Article

The fallout of failed share buybacks

Key points

• Despite their routine nature, share buybacks are often carried out incorrectly.
• One of the reasons for these errors may be that there are numerous company law requirements to consider, and complex legal issues.
• There are several mechanisms a company may use for a share repurchase: repurchase out of capital; repurchase from the proceeds of a fresh issue of shares made specifically for this purpose; and (the most common) repurchase shares out of distributable profits.
• The tax implications of an error will depend on numerous factors but if the company is a close company and the original payment is treated as a debt from the date it was made, s 455 tax and the interest thereon often mounts up to six-figure sums.

When it comes to transactions involving share capital, few areas are more frequently mishandled than a company repurchasing shares from existing shareholders – second only, perhaps, to employment-related securities and share option schemes. Despite their routine nature, buybacks are often carried out incorrectly, sometimes with serious consequences.

These mistakes usually come to light during a company sale, when legal and tax advisers scrutinise the company’s corporate history with a fine-tooth comb. In many cases, share transactions from years, or even decades, ago are placed under the microscope.

Why is this such a persistent issue, and how significant are the risks? Before answering that, it is important to revisit the fundamental legal and tax requirements governing a company’s ability to buy back its own shares.

Conditions of a company purchase of own shares

CTA 2010, s 1000(1)(B) tells us that any distribution in respect of shares is to be treated as a distribution and any ‘premium’ paid on the buyback (typically above the original subscription price) represents an income distribution (CTA 2010, s 1024).

However, provided certain conditions are met, the repurchase may be treated as capital for the shareholder. Briefly, these conditions are:

• the repurchase is by an unquoted trading company, or the unquoted holding company of a trading group (CTA 2010, s 1033(1)(a)). Note that trading in this context is a ‘wholly or mainly’ test, meaning at least 50% of the company’s activities must be trading in nature;
• the repurchase cannot be for tax avoidance (CTA 2010, s 1033(2)(b)(ii));
• the repurchase must be wholly or mainly for the benefit of the trade (CTA 2010, s 1033(2)(a));
• the seller must be UK resident (CTA 2010, s 1034);
• the seller must have held the shares for at least five years (if the seller acquired the shares on the death of a previous owner, this is reduced to three years and the deceased’s holding period is also included) (CTA 2010, s 1035/6);
• the seller must, as a result of the buy-back, reduce their interest in the company by at least 25% (CTA 2010, s 1037); and
• the seller must not be connected with the company following the buy-back (CTA 2010, s 1042).

Alternatively, the capital treatment may be available where it is by an unquoted trading company (or holding company of a trading group) and the cash is used substantially to discharge an inheritance tax liability.

Indeed, the tax consequences of failing any of the above conditions will mean that the payment is treated as a distribution, which typically results in the difference between the proceeds and the original subscription price being taxable as a dividend.

Where the shareholder was not the original subscriber and acquired the shares ‘second hand’, the difference between the shareholder’s base cost and the subscription price is then likely to create a capital loss.

Legal requirements

There are numerous company law requirements to consider, and the somewhat complex legal issues are perhaps the primary reason company buybacks fail.

There are several mechanisms a company may use to undertake a share repurchase. One is a repurchase out of capital (CA 2006, Ch 5 Part 18), which is complex, requiring solvency statements, a special resolution and public notice. If the amount falls within certain de minimis thresholds, a repurchase out of capital may be possible without meeting these requirements (CA 2006, s 692(1ZA)). It is also possible to repurchase shares from the proceeds of a fresh issue of shares made specifically for this purpose (CA 2006, s 692(2)(a)(ii)). However, by far the most common approach is to repurchase shares out of distributable profits (CA 2006, s 692(2)(a)(i)) and it is this that is our first company law issue.

Typically, the legal advice in cases where a company has repurchased shares and it has since come to light that there were insufficient distributable profits is that the transaction is unlawful and deemed never to have occurred.

The other common legal issue that causes these transactions to fail is that the shares must be fully paid (CA 2006, s 691(1)), and HMRC manuals make it clear that this means cash must be paid for the shares in full:

‘To effect a valid purchase the company must make full cash payment on purchase. The transfer of any other asset or the creation of a loan account because, say, the company does not have sufficient cash available does not represent payment. In such circumstances, the shares are not treated as cancelled and legal ownership remains with the vendor. The tax treatment following from an invalid purchase of own shares depends upon the actions taken (if any) to rectify matters.’ (CTM17505)

The company may seek to obtain external finance (eg from a bank) to raise sufficient cash to fund the purchase. However, this may be problematic as the accounting double entry for obtaining external finance is debit cash, credit liabilities. In other words, it does not create distributable reserves and typically, where a company does not have sufficient cash, it often will not have enough distributable reserves either.

So, from the perspective of a tax adviser, the two company law requirements that seem to be the main issues are the availability of distributable profits and not paying for the shares in cash at the time of the repurchase. If it later transpires that either requirement was not met, it is often the case that the repurchase is treated as unlawful, and the legal ownership of the shares is retained by the original shareholder.

Example 1

In 2010, Forrest Diversification Ltd was owned 50% each by Jayne and Diane. On Diane’s retirement, it was agreed that the company would repurchase her shares for £350,000. The company did not have sufficient cash to pay for the whole amount upfront, and the resolution stated:

‘Payment will be made to Diane as follows:

a) £200,000 on the date of this agreement

b) £50,000 on 30 September 2011

c) £50,000 on 30 September 2012

d) £50,000 on 30 September 2013.’

Then, in 2022, Jayne decided to sell 100% of the company to an EOT for market value of £8m.

On undertaking due diligence, the solicitors identified that payment had not been made in full on repurchasing the shares (contravening CA 2006, s 691(1)) and Diane was deemed to legally still own those shares. In theory, she may, therefore, have a claim to £4m of Jayne’s disposal proceeds.

The failure of a £350,000 share repurchase, could have resulted in £4m cost to Jayne as well as the tax implications explained below. Not only did this create a significant issue in terms of a potential claim on the EOT sale proceeds, but it also involved significant time and professional fees to resolve.

Example 2

In 2015, a company with a market value of £10m was owned 50% each by a husband and wife. On divorce, a share repurchase was undertaken to remove the wife as a shareholder, as she had little involvement in running the company. A bank loan was obtained and the wife agreed for her shares to be repurchased for £4m, representing a minority discount for her lack of control. Throughout the following period to 2024, the husband, now 100% shareholder, extracted profits as dividends of £800,000 a year, on average.

Despite paying for the shares in cash, it transpired that the company did not have sufficient distributable reserves, and this was brought to the ex-wife’s attention in 2024.

On legal advice, the wife was informed that she retained the legal ownership of 50% of the company and, not only might she have a claim on the company’s current value for her shares, but she also had a claim to dividends of an equal amount to the husband’s dividend over the previous nine years, some £7.2m. The wife sued the company for full payment of unpaid dividends.

While examples 1 and 2 might seem extreme, they are real cases encountered over recent years and are not, unfortunately, isolated issues.

Failed buybacks

What are the consequences of failed buybacks?

Liability to repay

The first issue, once a failed buyback has been identified, is how the original amounts paid to the shareholders should be treated.

For legal purposes, CA 2006, s 847 explains that an unlawful distribution may not be repayable unless the shareholder had ‘reasonable grounds’ to know the distribution is unlawful. However, this does not apply to payments made by a company to redeem or purchase its own shares (CA 2006, s 847(4)(b)).

Therefore, if a company repurchases shares, s 847 is not relevant to the repurchase itself. Assuming the shareholder believed the repurchase was lawfully completed, any future dividends are unlikely to become repayable, as they would not have had reasonable grounds to believe they were unlawful.

Future transactions

The impact on future transactions, whether that be dividend payments in future years to holders of the same class of shares or share reorganisations and restructures, must also be considered. In the first instance, this will be a legal issue.

Consider another real-life example: a trading company was originally owned by three shareholders, each holding 33 1/3%. When one of them retired, the company intended to buy back that shareholder’s shares, leaving a 50:50 ownership split between the two remaining individuals.

Following the buyback, a share-for-share exchange was implemented, placing a new holding company (HoldCo) above the original trading company (TradeCo). A property was then transferred to HoldCo, with the expectation that group relief would apply for both capital gains (under TCGA 1992, s 171) and stamp duty land tax (under FA 2003, Sch 7 Part 1), assuming the 75% ownership threshold was comfortably met in both cases.

But then came the surprise, the original buyback had not been validly executed. The retired shareholder still legally owned their 33 1/3% stake. Suddenly, HoldCo’s effective ownership in TradeCo was only 67%, falling short of the 75% threshold required for the tax reliefs.

At this point, the main question was whether the defective transaction could be rectified, potentially through court proceedings, or whether it was void altogether. If it was void, the buyback would only be taking place now, the group relationship would not exist at the time of the property transfer and the requirements of capital gains and SDLT group relief failed.

This kind of oversight, while easy to miss at the time, can have serious long-term implications, especially when corporate restructuring or tax reliefs are involved.

HMRC treatment

The outgoing shareholder has received payment without having legally disposed of the shares. Therefore, HMRC is likely to consider that there has either been a distribution (meaning income tax at dividend rates) or a loan has been made to the shareholder.

If the payment is treated as a loan to an individual, the main concerns will be in relation to the loans to participator provisions within CTA 2010, Part 10, and the beneficial loan provisions if the shareholder is also an employee (or associate of an employee).

Loans to participators and the ‘s 455’ charge

The loans to participators provisions apply where the company is a close company and a loan is treated as being made to a shareholder. This may be the case if the shareholder has received a payment without having legally disposed of the shares.

Very broadly, a ‘close company’, as defined by CTA 2010, s 439, is a company that is controlled by five or fewer participators, or any number of participators who are also directors. A participator being a shareholder or certain loan creditors. However, in the definition of control, we must also consider the rights of associated persons. Typically, this brings many owner-managed businesses within these provisions.

Where we have a debt outstanding, and the company is a close company, CTA 2010, s 455 requires a payment of tax from the company equal to the outstanding debt multiplied by the upper dividend rate.

In some failed buyback cases, s 455 may not apply where the position is rectified in time. In the case of a small company this would be nine months and a day following the company’s accounting period end. However, in my experience, these issues are often not identified until years later.

In practice, there may be a cash flow issue as the company is strictly liable to pay the s 455 tax and can only reclaim the tax, for small companies, nine months and one day following the end of their accounting period in which the matter is resolved.

Our other issue, which presents a real cost to the company, is that interest accrues for late payment of s 455 tax from its due date to the date the loan is repaid, released or written off. In this case, the date the transaction is rectified. On even relatively small transactions, this interest charge can mount up to six-figure sums if the transaction occurred years earlier.

Penalties may also arise on unpaid s 455 tax under FA 2007, Sch 24, where HMRC determines that there has been a deliberate inaccuracy in the company’s tax return.

In Gopaul (TC8917), the First-tier Tribunal upheld penalties for the deliberate suppression of profits for VAT and corporation tax, but found that HMRC failed to prove deliberate behaviour regarding the omission of s 455 liabilities, as they did not demonstrate that the director knew the extraction of money could trigger a s 455 charge.

In most cases, it is likely the failed buyback was not known to the directors, especially if they are not suitably qualified tax advisers or solicitors meaning it is likely that the error is neither intentional nor deliberately concealed. On that basis, it is difficult to see how HMRC could justify imposing a penalty for deliberate inaccuracies.

However, this would be more difficult to argue if one or more directors knew of the problem, or it is not disclosed once they are made aware.

Timing, timing, timing…

Section 455(4) states that a close company is regarded as making a loan to a person where ‘that person incurs a debt to the close company’.

It could be argued that, until the issue was identified, none of the parties involved in the transaction considered there to be a debt and that, upon the company making the payment to the shareholder, no debt was created as all parties believed the shares to have been validly repurchased.

If that is the case, then our s 455 problem goes away.

If, on the other hand, HMRC could successfully argue that a debt was created, and that the debt arose from the date of payment (rather than perhaps the date on which the error was identified), then there will be tax implications.

Personal tax position

From a personal tax perspective, if the repurchase cannot be rectified retrospectively, the transaction is now being treated as if it had never occurred, meaning any capital gains tax or income tax paid on the original disposal would have been charged incorrectly.

For the shareholders who have also been employees or directors, or associated with an employee or director at any point, the receipt of a loan where no interest was paid by the shareholder would result in a benefit in kind (BIK) arising for the individuals. This would have needed to be reported on a P11D, with the shareholder subject to income tax on the deemed benefit and the company liable for class 1A National Insurance. There are a number of exclusions from this rule, the most obvious in this instance where the values involved are less than £10,000 (£5,000 in 2013-14 and prior).

This means there may be income tax exposure for the shareholder on the deemed benefit arising from the interest-free loan. As well as interest on the outstanding amount during the period for which the tax liability remained unpaid.

Again, one might deem the charging of penalties in a case such as this to be harsh, given the circumstances in which the deemed loan arose, unless the shareholder had ground for being aware of the issue.

While HMRC would charge interest on unpaid tax, the fact that the original tax on the disposal of shares was incorrectly paid should create a credit on which repayment interest should be due. Of course, the lower HMRC rates of repayment interest rate will only partially offset the late payment interest charged.

Effect on other reliefs

On the original disposal, assuming the capital conditions were met, there may be a number of consequences if the transaction is treated as void and a CGT disposal occurs now instead.

The first is that the CGT annual exempt amount is now only £3,000; in previous years this was as high as £12,300.

The second, and more significant consequence is that, where the conditions for business asset disposal relief (BADR) were met, or entrepreneurs’ relief if the original transaction pre-dated 11 March 2020, the shareholder may have paid CGT on their entire gain at 10%.

Do they continue to meet these conditions if the transaction is treated as occurring now? The most likely failure is that they may have ceased to be an employee or officer of the company following the original transaction. Even if they do still meet the conditions, the lifetime allowance is now £1m, instead of £10m for entrepreneurs’ relief pre-11 March 2010 and the BADR rate is now 14%, instead of the previous 10%.

Impact on HMRC clearance

Where the capital treatment conditions are met, the company may have sought HMRC clearance (see CTA 2010, s 1044) to confirm they agree with this conclusion. If a new transaction is required to rectify the position, strictly, if no material facts have altered since HMRC made their decision, it should not be necessary to reapply.

However, depending on the facts of the case, particularly if years have passed since the original decision, it would be prudent to reapply for clearance and seek HMRC’s confirmation that their view is unchanged.

Conclusion

The consequences of a failed company repurchase of shares can be significant. If there is a legal process allowing the original transaction to be rectified with retrospective effect, this is likely to be the best solution from a tax perspective. However, this is often not the case, especially where the outgoing shareholder is unco-operative, and the impact can be far-reaching.

Arguably, the most serious impact may be the fact the shareholder retains legal ownership, putting future share transactions in jeopardy and potentially allowing the shareholder to have a claim to the company’s current market value and previous dividend payments.

The tax implications will depend on numerous factors but if the company is a close company and the original payment is treated as a debt from the date it was made, s 455 tax and the interest thereon often mounts up to six-figure sums.

For the individual shareholder, while there may be a potential benefit in kind tax on the ‘loan’, the impact on tax reliefs, especially, the availability and rate of BADR could have a material impact on their tax exposure.

It will also be necessary to assess the impact on any transactions from the date of the failed buyback to the date it is rectified, both at shareholder level and within the group.

If there is one thing to take away from all this, it is that company buybacks are not straightforward. The company law aspects are frequently implemented incorrectly and even relatively low value buybacks can have significant future consequences, given shareholders may have a claim to much larger values if the company has grown over time.

Proper advice on both the tax and legal implications is essential.

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