Private companies often remove a shareholder using a company buyback of shares.  The tax treatment can give rise to some nasty surprises, and it is crucial that the correct legal process is followed.

Most shareholders expect to pay CGT possibly with 10% tax under Business Asset Disposal Relief (BADR) (previously known as entrepreneurs’’ relief). However, the default position is that a buyback is taxed as a dividend, to the extent that the price exceeds the original share subscription amount, at rates up to 38.1%.

However, the dividend treatment is overturned, and the buyback will automatically be taxed as a CGT event, if certain conditions are fulfilled. The conditions, in brief, are:

• The company is an unquoted trading company or holding company of a trading group,
• The shareholder is UK tax resident,
• They have held their shares for at least 5 years,
• They are not connected with the company after the buyback (more than a 30% interest combined with their associates),
• They reduce their interest in the company by at least 25% as a result of the buyback
• The buyback is to benefit the trade. This test is subjective and can give rise to real difficulties as HMRC will not accept a buyback that is to benefit the shareholder with no real benefit to the trade.

Advance clearance can be sought from HMRC to check that CGT treatment will apply. The company must also report to HMRC any CGT buyback within 60 days of the transaction, even if they had clearance.

A less well-known tax issue is where the buyback payment exceeds the tax market value of the shares, usually because a minority discount is not applied, and the departing shareholder is or was an employee or director. The excess amount is taxable as employment income under PAYE with NIC rather than capital gains. We have seen a client assessed by HMRC on a share buyback that occurred almost 6 years previously, therefore, we recommend that clients undertake a share valuation at the time of a buyback using tax principles including a minority discount. If the buyback is at a clear undervalue, this can also have tax consequences.  Note that an HMRC clearance for CGT treatment does not mean that HMRC accept the price paid for the buyback and can come back on this point after the event.

Under company law, a share buyback must be fully paid in cash on the day of the buyback. If this is not done, the buyback fails. If the company does not have enough cash, there are several solutions outside the scope of this article such as a series of buybacks, a loan back from the shareholder to the company or using a “Newco” structure instead of a buyback.