Practical guide: HMRC's current view on multiple completion buybacks

Introduction

A company purchase of own shares is usually the go to mechanism to assist with the exit of a shareholder in an unquoted trading company. The retiring shareholder would sell their shares back to the company and as long the conditions in s.1033 Corporation Tax Act 2010 (CTA) are met, the payment by the company is not treated as an income distribution and falls to be taxed as a capital gain.

As with all company reorganisations though, the company law aspect needs to be understood and adhered to. When it comes to the payment for a purchase of own shares, s.691 Companies Act 2006 states that the shares must be paid for in full on purchase.

This prevents a company paying for its shares in stages and can therefore give rise to a cash-flow problem. The multiple completion buyback overcomes this.

Multiple completions

The principle of the multiple completion buyback is that the shareholder enters into a single unconditional contract to sell their shares back to the company, but not all of the shares are cancelled immediately. Instead, the shares are cancelled in multiple tranches and payments are made on each cancellation.

Example. Jim owns 400 £1 ordinary shares and has agreed to sell them back to the company for £400,000, with payment being received in four equal instalments over four years. On day one only 100 shares are cancelled in return for a payment of £100,000 - the remaining 300 shares continue to exist and are cancelled 100 shares at a time over the next three years for a payment of £100,000 each tranche.

Cancelling the shares in tranches allows the company to fund the buyback over a number of years out of annual profits, meaning a company only needs to have sufficient cash and distributable reserves to cover each tranche. In addition, the payment of stamp duty on the buyback is also only paid on the cancellation of each tranche.

Whilst the shares are cancelled in tranches, there is only one capital gains tax event which occurs on the date the contract is signed. This is because the contract is for the sale of the entire beneficial interest of the shares, and the shareholder only holds the remaining shares as nominee, i.e. on bare trust for the company.

Even though beneficial interest in the shares is lost on day one, it is still advisable to redesignate the shares as having no rights at all so that it is clear the individual has no voting or economic rights that could be exercised.

As a result, structuring a buyback with multiple completions has become a popular way for a company to fund a buyback, but HMRC has recently clarified its view on a certain aspect of them which could restrict their use. What’s the story?

Legal ownership

To understand HMRC’s change of view we first need to recap and understand the difference between legal ownership and beneficial ownership. Legal ownership sits with the person whose name the shares are registered in, but this may be different to the true underlying owner of the shares who actually enjoys the benefit of them, e.g. receiving dividends. That is the beneficial owner.

Example. If the minor children inherited some shares from their grandparents, the shares would be registered in their parent’s name as being the legal owner, but it would be the children, as beneficial owners, that would be entitled to the benefits, e.g. dividends.

On entering into the multiple completion contract, the individual is disposing of their beneficial interest in all of their shares, but they will remain the legal holder until the shares are actually cancelled, i.e. they lose the right to vote and receive dividends on the shares that are yet to be cancelled, but nonetheless the shares will remain registered in their name.

Connection test

Retaining legal ownership of the shares until the cancellation date has not, until now, posed a problem as the majority of the buyback legislation is only concerned with beneficial ownership.

S.1048(3) CTA 2010 states “references in s.1033 - 1047 to the owner of shares are to the beneficial owner”.

So, for the substantial reduction test at s.1037 CTA 2010 for example, which says that if a shareholder still owns shares after the buyback, they must have substantially reduced their shareholding; this test is referring to beneficial ownership. As the individual disposes of their entire beneficial interest in their shares on the signing of the contract, they will not own any shares for the purposes of this test.

However, there is also a test at s.1042 which states that a shareholder cannot be connected with the company after the buyback, but the definition of connected persons is contained at s.1062, which is crucially outside of the s.1033 - 1047 range.

A shareholder is connected to a company if they are entitled to possess more than 30% of the ordinary share capital, share and loan capital, or voting rights.

HMRC has now issued a note to clarify its view that the word “possess” in s.1062 refers to legal, and not beneficial, ownership, therefore if the remaining shares exceed 30% of the company’s ordinary share capital, the individual will be connected to the company and capital treatment will be denied. HMRC has previously alluded to this view in its manuals, e.g. at CG58644 but will now update the guidance to remove any doubt.

HMRC has confirmed that any clearance already given under s.1044 CTA 2010 will remain valid, but going forward clearances will be rejected if the remaining shares of the exiting shareholder exceed 30%.

Solution

The simplest way to avoid the connection test is to ensure that after the first tranche of shares are purchased, the remaining shares do not exceed 30% of the ordinary share capital. However, where this is not possible, it may be necessary to structure the sale of shares using an MBO-type structure.

In this scenario the remaining shareholders would form a new company (Newco) which would acquire all of the company’s shares, including their own. The remaining shareholders would receive shares in Newco as consideration, i.e. a share-for-share exchange, but the outgoing shareholder would receive cash consideration, with the desired element on deferred terms.

Example. Scott owns 400 £1 ordinary shares and has agreed to sell them for £400,000, with payment being received in four equal instalments over four years. Instead of undertaking a buyback, Newco would acquire the 400 shares and pay £100,000 upfront, with an agreement to pay the remaining £300,000 in three yearly instalments.

The company is still able to fund the purchase over a number of years out of annual cash profits, but it does so by paying tax-free dividends up to Newco each year (as its parent company), rather than by cancelling its own shares.