Don’t Forget the ‘Easy’ Rules!

A company purchase of its own shares from a shareholder is a popular ‘exit’ strategy when an individual shareholder is retiring, or a dissenting shareholder is departing.

Income Vs Capital

When a company buys back its own shares from an individual shareholder, amounts above the capital originally subscribed generally constitute a distribution of income (i.e., like a dividend). However, if certain conditions are satisfied, the vendor is normally treated as receiving a capital payment instead. This can be tax-efficient if capital gains tax (CGT) business asset disposal relief (BADR) is available and the CGT rate is only 10%. This ‘capital treatment’ is subject to various conditions (in CTA 2010, Pt 23, Ch 3). There is a natural tendency to focus on those conditions often considered the most difficult, such as whether a ‘trade benefit test’ is satisfied, or the extent (if any) to which the shareholder will remain connected with the company. However, it is essential not to overlook probably the most fundamental rule – the ‘trading company’ requirement.

Trading Company?

Broadly, the company must be an unquoted trading company (or the ‘holding company’ of a ‘trading group’). A ‘trading company’ for these purposes is a company whose business consists ‘wholly or mainly’ (i.e., more than 50%) of carrying on one or more trades. Unfortunately, there is little guidance on the meaning of ‘trade’ in the tax legislation. This has resulted in extensive case law over the years. The characteristics of a ‘trade’ are beyond the scope of this article. However, the ‘badges of trade’ can sometimes be helpful. These were first established in 1955, using case law about what constitutes a trade. Subsequently, in Marson v Morton Ch D 1986, 59 TC 381, nine badges were identified (e.g., profit-seeking motive, number of transactions). For HM Revenue and Customs (HMRC) guidance on the badges of trade, see its Business Income Manual at BIM20205. The company must carry on the ‘right’ trade; capital treatment on a company purchase of own shares does not apply to certain activities, namely dealing in shares, securities, land, or futures.

More Generous?

The definition of ‘trading company’ under the company purchase of own shares rules differs from the BADR definition for CGT purposes, which requires that the company’s activities do not include to a substantial extent activities other than trading activities. HMRC guidance (in its Capital Gains Manual at CG64090) indicates that considering whether non-trading activities are ‘substantial’ for BADR purposes involves measuring various indicators, and states: “For practical purposes it is likely that from accounts submitted some consideration can be given to the level of non-trading income and the asset base of the company. Where neither of these suggest the non-trading element exceeds 20% the case is unlikely to warrant any more detailed review.” Hence, it is possible that a company may satisfy the ‘wholly or mainly’ test of trading status on a purchase of its own shares, but a gain on the disposal of those shares may be denied BADR in the hands of an individual shareholder because the company’s non-trading activities are ‘substantial’.

Practical Tip

In HMRC’s view, it is not enough that the company was formerly trading or intends trading in the future; it must be a trading company when the company purchase of own shares takes place (Tax Bulletin, Issue 21).