Share Buybacks - New Opportunities for Corporate Investors, Including Life Companies

The recent High Court decision in Strand Futures and Options Ltd v Vojak overturns Revenue practice (SP4/89) and offers significant tax benefits to corporation tax paying investors on share buybacks. It is possible that the Revenue will appeal the decision or seek to reverse its effect by attempting to introduce new law.

The High Court has held that, on a share buyback, the distribution element of the buyback price does not form part of the consideration for the disposal of the shares by a corporate investor and so is not included in the computation of chargeable gains.

Strand Futures does not affect corporates which are not subject to tax on chargeable gains, such as investment trusts and authorised unit trusts.

In 1986 Strand Futures and Options Limited ("SFOL"), a UK resident company, subscribed for 29.9% of the issued share capital of another UK resident company, City of London Options Limited ("CLO"). In 1995 CLO bought back half of SFOL’s shareholding for £871,630. At the same time, SFOL sold the other half of its shareholding in CLO to a third party, also for £871,630.

SFOL did not include the payment received from CLO on the own share purchase in its computation of corporation tax on chargeable gains for the year ended 31 December 1995. The Revenue considered that the payment should have been included in the chargeable gains computation and issued a notice of assessment with net capital gains of £1.6 million. SFOL appealed unsuccessfully to the Special Commissioners but has now succeeded before the High Court.

Most aspects of the taxation of investors on a share buyback are not controversial. It was agreed by both parties in Strand Futures that:

• Individuals are subject to income tax under Schedule F on all dividends and other distributions of UK resident companies (section 20 Taxes Act 1988)
• "Distribution" includes any sum received on a redemption, repayment or purchase of a company’s own shares excluding any amount which represents a repayment of capital on shares (section 209(2)(b) Taxes Act 1988). This is referred to as "the distribution element".
• In the case of the purchase by CLO of its own shares from SFOL, the purchase price of £871,630 less so much of that sum as represented a repayment of capital on the shares was a distribution within section 209 TA 1988.
• In 1995, when a UK resident company made a distribution to a UK resident, the recipient of the distribution was generally entitled to a tax credit equal to the advance corporation tax paid by the distributing company in respect of the distribution.
• The investor’s gross receipt for the purposes of Schedule F taxation was the amount of the distribution plus the tax credit.
• UK corporates are not generally subject to corporation tax on income on a distribution from a UK resident company (section 208 Taxes Act 1988 – see below). However, the precise scope of section 208 was at the heart of the dispute in Strand Futures.

"Except as otherwise provided by the Corporation Tax Acts, corporation tax shall not be chargeable on dividends and other distributions of a company resident in the United Kingdom, nor shall any such dividends or distributions be taken into account in computing income for corporation tax."

The Revenue argued that, for corporate investors, the amount of the consideration for the disposal of the shares for the purposes of taxation on chargeable gains is the full amount of the buyback price. This view was applied from 19 April 1989 and set out in SP 4/89 (see below). Note that the Revenue accept that, for individual shareholders, the capital gains tax consideration for the disposal of the shares bought back is limited to the amount of capital repaid on those shares (see below – "Individual shareholders").

SP 4/89 has been controversial ever since it was introduced, particularly as it represented a change of view by the Revenue. It is difficult to reconcile with section 208 Taxes Act 1988 and was only applied to share buy-backs and not to share redemptions.

Company purchase of own shares – capital gains treatment of distribution received by corporate shareholder:

SP 4/89 professed to increase the consideration treated as received by a corporate shareholder on an own share purchase and thus to create or increase a chargeable gain (or reduce or eliminate an allowable loss).

The Special Commissioners held that section 208 Taxes Act 1988 had only the limited effect of exempting company distributions from corporation tax on income under Schedule F. In their view, section 208 did not prevent inclusion of the distribution in the computation of chargeable gains.

The High Court allowed SFOL’s appeal, in its decision of 7 February 2003. The Court upheld the straightforward interpretation of section 208 which is that it grants to UK corporates an exemption from both corporation tax on income and corporation tax on chargeable gains for distributions received from UK companies.

In doing so, the judge placed great weight on the legislative history and context of section 208. When section 208 was introduced (by Finance Act 1965), income tax was deductible at the standard rate from all distributions, whether made to individuals or companies. If the Revenue’s arguments were correct, corporate shareholders would have been subject to both income tax by deduction at source and tax on chargeable gains on the same receipt. The judge considered this to be "a highly anomalous and unlikely consequence". A number of other anomalies which resulted from the Revenue’s argument served to reinforce the judge’s conclusion that section 208 confers a complete exemption from tax.

The distribution element of the buyback price on an own share purchase is now completely exempt from tax in the hands of corporate investors, including in the I-E computation of life companies.

For corporate shareholders (as is the case for individuals) the chargeable gains consideration for the disposal of the bought back shares is capped at the amount of capital repaid on the shares.

This will reduce the tax charge suffered by a corporate investor on a buyback. Alternatively, it may increase or create a capital loss, although the rules relating to depreciatory transactions, which disallow a loss in certain circumstances, will need to be considered.

The position of individual investors on a share buyback was not at issue in Strand Futures but is worth reiterating:

• An individual liable to income tax under Schedule F on the distribution element of the purchase price paid by a company on an own share purchase is not liable to capital gains tax on the same sum by virtue of section 37 Taxation of Chargeable Gains Act 1992 (see below).

"There shall be excluded from the consideration for a disposal of assets taken into account in the computation of any gain, any money or money’s worth charged to income tax as income of, or taken into account as a receipt in computing income or profits or gains or losses of, the person making the disposal for the purposes of the Income Tax Acts."

• For an individual investor, the proportion of the purchase price which represents a capital repayment on the shares (the "capital element") is the sole consideration received by the individual for the disposal of the shares. Depending on the individual’s base cost in the shares (and ignoring any available reliefs), the individual may make a capital gain or an allowable loss on the buyback. Where shares are bought back from the original subscriber, he will make neither a gain nor a loss. This is because his base cost in the shares (the subscription price) will be equal to the disposal proceeds (the capital repayment).

Corporate investors affected by Strand Futures should consider amending previous corporation tax returns, to the extent permitted by time limits, with a view to securing a repayment of tax and/or an increase in brought forward capital losses.

These include:

• Corporate investors will prefer future buybacks to be structured with a significant distribution element so as to minimise their tax liability. Other shareholders however, particularly higher rate tax paying individuals, may prefer a buyback to be in capital form.
• A significant distribution element in a buyback should not cause tax difficulties for the company buying back the shares, provided it is not seeking to recover surplus advance corporation tax ("ACT"). Distributions trigger shadow advance corporation tax which has the effect of restricting recovery of surplus ACT. The buying back company will also need to ensure it has sufficient distributable reserves to cover the distribution element.
• Companies with surplus ACT may be more reluctant to structure buybacks in this way, as it will delay recovery of surplus ACT.

The Revenue has not yet indicated whether it will appeal Strand Futures nor reacted publicly to the decision. However, the revenue loss to the Treasury is potentially significant. As such, there has to be a possibility that legislation will be introduced in Finance Bill 2003 to counteract the decision, if it is not overturned on appeal before then. Companies may therefore need to take swift action if they wish to benefit from the decision. Section 703 Taxes Act 1988 probably does not apply to counteract advantages restricted to corporation tax on chargeable gains (a view which the Revenue are understood to share) so there is unlikely to be much risk of retrospective challenge under that section.

For further information on tax efficient returns of value please contact:

Ross Fraser
+44 (0)20 7466 2345
ross.fraser@herbertsmith.com

Bradley Phillips on
+44 (0)20 7466 2086
bradley.phillips@herbertsmith.com

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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