As of 30 April 2013, it has become slightly easier for private companies to buy back their own shares, including shares held by employees.
At first sight, the new provisions are of particular interest to private equity-owned companies, especially those which require employees to give up shares when they leave employment. However, the limited scope of the new rules and the lack of change in tax treatment mean that, in practice, it is unlikely that buybacks of employee shares will become common in the near future.
Currently, it is difficult for a private company to buy back its own shares. In particular because:
- every time a buyback is to happen, shareholders have to approve the relevant contract by special resolution, and
- payment by the company must come out of demonstrable distributable profits, the proceeds of a fresh issue of shares or out of capital (and, in the case of capital, there are particularly complicated and expensive procedures to follow).
These and related difficulties mean that a buyback in most cases is currently just too impractical or cumbersome to implement, particularly where the company has been loss-making and has negative distributable profits, and so companies understandably look to other solutions when removing shares from leavers. Traditionally, this has involved establishing and funding an employee benefit trust (EBT) or other custodian arrangements to buy the shares instead, but that is not ideal as it comes with additional cost and administration and the shares still remain in existence.
Many companies would prefer to cancel the shares and pay for them directly, rather than indirectly (e.g. by setting up an EBT to buy the shares and hold them). The new rules mean that in some cases this may now be a practical thing to do.
New rules for share buybacks from employees
The new rules make the buyback of shares simpler and more attractive in a number of ways, although on the whole it will only be where shares are acquired from bad leavers that these provisions can be used for employees due to the unfavourable tax treatment which still applies where an employee sells back shares to the company at a profit.
The new rules will allow private companies to:
- Finance de minimis purchases without having to check first that they have sufficient distributable profits
This change will allow companies to buy back a de minimis amount of shares without having to work out in advance whether, or to what extent, the purchase will be financed out of distributable profits. So long as the de minimis tests are satisfied, the company can decide after the event how it is to be financed. This exemption is not restricted to employee share buybacks – although in practice it is most likely to be used for them – and could be used for buying back shares from non-executive directors and other small shareholders too.
There is a limit on how much a company can buy back each year using this exemption. Companies will, in any financial year, only be able to purchase shares with a cumulative value of up to:
- £15,000; or
- if lower, 5% of the company’s share capital. We assume “capital” here means nominal capital, but this has still to be confirmed by the Department of Business Innovation & Skills (BIS).
To take advantage of this new de minimis exemption, a company must have inserted a specific provision into its articles authorising its use. In its response paper, BIS stated that where there is no such provision in a company’s articles, shareholder approval by special resolution would suffice. However, the final legislation only allows a company to use the de minimis exemption if its articles include a provision authorising it to do so.
This route will be useful where companies are buying back the shares of bad leavers who customarily only receive what they paid for their shares, or the company and its shareholders want to remove other small shareholdings. It also avoids the need to set up EBTs as, once acquired, the shares can simply be cancelled.
It appears to be the Government’s intention that, as long as the de minimis test is satisfied, the company can work out after the event how the purchase is to be financed. However, the final legislation is not clear on this point, and does not deal with the question of how a purchase using the de minimis exemption should affect the company’s balance sheet. BIS may provide guidance on this issue through FAQs. Until this appears, however, it is difficult to be confident about using this exemption, which is disappointing as when first introduced this proposal seemed promisingly simple.
- Obtain standing shareholder approval
Companies will still need shareholder authority to buy back shares. However, the new rules allow this authority to be given in advance by way of “standing” authority, rather than shareholders having to approve each and every buyback. A standing authority can last for up to five years. The shareholder resolution will have to specify the parameters relating to the minimum and maximum price payable and maximum number of shares which can be purchased. The purchase price can be calculated by reference to an objective formula. Conditions can also be attached.
Continuing to use the example of bad leavers, companies will therefore be able to buy back shares from them without contacting shareholders each time, so long as the parameters of the authority are satisfied. However, if the buyback needs to be financed wholly or partly out of capital, a special resolution of shareholders will be needed to approve the use of the company’s capital.
- Approve a buyback contract by ordinary, rather than special, resolution
Where shares are bought back other than pursuant to a standing authority, the purchase will (as now) need to be approved by shareholders. But an ordinary, rather than a special, resolution will suffice.
- Buy back shares out of capital with a simpler procedure
Currently, if a buyback is financed out of capital, the directors must make a formal statement that they believe the company will be able to continue as a going concern for the next twelve months; the company’s auditors’ must report on that statement (which can be costly); a notice must be published in the London Gazette; and the payment must only be made between five and seven weeks after the shareholders’ resolution approving the buyback is passed. These procedures therefore deter many companies from doing this.
There will now be a simpler procedure for approving a buyback of shares from an employee that is financed out of capital. The directors will need to sign a solvency statement and the shareholders pass a special resolution at that time. However, it will not be necessary to obtain an auditors’ report on the solvency statement, or to publish a notice in the London Gazette (which will create considerable savings), although the payment can still only be made between five and seven weeks later.
For a small payment to a bad leaver, these steps may now be worth taking to extinguish the shares using the company’s share capital.
- Pay for shares in instalments
Irrespective of how a purchase is approved or financed, private companies will be able to pay for employee shares in instalments. They will not have to pay for the shares in full at the time of buyback.
In practice, most leavers are bad leavers and forfeit their shares for a nominal amount and so providing full payment at the time of departure is not an issue. However, this change may be helpful where shares are being purchased from a good leaver who is able to receive the current market value of the shares (if there are no tax issues with buying back shares), there are a large number of leavers, or the company simply wants to defer payment and remove the shares but not give the shareholder his full money back ahead of other employees not being able to realise their investment. It is currently unclear whether a company can also impose conditions on payment e.g. compliance with non-compete covenants.
Although we refer in this article to certain provisions only applying to buying back shares from employees, the legislation refers to where shares are bought back “for the purposes of or pursuant to an employees’ share scheme”. It is not clear from the final legislation what is meant by “for the purposes of or pursuant to an employees’ share scheme” and further clarification is being sought from BIS. It may be that steps can be taken to fall within the definition by using appropriate paperwork and (perhaps) amending existing plans, but this would remove much of the intended simplicity from the proposals.
These changes only apply to private companies, except for the ability to obtain standing authority to buy back shares and authorise buy backs with an ordinary resolution, which will be available to all companies.
A major tax issue still remains
In themselves, these are helpful changes which will make it easier for companies to buy back shares from employees, although they could go further. It is hoped that the promised BIS review in three years’ time will relax the rules again.
However, where the price at which the shares are bought back is more than the original subscription price for the shares (common with good leavers, or occasionally continuing employees where the company wants to create a market for its shares), the changes are unlikely to be helpful unless and until changes are made to the tax treatment of buybacks.
The problem is that the amount paid for the shares less the subscription price for the shares paid when they were issued (not necessarily what the employee paid for them, eg if he bought them from an EBT) will be treated as a distribution for tax purposes. This means the gain will be subject to income tax at the dividend rate (with no credit given for any income tax originally paid by the employee if they acquired the shares at a discount) unless a tax exemption can be relied upon, which would be unusual.
In contrast, if the shares are sold to a third party such as an EBT for no more than market value, the employee should be subject to capital gains tax only on any real gain.
Until this differential is addressed, the buying back of shares which gives an employee a profit is unlikely to become popular, and EBTs will still be preferable.
A final change is that, where shares are bought back out of distributable profits or under the de minimis route outlined above by unquoted companies, they will no longer have to be cancelled. Instead, private companies and unquoted public companies will be able to hold shares in treasury, provided the company’s articles do not prohibit the holding of treasury shares.
Treasury shares have been used by quoted companies in the UK since 2003. Among other things, they can be used to satisfy employee share awards without issuing new shares, but given that most private companies will find it as easy to issue new shares as to hold and use treasury shares, very few companies are expected to make use of this change, although if a company were trying to develop an internal market, this facility might be useful.
New rules for all share buybacks by private companies
While the changes have principally been implemented for use with employee shares, the de minimis route, and the use of ordinary rather than special resolutions to approve buybacks and the ability to hold treasury shares, will be available for non-employee shares (although a standing authority will only be available for use with employee shares).
Click here for the BIS response paper published in February 2013.
Click here for the Regulations amending the Companies Act 2006.