A share buyback is the purchase by a Company of its shares from one of its shareholders. There are a number of reasons for carrying out a share buyback, including the distribution of profits or providing an effective exit route to certain shareholders. A buyback is one of several methods of achieving these objectives.
This article focuses on off-market buybacks by private limited companies for the purpose of a shareholder exit. This can have a number of advantages over a simple share purchase by the other shareholders.
Advantages of a Share Buyback
Whereas the shareholders (collectively or individually) may not be able to afford to purchase the shares, a buyback can use the resources of the Company to finance the transaction. This in certain circumstances may even extend to the Company’s capital. The Company will also take on the liability (if any) to pay Stamp Duty which in a simple share purchase will be the liability of the purchasing shareholder.
As the shares are often cancelled following a buyback each remaining shareholder’s stake in the business is proportionately increased. This can potentially avoid uncomfortable redistributions of control or the risk of a third party coming in.
Another advantage is the shares qualifying for capital gains tax treatment if certain conditions are met. In round terms, the conditions include:
- the shares being held for at least 5 years;
- the seller’s interest in the company following the buyback either ceasing or being substantially reduced;
- the buyback benefiting the trade of the company; and
- not being for the purpose of enabling the participation in the Company’s profits without declaring a dividend.
This means the buyback will not be treated as the distribution of income as a dividend (subject to income tax), which is the default position if the test isn’t met. Not paying income tax could result in the transaction being much more tax efficient for the seller depending on their tax payer rate, particularly if they qualify to receive Entrepreneurs’ Relief on the capital gains tax. This is for employees/directors who have held at least 5% of the ordinary share capital and 5% of the voting rights for over a year.
Potential Pitfalls of a Share Buyback
Failure to correctly consider and identify the tax position could result in the wrong position being reported to HM Revenue and Customs (HMRC) which may incur interest and penalties. It is usual for a clearance application to be made to HMRC to seek clarification that a buyback meets the conditions for capital gains tax treatment to apply.
Unlike share transfers between shareholders, share buybacks have to be carried out/structured in accordance with strict company law requirements. Failure to do so can result in a number of problems.
One significant problem is that there is a risk that the transaction may be void. This means that the buyback has no legal effect and the shares are still held by the exiting shareholder. They will potentially even have an entitlement to dividends declared in the intervening period.
Share buybacks are commonly investigated as part of a company sale and a void buyback can cause complications when the remaining shareholders are looking to sell the Company or even generate investment. If the ‘exited’ shareholder is unable to be contacted or unwilling to co-operate then this can needlessly complicate an already involved process. The shareholders may be required to indemnify against any potential risk/loss or, worse still, the deal may fall through.
If the transaction is void but the shareholder is no longer engaged in employment or as a director, then such person may no longer be entitled to claim Entrepreneurs’ Relief.
Furthermore, failing to comply with company law is an offence committed by the Company and any directors in default, potentially punishable by imprisonment or an unlimited fine.
BHW can work with your accountant or tax adviser on structuring share transactions to provide an effective outcome and to assist with any HMRC clearance application.
If you are contemplating selling your shares, buying out a shareholder, or are even worried about the status of a past buyback, then please contact BHW’s corporate team on 0116 289 7000 or email info@bhwsolicitors.com.