By TODD WANT
DIRECTOR, TAX SERVICES
By TODD WANT
When a client is looking to exit from a shareholding in a private company, a direct sale of shares by the departing shareholder to the continuing shareholders is often assumed to be the best option.
However, alternative methods can be used which may provide significant advantages over a simple share sale.
Do you know whether a share sale really gives the best outcome for your client?
Share sales are commonly recommended by advisers to exit share holders from private companies. Often the exiting shareholder’s interest in the company may be sold to continuing shareholders in that company, with the ownership percentage of the continuing shareholders increasing.
Assuming the shares are on capital account, the departing shareholder would make a capital gain to the extent that their capital proceeds exceed their cost base in the shares. Conversely, where the capital proceeds are less than the reduced cost base, a capital loss will be made. Concessions such as the 50% general discount and the small business CGT concessions can apply to reduce the assessable amount of the capital gains.
Benefits of share buy-backs
As an alternative to a share sale it may be possible for a shareholder to exit their holding by way of a share buy-back. Under a share buy-back, the company buys back and immediately cancels the shares. This means that the number of shares on issue for the company is reduced and the ownership percentage of the continuing shareholders increases accordingly.
Potential tax savings can be achieved, depending on the tax profile of the exiting shareholders. For example:
- A company shareholder in receipt of a share buy-back may pay no (or little) additional tax on the proceeds;
- A shareholder who is unable to access the small business concessions may achieve similar or lower tax on a share buy-back as compared to a discount capital gain; and
- A company that does not pass the active asset test (say due to Division 7A loans, excess cash holdings or passive investment assets) may be able to produce a lower tax outcome for an exiting shareholder through use of a share buy-back.
In addition to the potential lower tax cost for an exiting shareholder, the use of a share buy-back can also provide advantages such as:
- Funding the transaction from the financial resources of the company rather than the continuing shareholders;
- Avoiding the imposition of stamp duty;
- Enabling a more efficient transfer of company assets to an exiting shareholder; and
- Allowing for the use of excess franking credits in the company.
Each of these advantages are considered in more depth below:
Funding of exits
Under a share sale, the acquiring shareholder needs to fund the acquisition from their available financial resources or through borrowed funds. In some instances it may be contemplated that the company itself will lend the acquiring entity the funds in order to undertake the acquisition. This can lead to Division 7A and Corporations Act issues.
However, under a buy-back, it is the private company that funds the acquisition from its financial resources and the potential Division 7A issues are removed.
Depending on the State of incorporation, stamp duty may apply on the transfer of shares (for example in NSW) however in most jurisdictions stamp duty will not apply to a share buy-back.
Transfer of assets
If assets of the company are being transferred to an exiting shareholder (e.g. a company car), it may be possible to offset the value of these assets against some of the consideration payable under the share buy-back. Doing this under a regular share sale is often more difficult and could potentially trigger Division 7A issues if not appropriately managed.
Utilisation of franking credits
If the private company has a significant bank of franking credits which are not otherwise being utilised, a share buy-back provides a useful way to unlock the value of the credits.
Taxation of share buy-backs
Unlike a traditional share sale, the proceeds received under a share buy-back are split between two components:
- a capital component; and
- a dividend component.
For most private companies with limited paid up capital (e.g. $2), the capital component of a share buy-back will generally be minimal. This means that the majority of the proceeds will be represented by a dividend (which may be franked).
For companies with a more material level of paid up capital, there is a particular process that needs to be followed to determine the split of the capital and dividend components for the share buy-back.
The difference in tax outcomes that can arise under a share sale when compared to a share buy-back is essentially driven by the differing character of the proceeds under each option, with the share buy-back having a dividend component which the share sale does not. Determining the correct dividend and capital split is considered in this month’s other article: Share buy-backs in private companies: what are the tax issues?
Outlined below is an example scenario which demonstrates the differing outcomes that can arise for a shareholder looking to exit a private company.
Company A has two shareholders who each own 50% of the shares on issue. The shares were acquired when the company was formed (greater than 12 months ago), but do not satisfy the requirement to be considered an active asset.
One of the shareholders is looking to exit his interest in Company A on the 1st of July and will not have any other assessable income in that financial year. The shares will be disposed of for market value consideration of $70,001.
The equity section of the balance sheet of private company A is represented as follows:
All assets & liabilities of the company are recorded in the financials at their current market values. The company also has sufficient franking credits to fully frank all of its retained earnings.
The table below summarises the tax outcomes for the exiting shareholder if they were to exit under a buy-back or via a share sale. Under the share buy-back, the dividend component has been fully franked.
In this example, the use of a share buy-back to exit the shareholder would lead to an assessable dividend (including franking credits) of $100,000. As the franking credits of $30,000 exceed the tax payable on this income, the share buy-back results in a net refund of $3,553 to the exiting shareholder.
Under the share sale scenario, the shareholder instead makes a gross capital gain of $70,000. The assessable amount of the gain is reduced to $35,000 after applying the 50% general discount. As there are no credits available under a share sale, the shareholder has a tax liability of $3,272 arising on this $35,000 of income.
While the share sale gives a lower assessable income of $35,000, compared to $100,000 under the buy-back, the presence of the franking credits under the buy-back results in the exiting shareholder getting a tax refund (rather than having an amount payable).
The difference between the scenarios in this case is a net benefit of $6,825 for the exiting shareholder under a share buy-back (being the difference between having to make a payment of $3,272 compared to receiving a refund of $3,553).
In the above example, if the exiting shareholder was a company rather than an individual, the difference in tax payable between these options would increase to $21,000. This is because under the share sale scenario, the company would not be able to access the 50% discount for capital gains and thus would have an assessable capital gain of $70,000. This amount would be subject to tax at the corporate tax rate of 30%, resulting in a $21,000 tax liability.
Under a share buy-back however, if the exiting shareholder was a company it would instead receive a fully franked dividend of $70,000 plus $30,000 of franking credits (resulting in $100,000 of assessable income). The company would have $30,000 tax to pay on this income, however this liability would be fully offset by the availability of $30,000 franking credits. This would mean that for the exiting shareholder company, a share buy-back would not lead to any net tax liability.
Other factors to consider
While the advantages outlined above can make share buy-backs an attractive option for exiting private company shareholders, other factors to consider include:
- The marginal tax rate of the exiting shareholders;
- Whether the exiting shareholders have any available capital losses;
- The availability of franking credits in the private company;
- Whether the small business CGT concessions are being applied;
- Whether the shares held by the exiting shareholders are pre-CGT;
- Whether the remaining shareholders would be able to fund a purchase of the shares; and
- The minimum ASIC (Corporations Act) requirements and timing periods that apply to share buy-backs.
Determining the most appropriate way for a client to exit their shareholding in a private company requires a thorough consideration of tax, financial and other factors. While a share buy-back may not be appropriate in all circumstances, it provides an alternative which can be the most suitable to all entities involved in the transaction.
William Buck has assisted numerous parties in assessing and implementing the most appropriate method to exit their private company shareholding. Should you have any queries relating to the exit of private company shareholdings, or would like to know more about the most appropriate options for your clients, please contact your local William Buck advisor.