involved, and any other matters to consider. For example, the five-year holding period condition can involve ‘looking through’ the period of ownership when shares have been acquired as part of a scheme of reconstruction, for example a share for share exchange.
With regard to the substantial reduction test, it’s important to factor into the mathematics that the shares to be sold back are typically cancelled, which means that any retained shareholding will be uplifted in terms of its percentage shareholding due to there being fewer shares in issue.
When considering the connection test, as well as ensuring the shareholding percentage works, it’s important to consider any shareholder/director loans in place that might, in combination with any retained share capital, represent more than 30% of the total debt and share capital of the company.
The trade benefit test is subjective and HMRC have long-standing guidance and principles that are applied on a case by case basis. It is essential, however, that it is the company that benefits, rather than the transaction serving the personal or commercial interest of the departing shareholder. HMRC provide the following examples of where the test is satisfied:
- A disagreement between shareholders over the management of the company leads to an adverse effect on its performance
- Death of a shareholder and it would not be appropriate commercially for the beneficiary of the estate to retain a shareholding
- An external investor wishes to withdraw their investment
- Retirement of an owner manager to pave the way for a new management team
Generally, HMRC expect the entire shareholding to be given up, however the connection test and the substantial reduction test both imply this is not required in all cases, and HMRC also explicitly state that small shareholdings of 5% or less will not be challenged if retained for sentimental reasons.
As is the case for corporate reorganisations such as share for share exchanges and management buy-outs, clearance can be applied for from HMRC in advance of the transaction taking place to confirm HMRC’s agreement that capital treatment will apply. Clearance can also be requested under the transactions in securities rules, so that confirmation can be obtained that HMRC will not look to counteract the income tax advantage (being the difference between the capital gains tax payable and the income tax that would be due if the same consideration were received as a dividend) where the conditions for capital treatment are met. Finally, the company must file a return with HMRC within 60 days of the transaction explaining why capital treatment should apply.
Other pitfalls and issues to consider
Even if it can be demonstrated that the seller is jumping through all of the necessary hoops for capital treatment and there is a genuine benefit to the trade of the CPOS taking place, there are still some tax and legal matters for both the seller and the company to be aware of, and the key issues are summarised below.
- Valuation – CPOS transactions are specifically included within Employment Related Securities rules which require discounts to be applied to the value of shares to determine their market value for tax purposes. Discounts are applied to private company shares to reflect their lack of marketability, and in the case of minority holdings, to reflect their lack of influence. This means that if a CPOS is undertaken at gross market value, the difference between the sale proceeds and the discounted market value for tax purposes could be subject to income tax and National Insurance through PAYE (up to 47% income tax and employee’s NIC plus 13.8% employer’s NIC). A valuation exercise is therefore often crucial.
- Under company law, a CPOS must be satisfied by a payment of cash consideration. The tax treatment follows this, which means no deferred consideration can be issued under CPOS rules. This can cause difficulties when the company does not have sufficient liquidity to make the purchase. There are a couple of solutions to this issue which can work in the right circumstances, but great care needs to be taken to ensure that all of the qualifying conditions continue to be satisfied.
- Another company law requirement is that the company must have sufficient distributable reserves to undertake the transaction. This might need to be considered in the context of dividend policy or any other accounting matters to be addressed to ensure that the balance sheet can facilitate the CPOS.
Conclusion
Generally, CPOS transactions are pursued far less frequently than their more traditional alternatives such as an MBO. However, stringent qualifying conditions and other pitfalls notwithstanding, they can be right for some businesses in the appropriate circumstances, and the availability of the HMRC advance clearance procedure certainly can provide some comfort that a transaction can be undertaken at low risk to the seller’s tax position if all other ducks are put in a row. We would also emphasise the importance of a thorough review of the legal documents and accounts to ensure that any CPOS results in a clean break with no nasty tax surprises arising for either the seller or the company.
