technical factsheet 177 Company purchase of own shares CONTENTS 1. Introduction 2. Legal aspects 3. Taxation 4. Accounting 5. Reporting 6. General business planning issues 7. Ethical considerations for the adviser Appendix 1 Summary of the law relating to company buy back of own shares Appendix 2 Extract from the Auditing Practices Board bulletin 2008/9 Appendix 3 Example of a special resolution and notice of special resolution Appendix 4 Extract from HMRC publication SP2/82 company’s purchase of own shares Appendix 5 Extract from HMRC Tax Bulletin 21 (purchase by an unquoted company of its own shares) This technical factsheet is for guidance purposes only. It is not a substitute for obtaining specific legal advice. Whilst every care has been taken with the preparation of the technical factsheet neither ACCA nor its employees accept any responsibility for any loss occasioned by reliance on the contents. 1. INTRODUCTION Private companies often decide to purchase their own shares from shareholders. A common situation is when an existing shareholder wants to sell some or all of his/her shares and the other shareholders are unwilling or unable to purchase them. This factsheet also provides an overview of a reduction of capital which involves no payments being made by the company to shareholders. The legal, tax, accounting, reporting and general business planning issues need to be carefully considered. Ethical matters will also need to be considered by both accountants working in the business and external advisers if the accountant is advising both the company buying the shares and the shareholder selling the shares. 2. LEGAL ASPECTS Companies Act 2006 sections 641 to 653 deal with reduction of share capital and Part 18 sections 658 to 737 deal with the purchase by a company of its own shares. A summary of these sections can be found in appendix 1. The following legal requirements apply from 1 October 2009:  A private company may redeem or purchase its shares out of capital by passing a special resolution together with a statement by each of the directors that the company is solvent supported by an auditors’ report as to the reasonableness of such a statement. See appendix 6 for an example of a special resolution.  A private company may reduce its capital by issuing a solvency statement and passing a special resolution. This procedure does not require a report by the auditors.  Public companies continue to require court approval for capital reduction. Companies Act 1985 required private companies who wish to give financial assistance for the purchase of their own shares to comply with a ‘white-wash’ procedure. This requirement was abolished by the Companies Act 2006. From 1 October 2008 a private company can provide financial assistance for the purchase of its own shares, or shares of its private holding company, provided that it does not result in an unlawful reduction of capital. However, Companies Act 2006 prohibits a public company from giving financial assistance directly or indirectly for the purpose of the acquisition of its shares or those of its holding company or for the purpose of reducing or discharging any liabilities incurred in the acquisition of such shares (CA2006 s678 & s679). 3. TAXATION The shareholder selling the shares will be taxed on the sale of his/her shares to the company either based on the ‘‘distribution treatment’ or ‘capital treatment’. Distribution treatment is broadly the same as a dividend and subject to income tax whereas under the capital treatment the disposal is subject to capital gains tax. Where certain conditions exist, CTA 2010 s1033 provides that the distribution treatment does not apply to a payment made by an unquoted company on redeeming or purchasing its own shares. The effect is that the vendor is treated as receiving a capital receipt. However, if the vendor is a share dealer, the receipt will be trading income. CTA 2010 s1033 provides that the purchase consideration is exempt from distribution treatment under CTA 2010 s1000 if either: 1. the purchase is made wholly or mainly for the purpose of benefiting a trade, and certain other conditions are met (CTA 2010 s1033(2)(a)); or 2. the purchase is made to enable the vendor to pay inheritance tax (specific exemption in CTA 2010 s1033(3)). Where the conditions in CTA 2010 s1033 are satisfied capital treatment is automatic. It cannot be ‘disclaimed’. Nevertheless the vendor may be able to break one of the conditions to secure distribution treatment if this is beneficial. HMRC will give clearance for capital treatment only if the purchase consideration is to be fully paid immediately on completion and paid in money. This means that payment by instalments is not possible. HMRC have indicated that it is possible to make a contract under which successive tranches of shares are to be purchased on specified dates (see Revenue Tax Bulletin issue 21, the link for which can be found below). Under CTA 2010 s1044 a company proposing to make such a payment may ask HM Revenue and Customs to confirm either that CTA 2010 s1033 will apply, or that it will not apply. Further guidance on this clearance procedure can be found in SP2/82 the link for which can be found below. SP2/82 also gives guidance on the ‘trade benefit’ test referred to above. (SP2/82 has been reproduced in appendix 5). If a company makes a purchase of own shares that it believes falls within CTA 2010 s1033, it must make a return of the transaction to the Inspector (CTA 2010 s1046). The return must: (a) be made within 60 days of the payment (b) give particulars of the payment (c) explain why the company believes that CTA 2010 s1033 applies to the payment so as to exempt it from treatment as a distribution (see Statement of Practice SP2/82 (link below and appendix 5)). The company must make such a return even if the Board has confirmed that CTA 2010 s1033 will apply to the payment. If the company has agreed to pay the legal costs relating to a purchase of own shares such costs are generally disallowable in computing the company’s trading income. This is on the grounds that they are: (i) capital expenditure in respect of the company’s share capital, or (ii) within ICTA88 s74(1)(f). The expenditure is also likely to fail the wholly and exclusively test under ICTA88 s74(1)(a). Company Taxation Manual CTM17320 contains information on the relevant law references concerning relief for costs of distributions and demergers, this can be found at http://www.hmrc.gov.uk/manuals/ctmanual/CTM17320.htm 2 HM Revenue & Customs has produced the following documents which have useful taxation information relating to company purchase of own shares: 1. Statement of Practice SP2/82 is reproduced in appendix 5 and can also be found at http://www.hmrc.gov.uk/agents/sop.pdf HM Revenue and Customs issued guidance in Tax Bulletin 21 on purchase by an unquoted company of its own shares which is reproduced in appendix 6. It is for the company and vendor shareholder to agree a price for the shares, however the directors have obligations to creditors and the shareholders. The following tax implications may arise if the company purchases its own shares for a value other than market value. Purchase consideration exceeds market value 1. If HMRC can show that the purchase is not ‘a bargain made at arm’s length’ then they may seek to apply TCGA 1992, s17 which provides for market value to be substituted for the actual consideration. HMRC explain what they consider is ‘a bargain made at arm’s length’ in Capital Gains Manual CG14542 which can be found at http://www.hmrc.gov.uk/manuals/cgmanual/CG14542.htm 2. HMRC may argue that the excess of the consideration over market value is a distribution under ICTA 1988, s209(4). 3. HMRC may argue that the excess could fall within the definition of remuneration due to the wide scope of ICTA 1988, s19. Purchase consideration less than market value 1. HMRC may argue that TCGA 1992, s17 should be applied (as explained above). This may result in a chargeable gain greater than the vendor expected. The excess is a gift to the company, although hold over relief under TCGA 1992, s165 is not available. 2. The gift will be a transfer of value for inheritance tax purposes, which will not be a potentially exempt transfer because it is a transfer to a company. 3. Business property relief may be available on the transfer of shares, although this would not apply if death occurred within seven years as the shares are cancelled on acquisition by the company and therefore cannot remain within the estate of the recipient. 4. A transfer at undervalue followed by some remaining connection with the company may result in the ‘reservation of benefit’ provisions being relevant and the estate on subsequent death could be treated as including the gifted element. 4. ACCOUNTING CA 2006 s686 only allows redeemable shares to be redeemed if they are fully paid. Similarly s691 only allows a limited company to purchase its own shares if they are fully paid. Private companies, and public companies with shares which are not listed or traded on one of the markets highlighted below, will continue to be required to cancel any of their shares they purchase. Treasury Shares The Companies (Acquisition of Own Shares) (Treasury Shares) Regulations 2003 (SI 2003 No 116) amended the Companies Act 1985 so that in certain circumstances qualifying shares may be held ‘in treasury’ for future sale by the company. If the conditions are not met then the company must cancel the shares when they purchase them. Only ‘qualifying shares’ may be held as treasury shares. Such shares need to satisfy at least one of the conditions specified in CA 2006 s724(2) which are: 1. Included in the official list; or 2. Traded on the Alternative Investment Market; or 3. Officially listed in another EEA State; or 3 4. Traded on a market established in an EEA State which is a regulated market for the purposes of article 16 of Council Directive 93/22 EEC on investment services in the securities field. Companies Act 2006 sections 724 to 732 deals with treasury shares. Capital Redemption Reserve Where shares are redeemed or purchased wholly out of profits available for distribution a sum equal to the amount by which the company’s share capital is diminished on cancellation of the shares (there nominal value of the shares) should be transferred to the capital redemption reserve (CRR). (CA 2006 s733) Where the redemption or purchase is financed wholly or partly by a new issue of shares, the transfer to the CRR is reduced by the proceeds of the new issue. In the case of a private company the transfer to the CRR should be further reduced to the extent that the company can make a permissible capital payment. The capital redemption reserve may only be used subsequently to make a bonus issue of shares. Worked Example 1 Simple buy back at par value. A company has the following balance sheet: £ Cash at bank 25,000 Ordinary £1 shares 15,000 Profit and loss account 10,000 25,000 A decision is made to buy back 3,750 ordinary £1shares at par. The entries would be as follows: DR CR £ £ Ordinary share capital 3,750 Bank account 3,750 To redeem the shares Profit and loss account reserve 3,750 Capital redemption reserve 3,750 To maintain the capital at its original amount The balance sheet will now be: £ Cash at bank 21,250 Ordinary £1 shares 11,250 Capital redemption reserve 3,750 Profit and loss account 6,250 21,250 If there had been a fresh issue of shares, the second journal to maintain the capital would not have been necessary, except to the extent that the fresh issue fell short of £3,750. 4 Worked Example 2 Redemption at a premium If the above transaction had not been at par, but was instead at a premium of 20p per share, the entries would be as follows: DR CR £ £ Ordinary share capital 3,750 Profit and loss reserve 750 Bank account 4,500 To redeem the shares Profit and loss reserve 3,750 Capital redemption reserve 3,750 To maintain the capital at its original amount The balance sheet will now be: £ Cash at bank 20,500 Ordinary £1 shares 11,250 Capital redemption reserve 3,750 Profit and loss account 5,500 20,500 5 Worked Example 3 Redemption at a premium and shares issued at a premium A company has the following balance sheet: £ Cash at bank 28,000 Ordinary £1 shares 10,000 Redeemable preference £1 shares 4,000 Share premium account 1,800 Profit and loss account 12,200 28,000 The decision was made to redeem all the preference shares with a redemption premium of 25p per share. The preference shares were originally issued at a premium of 20p per share. The company also plans to make a fresh issue of 2,000 ordinary £1 shares at £1.50 per share. The entries would be as follows: DR CR £ £ Cash 3,000 Ordinary £1 shares 2,000 Share premium account 1,000 To record the new issue Redeemable preference shares 4,000 Share premium account 800 Profit and loss reserve 200 Cash 5,000 To redeem the redeemable preference shares Profit and loss reserve 1,800 Capital redemption reserve 1,800 To maintain the capital The balance sheet would now be: £ Cash at bank 26,000 Ordinary £1 shares 12,000 Share premium account 2,000 Capital redemption reserve 1,800 Profit and loss reserve 10,200 26,000 The amount of the share premium on the new issue, as restricted by the amount included in the share premium account from the original issue of the redeemable shares, can be released to set against the premium payable on redemption, thus reducing the amount to be debited to distributable reserves. The amount of the adjustment required to maintain capital is the amount that the proceeds of the new issue fell short of the nominal value of the shares redeemed, as adjusted for the amount already applied towards the redemption (£4,000-£3,000+£800). Share Premium Account Where the shares to be redeemed or purchased were issued at a premium and a fresh issue of shares is made for the purposes of the redemption or purchase, any premium payable on redemption or purchase may be charged against the share premium account. The premium so charged cannot exceed the lower of: 6 (a) the premium received on the issue of the shares now being redeemed or purchased (b) the current balance of the share premium account, including any premium on the new share issue (c) the proceeds of the fresh issue. Therefore where there is no fresh issue of shares no amount may be charged to the share premium account. Worked Example 4 Issue of new shares and redemption A private company has the following balance sheet: £ Cash at bank 3,500 Ordinary £1 shares 2,000 Share premium account 0 Profit and loss account 1,500 3,500 The decision is made to buy back 300 ordinary £1 shares for £2.00 each (£600 in total) which were originally issued for £1.50 each (£450 in total). The company is to issue 1,000 new ordinary £1 shares for £1.20 each (£1,200 in total). The share premium account which arose on the original issue of the shares now being redeemed or bought back was used some time ago to fund a bonus issue of shares. The journal entries for the new issue and buy back would be as follows: DR CR £ £ Share capital 1,000 Share premium account 200 Cash at bank 1,200 To effect the new issue Share capital 300 Share premium account 200 Profit and Loss Reserve 100 Cash at bank 600 To effect the buy back of shares Afterwards the balance sheet will look like this: £ Cash at bank 4,100 Ordinary £1 shares 2,700 Profit and loss account 1,400 4,100 Permissible Capital Payments (only applicable to private companies) The Permissible Capital Payment (PCP) is the amount by which the purchase or redemption cost exceeds the amount of distributable profits plus the proceeds of any new share issue. If the PCP is less than the nominal value of the shares redeemed or purchased, the difference is transferred to Capital Redemption Reserve (CA2006 s734(2)). This means that a private company should use its available profits and any share proceeds before making a payment out of capital. If the PCP is more than the nominal value of the shares redeemed or purchased, the excess may be used to reduce any of the following: 7 (a) capital redemption reserve (b) share premium account (c) revaluation reserve (d) fully paid share capital (CA2006 s734(3)) Worked Example 5 Redemption when insufficient reserves A private company has the following balance sheet: £ Cash at bank 15,000 Ordinary £1 shares 14,000 Profit and Loss Reserve 1,000 15,000 The decision is made to buy back 7,000 ordinary £1 shares at par. The distributable reserves are insufficient to allow this without a permissible capital payment. The procedures set out in the Companies Act have to be followed, and then the journal entries would be as follows: DR CR £ £ Share capital 7,000 Cash at bank 7,000 To effect the redemption Profit and Loss Reserve 1,000 Capital Redemption Reserve 1,000 To maintain the capital as far as possible Afterwards the balance sheet will look like this: £ Cash at bank 8,000 Ordinary £1 shares 7,000 Capital Redemption Reserve 1,000 8,000 In worked examples 1 to 3 above the share capital and undistributable reserves total to the same amount after the buy back as they did before, which is due to there being sufficient reserves to maintain the capital by virtue of a capital redemption reserve. In worked example 5 the total has reduced by £6,000 from £14,000 to £8,000. This £6,000 is the amount of the permissible capital payment which is equal to the shortfall on the profit and loss account reserves before the redemption. 8 Worked Example 6 Permissible capital payments (no new issue of shares) A private company has the following balance sheet: £ Cash at bank 13,000 Ordinary £1 shares 14,000 Profit and loss account (1,000) 13,000 The decision is made to buy back 7,000 ordinary £1 shares for £0.50 each (£3,500 in total) which were originally issued at par. The company has no distributable profits. The relevant calculations are as follows: £ Cost of purchase 3,500 Less: distributable profits nil Less: proceeds of fresh issue nil Permissible capital payment 3,500 Nominal value of purchase 7,000 Less: proceeds of fresh issue nil Less: permissible capital payment 3,500 Transfer to capital redemption reserve 3,500 The journal entries for the buy back would be as follows: DR CR £ £ Share capital 7,000 Capital redemption reserve 3,500 Cash at bank 3,500 Afterwards the balance sheet will look like this: £ Cash at bank 9,500 Ordinary £1 shares 7,000 Capital redemption reserve 3,500 Profit and loss account (1,000) 9,500 9 Worked Example 7 Permissible capital payments (with new issue of shares) A private company has the following balance sheet: £ Cash at bank 18,000 Ordinary £1 shares 10,000 Share premium account 5,000 Profit and loss account 3,000 18,000 The decision is made to buy back 5,000 ordinary £1 shares for £1.40 each (£7,000 in total) which were originally issued at par. The company is to issue 1,000 new ordinary £1 shares for £3.50 each (£3,500 in total). The relevant calculations are as follows: £ Cost of purchase 7,000 Less: distributable profits (3,000) Less: proceeds of fresh issue (3,500) Permissible capital payment 500 Nominal value of purchase 5,000 Less: proceeds of fresh issue (3,500) Less: permissible capital payment (500) Transfer to capital redemption reserve 1,000 The journal entries for the new issue and buy back would be as follows: DR CR £ £ Share capital 1,000 Share premium account 2,500 Cash at bank 3,500 To effect the new issue Share capital 5,000 Profit and loss account 2,000 Cash at bank 7,000 Profit and loss account 1,000 Capital redemption reserve 1,000 To effect the buy back of shares Afterwards the balance sheet will look like this: £ Cash at bank 14,500 Ordinary £1 shares 6,000 Share premium account 7,500 Capital redemption reserve 1,000 Profit and loss account nil 14,500 The following procedures must be followed before a payment out of capital can be lawfully made: 1. The payment must be approved by a special resolution (CA 2006 s716(1) 2. The directors must make a statement (CA 2006 s714(1-3) 3. A report by the company’s auditors must be annexed to the directors’ statement (CA 2006 s714(6) 10