Company purchase of shares & entrepreneurs’ relief

For many owner-managed trading companies the rules relating to purchase of shares are a useful tool to employ when shareholders fall out or one of the owner-managers decides to
move on.

Clearly, remaining owner-managers don’t want the dissenting shareholder to depart and continue to hold shares, while often none of them wants to buy the shares at the price demanded. In the absence of any likely outside purchasers, how can this dilemma be resolved?

Often the answer is for the trading company itself to purchase the shares from the departing shareholder, which is relatively straightforward if there are sufficient distributable reserves to meet the payment required. The shares purchased are then cancelled.

In tax terms, on first principles, the departing shareholder, when selling his shares back, will have received from the trading company an income distribution equal to the excess over the price paid for the shares. He will also have disposed of his shares but, in calculating his capital gains tax position, he deducts from his taxable proceeds the amount treated as an income distribution.

In most cases the departing shareholder would have just the tax on income distribution to pay as this will cover the whole of his proceeds. Nowadays this will usually produce an effective tax charge at 25% or 36.11% for him.

Not surprisingly the departing shareholder will want to pay only capital gains tax on a trading company purchase of shares. If the seller is a UK tax resident and has held the shares throughout the five years up to the date of the company purchase, the sale should not be treated as a distribution, provided the transaction is being undertaken to benefit the trade (and not to benefit the shareholder).

Generally, where there is a dissenting shareholder, it is beneficial to the trade for that dissenter to depart so this condition is satisfied. If the sale is not a distribution, the whole of the proceeds are subject to capital gains tax.

But securing capital gains tax treatment is only a halfway house. What the departing shareholder really wants is also to qualify for entrepreneurs’ relief to obtain a 10% tax rate.

Achieving this is not as simple as it first looks. For to qualify for entrepreneurs’ relief the departing shareholder must have held at least 5% of the ordinary share capital of the trading company with at least 5% of the votes, as well as been an office holder or employee throughout the whole of the 12 months up to the date of disposal.

If the dispute arises and one of the owner-managers resigns from the company immediately before starting to negotiate for the trading company to purchase his shares, he might pay tax under only capital gains tax, but he won’t qualify for entrepreneurs’ relief. He will not have been a director or employee throughout the whole of the 12 months up to the date of disposal of his shares.

The lesson to learn is don’t resign as a director until the exchange of the share purchase agreement.

Read more business tax advice.

Read about the Enterprise Investment Scheme (EIS) relief – great if you can get it, courtesy of Goldsmiths LLP