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The pitfalls of buybacks out of capital

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If your company wants to buy back it’s own shares from an existing shareholder of the company and more particularly, out of the capital of the company, rather than out of distributable profits, then you need to ensure that you follow the statutory process. If you don’t it could be a very costly process and, if selling your company in the future, your whole transaction could be void (i.e. treated as if it had never happened)!

I deal with buybacks, but more recently, unfortunately, it has been the result of a previous failed buyback which has been the reason behind my involvement. 

The key question is why do most buy backs out of capital fail?

The answer is, a lack of application of the rigid statutory process. 

Buybacks out of capital can be seen to be simply an accounting process…..which it is largely, but there is also a rigid statutory procedure laid down in the Companies Act 2006 that must be followed. Most failures occur when only the accounting processes are followed.

One of the most common mistakes is not advertising the process in both The London Gazette and a National Newspaper. This process is required to ensure that the creditors of the company are put on notice of the buyback for a period of time prior to the buyback taking place.

Any reduction in the capital of the company has always been considered a matter so fundamental to the status of the company that public notice has to be given of any changes.

If this step in the process is missed, the entire buyback is void in its entirety, regardless of whether the other stages of the process have been correctly carried out, i.e. the auditor’s report and Director’s Statement. The original shareholder, therefore, remains a shareholder and owes a debt due to the company for any payment made to them for their shares. 

If the discovery of the void buyback does not arise for some years post-completion, then all dividends paid by the company after the defective buyback are incorrect as are all the company annual returns. 

There are also the potential tax issues following the void buyback. Owen Kyffin of Whitley Stimpson Ltd Chartered Accountants comments: ”if the buyback does subsequently prove to have been defective then HMRC will consider any payments made to be a loan rather than proceeds for the sale of the shares back to the company. This will have potential tax liabilities for both the company in terms of the special tax charge levied on loans made to shareholders, and the vendor who will be exposed to the tax charge levied on low interest rate loans. It is also possible that the vendor could lose other valuable reliefs such as entrepreneur’s relief if he no longer meets the qualifying conditions when the defect is corrected”. 

Most void buybacks which I have dealt with have arisen as a result of the process of selling or purchasing a Company and when due diligence is being carried out. The discovery of such a void action does not cast the company in a positive light for any prospective purchaser and may well cause the sale or purchase to falter or fail.

Ultimately, if you are considering a Company buyback out of capital, you should ensure that you seek legal as well as accounting advice to avoid the potential costly pitfalls of failing to follow the correct process!

For more information contact our Company Commercial team.

With special thanks to Owen Kyffin of Whitley Stimpson Ltd Chartered Accountants for his contribution to this blog.