A company purchase of own shares (POS) has always seemed to me a bit of an oddity for tax purposes. The consideration paid for the buy-back is a distribution for both company law and income tax purposes, like a dividend. However, if certain tests (at CTA 2010, ss 1033– 1042) are met, we pretend that the payment is a capital distribution in respect of shares (within TCGA 1992 s 122).
As many readers will be aware, an HMRC statutory clearance procedure applies, for which further guidance is provided by HMRC’s statement of practice SP2/82.
Back to Basics
There are two fundamental conditions A and B, which introduce the relevant legislation. Condition B does not concern us here, while Condition A is the trade benefit test, meaning that the purpose of the buy-back must be ‘wholly or mainly for the purpose of benefiting a trade carried on by the company or any of its 75% subsidiaries’ (and not for tax avoidance purposes).
The first port of call, though, is probably to check that the five-year ownership requirement is met, which is easy to overlook initially, and time may be wasted in focusing on other requirements.
It is, of course, essential that all requirements are met, such as the ‘substantial reduction test’ and the ‘connection test’. Those tests allow for some flexibility in terms of retaining some holding in the company.
However, HMRC’s approach parts company with the legislation to some extent. It states that unless the seller divests themselves of their entire holding (except for up to 5% retained for ‘sentimental reasons’), they would not normally accept that the trade benefit test is met. All roads lead to Rome, one might say.
Trade Benefit Test Under SP/82
SP2/82 weighs in on the trade benefit test from the ‘get-go’ by insisting that the test is not met where the transaction is ‘designed to serve the personal or wider commercial interests of the vending shareholder’.
The guidance does give some examples of situations where the trade benefit test is likely to be met; perhaps the main ones being where there is a disagreement among shareholders over the management of the company, which may have adverse consequences for the company’s trade, or where a controlling shareholder wishes to retire as a director and end their association with the company.
On that note, HMRC normally does not like the seller to remain as a director or consultant, although in practice it will often accept a continuing role for a temporary period for commercial reasons.
The guidance does accept the seller retaining part of their holding (subject to other tests being met) if the company does not have the resources to buy back the entire holding, so it buys as many shares as it can afford with a view to buying the remainder when possible.
It can be difficult to demonstrate that the trade benefit test is met where minority holdings, which may therefore have little influence, are concerned. If the shareholder is a director or key employee who is leaving the company, the test could arguably be met in that context, as few private companies are comfortable with minority shareholders who have no other connection with the company.
Practical Tip
The trade benefit test is not a mere formality to be glossed over, and it is important to explore every nuance of the circumstances with the client to put forward the best case possible. However, if there appears to be a significant risk that the test may not be met, it may be preferable to consider a management buyout-type structure involving insertion of a holding company – which also has certain tax and commercial benefits.