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Key reasons for buybacks

A company and its shareholders may want there to be a buyback were, for example:

• a founder or long-standing shareholder wants to retire.
• a shareholder no longer wants to be involved in the company and wishes to pursue other interests; or
• there is a shareholder disagreement about the future direction of the company or other dispute.

In any of those cases it may not be practical or desirable to bring in another shareholder or for the current shareholders to be able to afford to buy them out.

Typically, it is the thing that the shareholders would like to happen if they have a shareholders’ agreement and one of them leaves because the shares once bought by the company can be cancelled leaving the remaining shareholders with an increased share of the company.

Funding the buyback

The buyback procedure isn’t necessarily that simple because the process is a statutory procedure and there are a number of statutory requirements that can’t be met in all cases.

The main problem area tends to be that the Company does not have funds available to fund the buyback.  There are strict rules about what can be used to fund the buyback:

• a payment from distributable profits (so profits that otherwise might be used to pay dividends)
• the proceeds of a fresh issue of shares,
• a purchase out of capital (if the amount of consideration is small, that is the lower of £15,000 and the 5% of the aggregate nominal value of the fully paid share capital) otherwise there is a special procedure to be followed.

Generally, the purchase will be out of distributable profits.

A further problem is that all the purchase price for the shares has to be paid at once in one lump sum with no opportunity for payment in instalments.

If this is an issue, there can be other options available (for example a share buyback in instalment which can create tax risks) or a buyback through a holding company which is more complex and will require additional tax clearances.

Why are share buybacks increasingly popular?

One reason is that if a shareholder wants to leave a Company there won’t necessary be a willing buyer who has the funds available and if a new shareholder is willing to come in the existing shareholders may be concerned as to whether they are a “good fit”.

But the other reason share buyback are popular is tax, because if you can satisfy the Companies Act and HMRC requirements and a shareholder wants to exit and HMRC is happy with the justification for this and doesn’t believe it is just to avoid tax, the shareholder who is leaving may be taxed on the buyback at a lower rate than tax on dividends.

To put it another way, if the shareholder is an employee or director, the proceeds would generally be regarded as income and taxed as such, but if the HMRC requirements are met (it is possible to get HMRC advance clearance in this respect) the proceeds will be regarded as capital and subject to CGT, so there is a lower rate of tax payable.

There may be an even lower rate of CGT payable if the leaving shareholder can qualify for Business Asset Disposal Relief (depending on the percentage of shares held, how long they have been held and the leaver being a director or employee).

This is a specialised area of work and involves not only good legal drafting and an understanding of the procedure and possible pitfalls but also an understanding of tax and the underlying commercial drivers. We are experienced in share buybacks and our fees are competitive, so please do get in contact to discuss how we can help you.

Company shares buyback rules

The main rules to be aware of are:

• Rules relating to the funding of the buyback and payment of the purchase price (see above).
• The shares being bought back must be fully paid.
• Shareholder approval of the buyback contract is required by ordinary resolution (50% of the shareholders excluding the person whose shares are being bought).
• There are additional procedural requirements if the shares are being bought back out of capital, where the criteria for a small amount of capital buyback aren’t met.
• The company’s articles of association must not prohibit the buyback of its own shares.  Most don’t prohibit this and allow it or are silent. 
• The Buyback contract must be available for shareholders to inspect for at least 10 years after completion of the buyback.
• HMRC can deny beneficial tax treatment (i.e. capital treatment rather than income treatment) if the rules are not complied with and HMRC criteria for capital treatment are not met.

Tax clearance

For maximum tax benefits, it is almost always advisable to get HMRC tax clearance in advance. The main issues for tax centre around demonstrating that:

• there is a benefit to the business of the company in the buyback.
• the company is a trading company rather than one that holds investments (shares, property etc).
• the selling shareholder is a UK resident.
• that the selling shareholder has owned the shares for 5 years.
• that the selling shareholder; interest in the company will cease (occasionally HMRC will allow a shareholder to retain up to 5% for “sentimental reasons”) and the seller’s family interests in the company must be substantially reduced (and be less than 30%); and
• that the buyback is not a form of tax avoidance.

It can be difficult in some cases to show a good business reason for the buyback, but this can be things like a dispute, a shareholder who has provided funding now wishes to withdraw this, a founder is retiring to make way for new management, or the personal representative of a deceased shareholder do not wish to hold the shares and want to realise the value.

Legal work involved

As share buybacks are complex and require strategic planning, we always run through the basic elements before starting work on any documents. The basic process is: –

• Checking the company’s articles and shareholders’ agreement (if any) before any other steps to check if there are any specific provisions or impediments.
• Considering whether the proposed transaction complies with the rules and is tax efficient.
• Seeking tax clearance for capital treatment, where relevant.  (In any event details of the share buyback back need to be notified to HMRC once the transaction is completed).
• Drafting the Share Buyback Agreement and board and shareholder resolutions.
• Obtain Shareholder approval of the Share Buyback Agreement by ordinary resolution from the shareholders other than the shareholder who is leaving (there are additional requirements for a buyback out of capital which does not meet the small amount criteria).
• Dealing with the necessary filings with HMRC for stamp duty (payable by the company at the rate of 0.5% if the purchase price is more than £1000) and also at Companies House (SH03 to record the buyback and SH06 if the shares are to be cancelled) and any other resolution changing the articles etc.
• The company books (e.g. register of members of the company and register of persons with significant control will need to be updated).

If the buyback is by a series of purchases by instalments, deal with the protection of the departing shareholder(s) by safeguarding against the company’s default before the full price for the shares is paid. The usual way to do this is with guarantees and default clauses.