Company law update: share buybacks

On 4 July, BIS published the Nuttall Review of Employee Ownership which examines barriers to employee ownership arrangements. One of the findings is that private companies 'would like the facility to buy shares by paying for them in instalments'.

Share buybacks are widely used and for a variety of reasons. Increasingly, given the relative dearth of funding for outright acquisitions and MBOs, they have been used as an exit strategy to allow one shareholder to leave the company while increasing the shareholdings of the remaining shareholders. Such use has risen dramatically since 2008. At the same time, the remaining shareholders are increasingly looking, as a matter of caution, practicality or funding, to avoid the company paying all the consideration at completion. They want to defer payment over time, often over a few years. There are two immediate barriers:

? Section 691(2) of the Companies Act 2006 requires that 'the shares must be paid for on purchase' in other words in full on the date of purchase and in cash. So it is not possible to defer payment (Pena v Dale [2003] EWHC 1065 (Ch)) or pay by the transfer of a non-cash asset (Chappell & Co v Nestle & Co Ltd [1960] AC 87) or set-off any existing liability in consideration of the shares; and

? Section 1033 of the Corporation Tax Act 2010 sets conditions as to whether the buyback will be a distribution of income or a capital receipt. Unless real care is taken, the proceeds of the share buy-back will be taxed as the seller's income.

Share buyback with a loan back?

One of the solutions which has been popular in the past few years is for the seller to loan the proceeds immediately on completion back to the company. This still requires all the cash to be both made available at completion and to be lawfully financed out of distributable profits, out of a fresh issue of shares or out of capital. If the seller is looking to receive more for the shares than the distributable profits or the available cash, the company will have to fund the buy-back externally (which will be unattractive). The deal may also fail the conditions for capital treatment and have other adverse tax consequences.

Conditions for capital treatment

Section 1033 sets the following tests if the receipt is to be treated as capital in the seller's hands:

? the company must be an unquoted trading company or the unquoted holding company of a trading group;

? the buyback must be wholly or mainly for the benefit of a trade carried on by the company or its subsidiary;

? the seller must be ordinarily resident in the UK in the tax year in which the shares are purchased;

? the shares must have been owned by the seller for at least five years;

? the seller's interests must be substantially reduced by the sale. This will be satisfied if his ownership and entitlement to profits is reduced by more than 75 per cent; and

? immediately after the sale the seller must not be connected with the company or any other group company. A person is connected if he directly or indirectly has or is entitled to more than 30 per cent of the issued shares, the loan capital and issued ordinary shares or the voting power.

The immediate and obvious ways in which these conditions may not be met are if the seller becomes a lender to the company or if the seller wishes to remain as a director or employee. The former issue has been dealt with by the seller lending the monies to a third party who then lends to the monies to the company '“ but this approach is falling out of favour. The latter issue is a real problem if the seller wishes to take the benefit of entrepreneur's relief as section 1691 of the Taxation of Chargeable Gains Act 1992 requires the seller to be an officer or employee of the company or a member of its group for at least one year before the date of the sale '“ if he resigns at completion but sells shares subsequently that relief will not be available in respect of the shares sold after his resignation.

A new solution

The neat new solution which, if carefully handled, will satisfy both the conditions for capital treatment and avoid the transaction falling foul of section 691 is for the seller ?to agree:

(i) to sell the shares in (usually equal) instalments on agreed dates (for example, one quarter of his shares on the date of the agreement and a further quarter on each of the next three anniversaries). While payment by instalments is prohibited, HMRC has accepted the wisdom of the ICAEW Technical Release 745 which confirmed that a 'company may contract to buy shares for completion to take place for a particular number of shares on different dates'; and

(ii) to transfer to the company at completion all his beneficial interest in the remaining shares. Helpfully HMRC also takes the view in the above release that if the shareholder agrees to transfer the beneficial ownership of the shares, it will regard the disposal of all the shares as taking place for capital gains tax purposes at the date of the agreement, notwithstanding that payment is due later.

The shareholder must transfer all his rights in the shares to the company, including the rights to receive any dividends, any share of the capital and any right to vote. In addition to other warranties as to his right to sell the shares, he should also agree that the company shall be the sole beneficial owner of the remaining shares and that he merely holds the shares as a nominee and on a bare trust for it.

The seller's waiver any of these rights, pre-emption rights and other rights attaching to the shares or under the articles will also help and serve as a prompt for him to waive or cancel any rights under any shareholders' or other agreement. Employment rights need not, but might sensibly, also be compromised, but obviously should be dealt with under section 203(3) of the Employment Rights Act 1996.

Of course, whether a shareholder can transfer the beneficial interests in the shares back to the company itself is a moot point. Section 658 of the Companies Act prohibits a company acquiring its own shares except as specifically provided but the Act neither expressly forbids nor permits a company taking a beneficial interest in its own shares. Since HMRC has long recognised the possibility of the transfer of the beneficial interest in shares to the issuing company, I presume it will not take the point. HMRC has argued that if the shares still carry the right to vote, the shareholder is potentially still connected to the company. Similarly, it sometimes argues that the monies due in time to the shareholder represent loan capital. We have seen both arguments successfully defeated.

Other benefits of transfer of the beneficial interest

As the transfer of the beneficial interest is treated by HMRC as a disposal of all the shares at the date of the agreement, the seller may resign as a director or employee without fear of invalidating his entitlement to entrepreneurs' relief. That transfer and resignation will also help him to satisfy the substantial reduction and connection tests.

If there is still any doubt it is not infrequent to convert the shares into non-voting and non-dividend participating shares. This usually assists, more than anything, by providing some comfort to the remaining shareholders that they have all the voting and dividend rights.

The risks

Of course, this mechanism does not avoid the fact that there must be sufficient distributable profits on the date of each instalment to fund the payment. It also fudges the issue that, while HMRC will want the contract to be unconditional in order for it to treat as an immediate disposal of all the shares, the need for sufficient distributable profits on each instalment date means that the contract is, as a matter of law, anything but unconditional.

The seller is obviously therefore risking that the company may not generate sufficient profit or that it may expend its profit deliberately to avoid its obligations. In most cases, given that the company has incurred expense, time and professional fees to assist with the structure, negotiations and documentation of the deal, that fear looks like paranoia.

However, a seller may fear that control of the company may change, relationships may deteriorate and other considerations may come to the surface (particularly after the shareholder has left). It is possible to agree provisions to protect or maximise the profit of the company along the lines of the provisions that might be negotiated on an earn-out.

The seller also must accept that he is not entitled to the benefit of any dividends after the date of the agreement and that ought to be reflected in the price.

The company is also running a risk. Whilst the seller is legally obliged to sell, it is wise to have provisions to allow a director, in case the seller fails to cooperate, to receive monies on the seller's behalf and to execute and deliver all such necessary documents in his name.

The company also runs the same risk that it may have insufficient distributable profits. If it does not, there can be no claim by the seller who, if he is well advised, should appreciate that he cannot sue the company for failure to perform what it cannot lawfully perform.

The company can protect itself (and give some comfort to the seller) by provisions ?so that:

? if the available distributable profits will only buy some of a tranche of shares, the company may still buy such number as it can afford;

? if shares remain unsold from that tranche, the purchase dates are reset so that there are other occasions upon which the company must purchase if it then has distributable profits; and

? the company should have a general power to accelerate its right to purchase all of the shares at any point so long as the seller receives what he otherwise would have received.

My team has completed quite a number of buybacks in instalments in this way. You will also need to bear in mind the other procedural requirements of the Companies Act. It will also be essential that both parties are well-advised on tax and that advance clearance is sought from HMRC.