We are back with our blog series on business exit planning on what is a gorgeous sunny day out there, even though it is a Monday. Elections are over and while we know most of the people that got in we are still waiting on the results of the European and mayoral one. Never do I remember having so many things to vote on or have I ever received so much paper when voting. All was missing was a ballot paper for the next Conservative party leader in the UK. Teresa made a tearful exit from what must have been an extremely stressful job. On the sporting front Davy F is still getting sent to the stand in what was a dire match with some dreadful shooting, albeit the conditions weren’t easy and a super win for Roscommon over Mayo. Mayo, the carnage continues! Joe Brolly seemed to be excited on the Sunday Game about the latest debacle.
What is it?
Basically the company buys back the shares from the existing shareholders and cancels them and it is done as part of an exit strategy to extract some value from the business. The first step in the process would be to see what value the company is and this is done by using one of the accepted valuation methods out there – see our earlier blog on company valuations. Once the value has been ascertained then that value is divided among the issued share capital. Assume the company was valued at €1,500,000 and there were 100 shares in issue then each share is worth €15,000. If the company is in a very fortunate position of having this amount in cash it could purchase all the shares from the owners and pay them in full for the value of their shares. On purchase the usual position would be to cancel the shares so that they no longer exist.
When is it useful?
It can be very useful in a number of different scenarios to include business exit or transfer or in the case of trying to exit a disgruntled shareholder who is affecting the performance of the business.
Davy and Jim have run a successful business for many years making hurleys for the export market called Caman Ltd and Jim is getting older and wants to take it easy. Jim is 65 and Davy is 46. The business is valued at €1,300,000. There are 150 shares in issue and Davy and Jim own 75 shares each so each of their shareholdings is worth €650,000. Fortunately the company has existing cash so it can purchase all of Jim’s shares for the full price. The company pays Jim €650,000 for the shares and after the purchase it cancels Jim’s 75 shares. Therefore there are now only 75 shares in issue which Davy owns, so he now owns 100% of the company. The payment to Jim is liable to Capital Gains Tax assuming that the situation benefits the trade – see below. If Jim was to pay CGT on the gain his tax liability at 33% would be €214,500. However if he was to qualify for full retirement relief he would not pay any CGT – see earlier blog on Retirement relief.
Failing a retirement relief claim he could qualify for Entrepreneurs relief and pay CGT at 10% on the gain. One point to note here is that if Jim was 66 at the time of the share buyback then Retirement relief would be limited in that the €750,000 threshold on the sale to a third party would be reduced to €500,000. The maximum CGT to pay then under retirement relief would be €75,000 which is where marginal relief comes into play. The CGT is limited to 50% of the excess over the relevant threshold [€650,000 – €500,000] X 50%. In this scenario Entrepreneur’s relief would be more beneficial.
Benefit of the Trade
To get favourable CGT treatment the share buyback has to be of benefit to the trade. If it is not of benefit to the trade then the person whose shares are bought back would be liable to Income Tax on the payment which, when USC and PRSI are factored in, the tax rate would be over 50%. This Trade Benefit Test requires that the sole or main purpose of the buyback is to benefit a trade carried on by the company or of one of its 51% subsidiaries. The following, in italics, is taken from Revenue’s Tax and duty manual “Acquisition by a company of its own shares”
Revenue will normally regard a buy-back as benefiting the trade where for example:
There is a disagreement between the shareholders over the management of the company and that disagreement is having or is expected to have an adverse effect on the company’s trade and where the effect of the transaction is to remove the dissenting shareholder.
The purpose is to ensure that an unwilling shareholder who wishes to end his/her association with the company does not sell the shares to someone who might not be acceptable to the other shareholders.
Examples of this would include:
- An outside shareholder who has provided equity finance and wishes to withdraw that finance.
- A controlling shareholder who is retiring as a director and wishes to make way for new management.
- Personal representatives of a deceased shareholder where they wish to realise the value of the shares.
- A legatee of a deceased shareholder, where she/he does not wish to hold shares in the company.
Revenue go on to state that in the examples they have given they would expect the shareholder to make a complete break from the business so that they would no longer have any control [cease to be a director] as otherwise, in their view, the share buyback wouldn’t benefit the trade. However they give an example of 2 situations where the trade benefit test would still be met as follows;
The shareholders wishes to retain a small percentage, less than 5%, shareholding for sentimental reasons and
The shareholder stays on as a director for a period post share buyback as it would be detrimental to the business if the shareholder exited immediately. They may need time to bed down new management. Their view is that 6 months should be sufficient which seems a bit on the short side.
It is also important to look at the financials. Does the company have sufficient cash to purchase the shares or would it have to borrow? Would the loan repayments to fund the borrowing put the company in a very weak financial position? If there is a large borrowing that weakens the finance of the company in that scenario it is unlikely that the buyback would meet the trade benefit test.
One key point to be aware of is that it is no longer a requirement to get Revenue approval to confirm that the trade benefit test has been satisfied. Once you have met the conditions then it should be quite clear that the trade benefit test has been met then. In cases of doubt it is still possible to get an Advance opinion and Revenue will require detailed information about the shareholders, price paid and the area of doubt. Practitioners should certainly be very wary of looking for an Advance opinion.
Other key conditions
- The company purchasing its own shares must be an unquoted trading company or the unquoted holding company of a trading group
- The vendor must be resident and ordinarily resident in the State
- The vendor must have owned the shares for at least 5 years (except in the case of inherited shares when 3 years is sufficient)
- There must have been a proportionate 25 per cent reduction in the vendor’s interest in:
- the issued share capital, and
- the distributable profits
- The vendor must not be connected with the company immediately after the purchase
Example – 25% reduction
Hurley Ltd has 1,000 shares in issue and Liz own 200 of those shares, so 20% of the company. Hurley Ltd proposes to purchase 50 of Liz’s shares so that her own holding will reduce by 25%. Liz will then hold 150 shares out of the 950 shares in issue. She will then own 15.79% of the company and as the reduction in her interest in the company is less than 25% the payment to her will be liable to Income tax and not Capital Gains Tax. If Liz had sold 59 shares she would then own 14.98% of the company and would have met the 25% reduction test.
A common theme we have mentioned in our recent blogs on this topic is the necessity for advanced planning so the conversation has been had and plans put in place for the exit of the shareholder. Some of the key considerations would be;
Has a successor been identified and does that successor have the necessary skills and experience to manage the business in the absence of the departing shareholder
Are there sufficient cash reserves in place to complete the share buyback or will borrowing have to be considered? Will funding be easy to get and will it place the company in a very weak financial position
Be careful in terms of the overall percentage reduction in the shareholder’s interest in the business.
Will the departing shareholder be connected to the business after the share buyback. Remember that the shares should be paid for in full as if the shareholder is sitting on the balance sheet as a loan creditor then he/she would be connected.
Ensure that a proper valuation has been completed by someone with good experience in this area.
Does the vendor own the shares for the required period and is the vendor tax resident and ordinarily resident in the country.