Capital losses in a company purchase of own shares

The issue

A company purchase of own shares (CPOS) can be a very good way of a shareholder extracting value from the company when they are exiting. Often they will try to seek special capital gains tax treatment for any CPOS but this will not always be available because of the various conditions that need to be met. One such condition is that the shares need to have been held for five years and another is that the CPOS must have been undertaken for the benefit of the trade. The default position is that any difference between proceeds and subscription price is taxable as a distribution at dividend tax rates – unless the special capital gains tax rules apply.

However, there are capital gains tax implications even for a CPOS with distribution treatment.

Capital gains tax issues for a ‘distribution treatment’ CPOS

The precise way that the legislation works is to strip out from the capital gains tax computation, any part of the CPOS treated as a distribution. In other words, the difference between proceeds received and subscription price is removed from the calculation. This leads to a few observations:

1. HMRC could challenge the transaction if they do not feel the proceeds equate to market value. As a result, market value could be imposed for capital gains tax purposes. Therefore, if the CPOS has taken place at undervalue, there will still be a capital gain to the extent that market value exceeds proceeds. In reality, this challenge can usually be quashed, as both parties will have negotiated the proceeds.

2. If the shares have been acquired ‘second hand’ a capital loss can arise.

Example

Derek acquired his shares for £50,000, although they were originally subscribed for at £2,000. There is a ‘distribution treatment’ CPOS in which he receives £500,000 for all his shares.

Here, Derek will be taxed on a distribution of £498,000 (the difference between proceeds and subscription) but he will also have to consider his capital gains tax position. In this case, he will trigger a capital loss of £48,000 (£2,000 subscription price less £50,000 acquisition cost).

This £48,000 capital loss can be used in the normal manner, as it is not restricted by connected party loss rules.

Occasionally such a loss may be triggered due to a March 1982 value, which is higher than the subscription price. In these circumstances, it may even be possible to convert the loss into an income tax loss which can offset the tax on the distribution.

Forbes Dawson comment

The take home message is to make sure that CPOS distributions are recorded accurately in line with the legislation. Losses should not be forgotten about and thought should be given to their most effective use.

It goes without saying, that a taxpayer should also explore every option to get capital gains tax treatment before resigning himself to ‘distribution treatment’!

 

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