Buyback of Shares and Share Capital Reductions

• To exit a shareholder from the company: the most common use for a buyback is to allow for the purchase of an exiting shareholder’s shares. This may be because the continuing shareholders are unwilling to fund the exit themselves (as it will effectively be paid out of taxed income) or because the price for the shares is too expensive for the continuing shareholders to pay. This allows the continuing shareholders to maintain control of the company in the same proportions that they have without risking the exiting shareholder’s shares being offered to a third party;

• To return cash to shareholders: companies that hold large amounts of cash whether from accruing retained profits or following the proceeds of sale from the disposal of an asset may want to divest some of it by returning capital to shareholders;
• To operate an employee incentive scheme: a company that operates an employee share scheme may wish to facilitate the purchase by the company of an employee’s shares when they leave the employment of the company; or

• To adjust the proportions in which shareholders hold shares: some shareholders may wish to realise part or all of their investment in shares while other shareholders may wish to increase their proportionate shareholding.

The Taxation Trap

The selling shareholder’s tax position must be considered very carefully before proceeding with a buyback. Monies paid by a company to an individual to buy back his or her shares are generally treated as a payment of income unless the transaction is exempt (see below). As the buyback is treated as income and not a capital payment, Entrepreneur’s Relief may not be available. Tax advice should be sought in this position.

In order to ensure that the payment is treated as capital and not income (so that Entrepreneur’s Relief may be claimed), the transaction must qualify as an exempt distribution, the following conditions (some of which have complicated formulae and requirements) have to be met:

• The company must be an unquoted trading company;
• The purpose of the buyback must be to benefit a trade carried on by the company or to discharge an inheritance tax liability on death to avoid causing undue hardship;
• The selling shareholder must be resident in the UK and the shares must have been owned by him/her (or his/her spouse) for five years before the buy-back (or three years where the shareholder has died);
• The interest and right to share in profits of the shareholder must be “substantially reduced”; and
• Immediately after the sale, the shareholder must not be connected with the company.

Failure to follow the procedure correctly

Restrictions are imposed on companies buying back their shares under the Act in order to protect creditors. The procedure to effect a purchase of own shares must therefore be followed strictly. If the relevant part of the Act is contravened the transaction will be void and an offence will be committed by the company and every officer in default

Payment by instalments?

Exiting shareholders may need to sell all of their shares in one go to preserve their claim for Entrepreneur’s Relief or majority shareholders may seek to acquire all the shares of a minority shareholder in order to gain complete control of the company. However, the company may not have sufficient funds to purchase all of the shares at the agreed price in one transaction.

For this reason payment of the purchase price for the shares by instalments would be useful, however, under the Act the shares must be paid for at the time they are purchased (unless the buyback is for the purposes of or pursuant to an employee share scheme). An alternative structure would need to be used (see below) if there are insufficient funds to buyback all of the shares at the agreed price.

This will depend on what the company and shareholders wish to achieve. If the company wants to return surplus cash to shareholders, it could consider declaring a special dividend or reducing its share capital (see below).

Determining which of these is most appropriate is likely to be dependent on the tax treatment of the relevant transaction.

If there is an exiting shareholder but there are insufficient funds to buy back his shares at the relevant time, then there are several options:

• Carrying out the share buyback with multiple completions (essentially a series of separate buybacks on different dates), however, each completion would be subject to the company having the necessary distributable reserves to purchase the shares on that date;

• A partial buyback with an option for the shareholder to require the company to buy the remaining shares on a future date, but again, each further transaction would be subject to the company having distributable reserves;
• All of the shareholders in a company sell their shares in that company to a new holding company owned by the continuing shareholders (via a share exchange arrangement) with payments for an exiting shareholder’s shares to be paid over a period of time. It should however be noted that this option may attract additional stamp duty (as it may be payable on all of the shares being sold/purchased); or

There are advantages and disadvantages to each of these structures, each with differing tax treatments, depending on the particular circumstances.

A reduction of share capital can be carried out for several reasons. These include:

• Return surplus capital: if a company has surplus cash or assets it may pay/transfer it directly to its shareholders by cancelling the shares issued to such shareholders;
• Creating distributable reserves: a company can be prevented from paying out dividends to shareholders where the company has accumulated realised losses, even if it is trading profitably. A reduction of share capital can be used to eliminate such losses and/or increase distributable reserves, enabling the payment of dividends which may be more tax effective to shareholders; or

• Supporting a share buy-back or redemption: a company wishing to buy-back or redeem shares out of distributable profits may carry out a reduction of share capital to create sufficient distributable profits to carry out the process.

Reductions in share capital may also be used in conjunction with schemes of arrangement as a way of structuring mergers and acquisitions.

Solvency statement

The solvency statement procedure is the simplest option, however it is only available to private limited companies (not PLCs) and it cannot be used to reduce the company’s share capital to zero.

In brief, the solvency statement procedure involves:

• A statement signed by all of the directors stating that the company is solvent. It is an offence to make this statement without having reasonable grounds to believe it is true. Usually directors will wish to review the last statutory accounts, most recent management accounts and any material changes since the date of the last management accounts. They may also consider seeking an opinion from the company’s auditors;

• A special resolution passed by the shareholders of the company approving the share capital reduction; and

• Filing the solvency statement, the special resolution, a statement of capital and a statement of compliance by the directors at Companies House within 15 days of the resolution being passed – the reduction in share capital takes effect on registration.

Court approved procedure

PLCs and private limited companies may carry out reductions of share capital using a court approved procedure. Contrary to a solvency statement procedure, a court approved procedure can be used to reduce a company’s share capital to zero, if required. However, as a PLC must have a minimum share capital of £50,000 of which one quarter of the nominal value and all of any premium must be paid up – any reduction below these levels can only be carried out if the company first re-registers as a private limited company or if the court specifically permits it.

The court approved procedure involves:

• A special resolution of the company’s shareholders approving the reduction in capital;

• An application to the court;

• The confirmation by the court; and

• Filing the court order and a statement of capital with Companies House – the reduction in share capital takes effect upon delivery or, if the court directs, registration.

The court will only approve a reduction of capital if the company’s creditors’ interests will not be damaged. This is usually achieved in one of the following ways:

• Compiling a list of creditors who may object, advertising the proposed reduction and giving creditors the opportunity to object;

• Obtaining the consent of all creditors;

• Showing that the company has enough liquid assets to pay for the reduction in share capital and all amounts owed to creditors plus a margin of 10%;

• Setting aside a blocked bank account with enough funds to cover creditors’ debts;

• Obtaining a bank guarantee; or

• Giving an undertaking that the company will not make a payment out of capital until all creditors have been repaid or have consented, or that the repayment will be made out of distributable reserves.