When a major shareholder in a private company wants to sell their shares and exit the business, the ideal scenario is for the other shareholders to buy them out immediately. But what if the company or other shareholders don’t have the cash to pay for the shares right away? This presents a dilemma.

Company law prohibits share buybacks unless full payment is made when the buyback contract is completed. So, the company can’t agree to buy the shares and pay instalments over time. Doing a share buyback in stages where the company buys tranches of shares on different dates is allowed but can result in a large tax bill for the departing shareholder. Here’s why.

The Substantial Reduction Condition

For a share buyback to qualify for capital gains tax (CGT), it must meet the “substantial reduction” condition. This requires the shareholder’s percentage ownership to drop by at least 25% after each buyback transaction.

If the reduction is less than 25% each time shares are bought, the shareholder won’t meet this test. As a result, any gain on the shares would be subject to income tax instead of the lower CGT rate.

For example, say James owns 60% of a company’s shares originally worth £1 and now worth £10,000 each. The company agrees to buy his shares in four equal instalments over four years for a total of £600,000. After each tranche, James’ ownership percentage drops from 60% to 50%, still above the 25% threshold. He’d face income tax up to 39.35% on the £600,000 gain.

The Connection Test

Previously, share buybacks with multiple completion dates were allowed, but a single contract met the substantial reduction test. However, a 2022 change to HMRC guidance also imposes a “connection test” in these cases.

This test requires the shareholder to own 30% or less of the company’s shares after the first completion date. If they still own over 30% after the first buyback, the connection test is failed, and income tax applies.

In our example, if James sold 15 of his 60 shares on the first date, he would still own 50% of the company. This fails the connection test and subjects him to income tax on the gain.

Structuring Buybacks to Qualify for CGT

While deferred buybacks are tricky, there are still ways to structure them to meet both the substantial reduction and connection tests and qualify for CGT:

• Sell enough upfront – Have the first completion date buy back enough shares to get the shareholder under 30% ownership.
• New company structure – Set up a new holding company to acquire the old company. The departing shareholder is bought out in cash, while others get shares in the new company.
• Multiple contracts – Rather than tranches under one contract, do separate buybacks under different contracts.

With proper planning, deferred share buybacks can still result in lower CGT than income tax. However, substantial reduction and connection tests must be considered to achieve tax efficiency. Careful structuring of the buyback schedule and terms is key.