Andy Poole and Nigel Holmes provide an overview of a common issue with the limited company structure and how to overcome it
A significant number of law firms have incorporated to become limited companies, which could be storing up problems for the future when ’partners’ begin to retire. Unless properly planned, it is not as simple as retiring from a traditional partnership or LLP.
A common way for a shareholder to structure their exit is by way of a Company Purchase of Own Shares (CPOS). This helps the remaining shareholders as they do not have to find the funds to buy out the departing shareholder, which would often have to be from post tax funds, increasing the overall cost.
A CPOS is a distribution for tax, meaning that it is taxed as a dividend. In some circumstances, however, if certain criteria are met, it can be taxed as a capital receipt, and thereby subject to Capital Gains Tax (CGT). With the Entrepreneur’s Relief rate of CGT being only 10% on the first £10m of qualifying gain, this is often the most attractive proposition.
It is not always the case that the capital route will be available or, if available, preferred, but for the rest of this article it is assumed that the capital treatment is desired, available, and most of the necessary criteria for both capital treatment and Entrepreneur’s Relief will be met.
In our example, the individual meets all the necessary criteria, as does the company, but for one point; whilst there are sufficient distributable reserves to allow the CPOS to happen, there is insufficient cash to make a one-off payment. The business may have all its working capital tied up in stock, WIP or debtors. In order to meet all the criteria the CPOS transaction must substantially reduce the shareholder’s holding (the post sale interest being not more than 75% of the pre-sale interest in the shares) but, furthermore, in reality HM Revenue & Customs will usually only grant clearance based on a retirement / exit scenario if the shareholder retains no more than 5% (for sentimental reasons). In other words, buying the shares back in tranches cannot qualify for the capital treatment. Or can it?
The solution is a multiple completion contract. This is a single unconditional contract under which the shareholder disposes of their entire beneficial interest in their shares on the date of entering into the contract, but the sale is completed in tranches.
The contract needs to ensure that the shareholder:
- retains no beneficial ownership of the shares;
- holds the un-cancelled shares as nominee and bare trustee of the company;
- will transfer legal ownership on the relevant completion dates;
- will not transfer, sell or dispose of the shares in any other way; and
- acknowledges that they have no rights to vote, dividends or to participate in a distribution of assets on a winding up.
Whilst company law prohibits unquoted companies from paying for their shares in instalments, the use of completion stages and payment on completion should ensure this structure can proceed.
There may still a problem with HMRC, however. It is always advisable to seek pre-transaction clearance for a capital treatment CPOS and whilst the structure described above is perfectly acceptable, it is quite unusual and, therefore, some HMRC Inspectors may need convincing that it meets the requirements of a capital transaction and does not breach company law. HMRC may also try to argue that the shares still carry voting power, despite the contract. If such an argument is put forward, the shares could be reclassified as non-voting shares.
Failure of the loan capital test cannot be put forward by HMRC as the debt will not meet the loan capital definition.
As beneficial ownership passes on the date of entering into contract, from a capital treatment perspective the shareholder is making a full disposal immediately. This creates two issues that need to be borne in mind:
- The disposal date for CGT is the date the contract is entered into: if a contract is entered into in 2015/16, the CGT will be due on the full amount 31 January 2017, so the first transaction must generate sufficient funds for the shareholder to pay this.
- As it is essential to be an officer or employee for Entrepreneur’s Relief at the date of disposal, retirement and resignation can take place immediately after entering into the contract; there will be no need to wait for the final payment.
Many shareholder agreements contain exit provisions to facilitate a CPOS but few consider a multiple completion buyback. Armstrong Watson has worked with a number of legal firms to factor in the possibility of a multiple completion buyback into a shareholders agreement, and incorporation of a practice is an ideal time to consider this.
If you are considering incorporating your practice or you have already incorporated, this is a factor that will need to be reviewed. We are already being called in to help in situations where practices have incorporated without our help and now need solutions as partners begin to retire.
Andy Poole is the Legal Sector Partner at Armstrong Watson, specialising exclusively in advising law firms. Nigel Holmes is a Tax Partner at Armstrong Watson, contributing to the legal sector team. Andy heads the legal sector team at Armstrong Watson, which has 15 offices and over 400 people. The legal sector team advises law firms throughout the UK on strategic, structural and other business improvement issues as well as providing efficient accounting, tax and SRA accounts rules services. Further information can be found at: www.armstrongwatson.co.uk/legalsector
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