On the back of our corporate colleagues' blog on 'what are share buybacks, why do companies do them and how do they work?' we are now looking at the tax consequences of share buybacks.

Share buybacks can be an effective solution if a shareholder wishes to retire and exit a business where there are no third-party investors willing and able to purchase the shares. In this current market of historic high interest rates and lack of investors a share buyback can be a great route for individuals to explore if they wish to retire and exit the business.

Tax consequences

What are the tax consequences of a share buyback for an individual shareholder? Many assume that the transaction will be subject to capital gains tax since it is a disposal. However, the default position is to treat the consideration (in excess of the capital originally subscribed for the share) as a distribution (which will be taxed as income) unless specific conditions for capital treatment are met.

Under the income treatment, an individual would be treated as receiving a dividend and would be taxed at 8.75%, 33.75% or 39.35% after the tax-free dividend allowance of £1,000.

However, the receipt of consideration will be treated as capital and taxed at lower rates of capital gains tax if the following conditions are met:

  • the buyback of the shares is made by an unquoted trading company which is not a 51% subsidiary of a quoted company (e.g. listed in the London Stock Exchange), or by unquoted holding companies of a trading group;
  • the buyback of the shares is made for the benefit of the trade;
  • the selling shareholder is UK resident and has held the shares for at least five years (three if acquired from death);
  • there is a substantial reduction (of at least 25%) of the selling shareholder interest in the company; and
  • the selling shareholder is no longer connected (the threshold to be considered connected is more than 30%) to the company following the share buyback.

If all the above conditions are met then the capital treatment will apply and the buyback will be considered a disposal for capital gains purposes which is taxable at 10% or 20% and may qualify for business asset disposal relief. However, care needs to be taken when applying the tests.

What is considered to be for the "benefit for a trade" for the purposes of meeting the second bullet point above? HMRC's Statement of Practice 2/82 provides examples of where the benefit of trade test could be met:

  • Where a disagreement between shareholders over the management of the company is leading to an adverse effect on the trade of the company, then the purchase of own shares removes the dissenting shareholder.
  • On a death of a shareholder where the personal representative or beneficiaries do not want to keep the shares.
  • An outside provider of equity finance wishes to withdraw their investment so the company initiates a purchase of own shares.
  • The proprietor of the company wishes to retire, paving the way for new management – generally they should resign as an officer but remaining in position over a short-term handover period can be accepted depending on the facts.
  • Exceptionally, where the retiring director has kept a shareholding, not exceeding 5% of issued share capital, for sentimental reasons.

Care also needs to be taken in establishing whether there has been a substantial reduction in the shareholding interest and whether the connection tests have been met (which can be difficult particularly where the Company does not have sufficient distributable reserves to effect the buyback in one transaction and wishes to phase the transaction using multiple completions).

The rules under the Corporation Tax Act regarding share buybacks are not straightforward so caution is needed when seeking capital treatment. A shareholder cannot simply proceed with a share buyback to facilitate its exit an expect the capital treatment to apply. Consideration should be given to seeking HMRC clearance in relation to the conditions, with the timescales for obtaining clearance factored into planning the transaction.