When a company purchases its own shares then the default position is that proceeds will be taxed as a distribution. If various special conditions apply, then the transaction can be treated as a capital disposal subject to capital gains tax and this will usually be preferable.
Consider Jim who subscribed £100 for his shares and sells them to the company for £100,000. The default position here is that Jim will be treated for tax purposes as receiving a £99,900 dividend and taxed on it at income tax rates. Alternatively, if special capital conditions apply Jim will have a £99,900 capital gain taxed at capital gains tax rates (which are generally lower).
The main capital conditions are that the shares need to have been held for five years, generally shareholders need to dispose of all of their shares and the shareholder cannot be connected with the company after the purchase.
Although care is usually taken over confirming that conditions have been met, valuation issues can sometimes be neglected.
A purchase of own shares which meets the capital conditions will not automatically mean that all proceeds will receive capital treatment. If HMRC can show that the purchase is not ‘a bargain made at arm’s length’, then it may seek to apply TCGA 1992, s17, which provides for market value to be substituted for the actual consideration. This would then pave the way for HMRC to argue that the excess of the consideration over market value should be treated as a distribution subject to income tax.
There can also be issues if the proceeds are less than market value. Here, HMRC can again use section 17 to use market value and therefore increase the gain. There could also be inheritance tax implications on this ‘transfer of value’ into the company if the shareholder was to die within seven years.
Forbes Dawson view
Often it will be easy to justify that a market value has been used in a company purchase of own shares. This is because there will have been genuine arm’s length negotiation between the shareholders. The position will not be so clearcut when the shareholders are family members.
There can also be confusion about how minority discounts should be applied in the context of a company share purchase. The fear can sometimes be that if a pro rata valuation is used (e.g. a 25% shareholder gets £500,000 for his shares in a £2m company) then income tax could apply to the excess over the discounted value. Our view here is that whilst caution should be shown, there is an argument that because the company is essentially a special purchaser, a discount does not necessarily need to apply to the shares. All continuing shareholders retain the same pro-rata value in their shares before and after the acquisition by the company, due to the cancellation of the acquired shares. Whilst we have had success on this basis, the risks of challenge do need to be set out to the client. Generally, it does make sense to document the basis for any valuation where it is difficult to demonstrate that it has been arrived on an arm’s length basis.
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