Mark McLaughlin considers whether capital gains treatment on a company purchase of its own shares is always the best choice.
For individual shareholders of family or owner-managed trading companies, a company purchase of own shares (CPOS) can be a useful ‘exit’ strategy in the right circumstances, subject to certain company law requirements being satisfied.
Income or capital?
When the company buys back its own shares from the shareholder, any ‘premium’ (i.e. payment exceeding the capital originally subscribed for the shares) constitutes a distribution of income (i.e. like a dividend).
However, if certain conditions are satisfied (in CTA 2010, Pt 23, Ch 3) the vendor is normally treated as receiving a capital payment instead. This sometimes provides individual shareholders with a tax-efficient departure from the company, particularly if capital gains tax (CGT) business asset disposal relief (BADR; formerly entrepreneurs’ relief) covers the whole gain so that the CGT rate is only 10% (for 2020/21).
The conditions for capital gains treatment on a CPOS include a ‘trade benefit’ test and various other requirements (e.g. as to the vendor shareholder’s residence, length of ownership of the shares and the extent of any ongoing connection with the company). The conditions are detailed and outside the scope of this article.
The herd instinct
The tendency on a CPOS is to seek capital gains treatment (if available). As indicated above, if BADR is available it can result in a CGT rate of 10% on gains of up to £1 million from qualifying business disposals.
However, even if BADR is not available it may still be preferable for the transaction to be treated as a capital payment. A CGT rate of 10% applies where an individual is not liable to income tax at the higher rate. There is also a CGT rate of 20% if the individual is a higher rate taxpayer, or to the extent that chargeable gains exceed the unused part of the individual’s basic rate band (subject to certain limited exceptions). By contrast, the rate of income tax on distributions (subject to a £2,000 nil rate) is 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers (for 2020/21).
If the vendor shareholder was ineligible for BADR, a CGT rate of 20% will often be more attractive than income distribution treatment, especially if the disposal proceeds are substantial.
However, in certain circumstances (i.e. particularly where BADR is unavailable) income distribution treatment may be preferable. For example, disposal proceeds may be relatively small; or it may be possible to dispose of the shares in tranches over more than one tax year, possibly enabling the individual’s basic rate band to be fully utilised (e.g. if a director shareholder is retiring, the proceeds on a disposal in a later tax year might supplement retirement income).
As always, it would be sensible to ‘crunch the numbers’ to establish whether capital gains or income treatment will be more beneficial on a CPOS, based on the particular circumstances.
Capital gains treatment on a CPOS is automatic if the relevant conditions are satisfied. However, if income distribution treatment is preferred for any reason, it may be possible to break the conditions for capital gains treatment. Expert professional advice is recommended.