Share Repurchases
PHILIP SHIRLEY*
Abstract
The UK government recently introduced legislation to treat the qualifying distribution on a repurchase of shares in the same way as ‘foreign income dividends’. This paper examines and criticises this reform from two perspectives. First, there is no underlying rationale for such an approach. Second, the legislation moves the tax system further away from simplification. A better approach would have been to remove the advance corporation tax (ACT) charge on a repurchase.
JEL classification: H25, K34.
I. INTRODUCTION
On 8 October 1996, the Chancellor of the Exchequer announced measures to stop shareholders being entitled to a repayment of a tax credit where a company repurchases its own shares or pays a special dividend. These measures have now been enacted in the Finance Act 1997.
The purposes of this article are to
1. explain the background to the introduction of these measures;
2. review the policy behind this proposed change in the context of the current taxation system;
3. comment on the adequacy of the proposed legislation;
4. consider how the proposed changes comply with the government’s objective of simplifying the tax system; and
5. show how the Inland Revenue could have reformed the legislation in a more satisfactory way.
The article is intended to be of interest to those readers interested in company taxation, but the more general reader may find it interesting to follow the argument as an illustration of how the tax system is being unnecessarily complicated.
II. IMPUTATION SYSTEM
The UK has had, since 1973, a partial imputation system of corporation tax. Where a shareholder receives a dividend from a company, he is entitled to a tax credit. The tax credit was, prior to 1993–94, equivalent to the basic rate of tax and is now equivalent to the lower rate of tax. The shareholder takes the dividend plus the tax credit into account in computing his taxable income and, if exempt from tax, he is entitled to a repayment of the tax credit.
Where a company pays a dividend, it has to account for advance corporation tax (ACT) which is equivalent in amount to the tax credit to which the shareholder is entitled. The exchequer therefore receives an exactly similar amount of tax from the company which it may have to pay the shareholder. The ACT is, however, creditable against the company’s corporation tax liability. The amount of ACT that the company can offset is restricted to the lower rate (that is, 20 per cent) of the company’s chargeable profits. Companies that have insufficient taxable profits or have profits from overseas on which double taxation relief is claimed cannot relieve their ACT and have what is known as a surplus ACT problem.
III. BACKGROUND TO SHARE REPURCHASES
The UK has traditionally had a company law system which has discouraged the repayment of capital to shareholders. It was only in the early 1980s that UK company law was changed to permit companies to repurchase their own shares. There has been a reluctance on the part of most UK companies to repurchase their shares and it has only been in the 1990s that a considerable number of companies have started to do so.
ACT is payable on a qualifying distribution. This term encompasses not only dividends but other distributions including repurchases and redemptions in respect of shares. If a company repurchases or redeems its shares for more than the new consideration received for the original issue of the shares, the excess is treated as a qualifying distribution. The company may well have issued the shares a long time ago at a low price, and the shares may have been bought and sold many times in the mean time.
When company law was changed to allow repurchases of shares, market makers and dealers were prevented from treating the distribution element as such and were denied utilisation of the tax credit. However, if the shares were purchased either off market or on market with the market maker acting as agent, the selling shareholder was entitled to a tax credit on the amount treated as a qualifying distribution and the shareholder’s tax position was the same as if it had
received a dividend. Exempt funds such as pension funds and charities could recover the tax credit, and certain foreigners could obtain a partial repayment under double taxation treaties. This led to a certain amount of comment in the newspapers such as The Times and the Daily Telegraph about institutions being able to sell on more advantageous terms. They were portrayed as getting large repayments at the expense of the exchequer.
This criticism was to some extent unfair. The exchequer does get a corresponding receipt from the company in the form of ACT, and the position is no different from that of a conventional dividend where exempt funds obtain repayment of the credit. Whether there is a net loss to the exchequer turns on the corporation tax position of the particular company concerned. In 1988, BP repurchased the shares of the Kuwaiti Investment Office. Being a sovereign body, it was entitled to a full repayment of the tax credit, but BP, with a large amount of foreign income, was not able to utilise the ACT. The exchequer was therefore neutral as a result of the transaction. In 1990, BATs repurchased its shares in response to a take-over led by Sir James Goldsmith. It repurchased its shares from market makers such that no tax credit was available and as it had a large amount of foreign earnings, it could not relieve the additional ACT. The exchequer therefore enjoyed a considerable windfall benefit.
If a company that has sufficient UK taxable profits repurchases its own shares, there will be no net cost to the company apart from the cash-flow cost to the company of paying tax early. If therefore the shares are repurchased from persons who can recover the ACT, there is a cost to the exchequer. Whether that cost is objectionable is a matter for debate. Companies have the ability to relieve ACT on a repurchase if they do not distribute all their earnings by way of dividends, and if an institution is entitled to a tax credit on a dividend, it is not clear why it should be denied a tax credit on a repurchase. However, the objectionable feature of a repurchase is that, unlike a dividend, it does not go to all shareholders. It is only those shareholders who can get back the tax credit who will sell into the repurchase programme, and it will be tempting for those who are exempt to buy from those who are taxable or who are not able to recover the tax credit in order to recover the tax credit. The government does not therefore get any tax from shareholders who are subject to tax or who are otherwise unable to recover the credit. It is not surprising that the government decided to take action to preserve its tax base. If it had not done anything, it would have encouraged more companies to look at ways of directing their ACT capacity at exempt shareholders who can use the corresponding tax credit.
IV. SHOULD REPURCHASES GIVE RISE TO DISTRIBUTIONS?
Whilst objection can be made to institutions recovering tax credits, the more fundamental question which has not been addressed by the Chancellor is why
repurchases of shares need give rise to qualifying distributions in the first place. If there is no qualifying distribution, there is no corresponding tax credit.
A repurchase does not have the normal features of an income payment. Whilst it may involve a distribution of the company’s assets, it brings a share to its end and has the more typical features of a capital transaction. In the case of most companies, the vendor will have purchased the shares in the market, and not even the vendor’s gain will correspond to the amount treated as income. Notwithstanding that a repurchase may be income for tax purposes, it is regarded as a capital transaction for the purposes of trust law. It should be noted, however, that if a company were to repurchase shares from all its shareholders pro rata, this would have the same commercial effect as a dividend.
When individuals were subject to much higher rates of tax on their income and either (before 1965) were not taxed on capital gains or (between 1965 and 1988) were taxed at lower rates on capital gains, there was a major fiscal incentive for many shareholders to extract profits from companies in capital form. Under the present tax system, there is actually a tax disincentive to extract cash in capital form. Capital gains are taxed at the same rate as income. However, a capital gain comes with no gross-up for a tax credit. If a shareholder receives income from a company, he is only subject to higher-rate tax on the grossed-up amount. A higher-rate taxpayer therefore only pays an effective rate of 25 per cent on his net receipt. The need to treat repurchases as income is very much a hangover from the historic tax system, and is not a current requirement.
The illogicality of the current system is that private companies are allowed to repurchase shares without giving rise to a distribution in bona fide circumstances. No such relief is available for publicly quoted companies, but in the case of publicly quoted companies there is even less reason for repurchases to be treated as distributions. Shareholders who are liable to tax can readily sell their shares in the market for a capital sum, and can avoid an income tax liability by selling first to a dealer who then resells the shares back to the company.
It is important to note that a company’s capital can be repaid to shareholders in capital form if it is taken over. A purchaser can buy out a company for a capital sum. It can then extract value from the company in tax-free form to finance the acquisition. If a company has to pay ACT on a repurchase of own shares, it does not have a level playing field on which to fight a take-over. A considerable number of companies, such as BATs and the electricity companies, have repurchased shares in response to take-overs. It is possible, though administratively difficult, for a public company to create a new holding company which can then pay cash to shareholders. It is not therefore that there are fundamental rules to prevent the extraction of cash in capital form from a company without an ACT liability and it is not clear why the government should be insisting on ACT being paid.
Under the present tax system, there can only be a case for charging ACT on a repurchase if the repurchases are intended to be in the nature of a dividend — that
is, if the company is repurchasing from all shareholders pro rata. However, the Revenue already has powers to counter such tax avoidance.
V. FOREIGN INCOME DIVIDENDS
In order to deny repayment of the tax credit, the Chancellor has chosen to treat the qualifying distribution on a repurchase or redemption as a foreign income dividend (FID). FIDs were introduced in 1994 in response to criticism that the UK imputation system unfairly penalised UK companies investing overseas. Such companies were subject to foreign tax and therefore, because they paid little UK corporation tax, they could not relieve the ACT arising on dividends paid to their own shares. If a company elects to pay a dividend as a FID, it is received net of lower-rate tax and no repayable tax credit is available to shareholders. The company still has to pay ACT on the dividend, but it is entitled to a repayment of that ACT to the extent that it shows that the ACT is surplus because the FID has been paid out of income on which double taxation relief has been claimed. In order to ensure that the FID rules were not abused, the Revenue provided that FIDs could only be paid to all shareholders, and shareholders could not be allowed to choose whether to receive a FID or some other form of distribution.
The shareholder selling will now be treated as receiving income net of lower-rate tax and will be subject to higher-lower-rate tax if applicable. Since the lower-lower-rate tax is not a tax credit and is never repayable, exempt funds will not therefore get the benefit of any repayment. However, the company will still have to account for ACT. This ACT can be offset in the normal way against corporation tax, though it may be repayable if the company has sufficient income taxed overseas.
There is some logic to the original FID system. If the underlying shareholders were to invest directly overseas, they would generally receive some credit for overseas tax withheld to the extent that they were tax-paying in the UK, but they would receive no tax credit if they were not tax-paying (for example, they were exempt). If those shareholders invest through a UK company, there is some sense that there should not be a tax penalty in the form of surplus ACT. By treating shareholders as receiving a dividend under deduction of non-repayable lower-rate tax, the government has achieved a broadly equitable result. However, it is difficult to see how this logic extends to repurchases of shares. Companies that repurchase their shares do not necessarily have foreign earnings, and one cannot justify the tax treatment of shareholders under the principles of the UK’s imputation system. Companies that have overseas earnings will benefit from the new system to the extent that they can relieve their ACT against a wide range of tax liabilities, but the effect of this will be haphazard amongst the general population of UK companies.
VI. DIVIDENDS
The government has decided to apply FID treatment not only to repurchase and redemptions of shares, but also to special dividends. The government’s policy objectives are not at all clear.
A company has full discretion as to what profits it pays out by way of dividend, and there is no tax or legal reason why a company cannot pay out surplus funds as dividend. Shareholders generally prefer a stable or rising level of dividend, and react very negatively if their dividend is cut. Companies are therefore reluctant to increase dividends unless the increase can be sustained. A number of companies have taken steps to pay dividends in a way to which the Revenue appears to be taking exception.
A payment of a large dividend reduces the assets of a company and therefore reduces its share price. This may cause the shareholders and the stock market to perceive that the company has done poorly. In order to maintain its price and to avoid the impression that a special dividend is an accrued dividend, a number of companies when paying dividends have chosen to consolidate their shares. East Midlands Electricity PLC in 1994 proposed a dividend of 85p net / 106.25p gross per share, and consolidated every 25 ordinary shares of 25p each into 22 new ordinary shares of 569/11p. It is very difficult to see what is wrong about this. It is really no different from a company making a bonus issue or dividing its shares if it considers that the market price of its shares has become too high. Every shareholder in East Midlands received this dividend. One could understand the Revenue taking exception to arrangements, which would be technically possible, whereby a shareholder could avoid a dividend in return for not having his shares restructured. This would allow dividends to be directed only to those shareholders who found it tax-advantageous to receive a dividend. Such arrangements could, in any event, be dealt with by extending the stock dividend rules.
Reuters proposed in 1996 to issue a special share to shareholders. This special share was to carry a series of dividends for a period of five years and would then become worthless. The Chancellor’s announcement of 8 October 1996 was timed to prevent the issue of this share. One needs to examine in more detail to what extent this arrangement was offensive.
If an existing shareholder receives the special share and holds it throughout its life, it is difficult to see why this is objectionable. The shareholder’s position is the same as if Reuters had simply increased its dividend, which it would have been free to do. The objectionable nature of the Reuters special share comes when shareholders start to trade the share. Since it is a separate share in its own right, existing Reuters shareholders could have sold their special share without selling their ordinary shares, and other persons could buy the special share without buying Reuters ordinary shares.
For a top-rate taxpayer, the effective rate of tax on the net dividend is only 25 per cent. If a shareholder sells the special share, he will be entitled to deduct a
proportion of his acquisition cost, and any resulting chargeable gain will be taxed at 40 per cent. It is not immediately obvious that there will be a significant economic benefit for shareholders selling special shares in a company such as Reuters which has performed well, and shareholders are likely to have unrealised gains. However, if the government found sales of such shares objectionable, it could have simply provided that the sale proceeds of such shares should be taxed as if they were dividends.
The more concerning issue for the Revenue would be persons buying the special shares and recovering the tax credit. The price that such persons can afford to pay would stimulate to sell their shares first those shareholders who would be subject to tax on the dividends and second those shareholders who would not be subject to tax but could not recover the tax credit. This could lead to a substantial loss of revenue.
The persons most likely to recover the tax credit would be
• dealers: although they are taxable, they can amortise the cost of purchasing the special shares; and
• exempt funds: they can recover the tax credit.
There are statutory provisions which would prevent dealers and exempt funds utilising their tax-favourable status. However, they only clearly apply where the dealer or exempt fund owns 10 per cent or more of the class of securities or if the dealer or exempt fund is undertaking the transaction for tax avoidance purposes. In the case of a quoted issue of special dividend paying shares by Reuters, one can appreciate concern by the Revenue that the existing statutory rules would not be sufficient to prevent substantial repayments of tax credit.
The proper approach to deal with such transactions is not to change the whole imputation system for the payment of dividends on special shares, but to hone the tax rules to deal with the economic reality of what is happening. If an exempt fund or dealer purchases a share that carries the right to a series of dividends, the dividends do not wholly represent the genuine income of the purchaser. Part of the dividend represents an amortisation of the purchaser’s cost of acquiring the shares and the balance of the dividend only represents income on the cost of his investment. It would be quite consistent with the principles of the imputation system to deny a tax credit on that proportion of the dividend that represents an amortisation of capital.
The Revenue was also concerned about large special dividends paid in connection with take-overs. It is difficult to see why a long-standing shareholder should not enjoy the benefit of a tax credit on such dividends, but the Revenue has a legitimate concern about persons such as dealers and exempt funds buying the shares with the intention of benefiting from a tax credit on a forthcoming dividend. The approach suggested above in relation to special dividend bearing shares could equally apply. If shares are bought when there is an expectation of a large
dividend or a large dividend is paid within a period of purchase, all or part of the dividend could also be recategorised as a repayment of capital and not as genuine income in the hands of the shareholder.
VII. LEGISLATION
Whilst the general reader may not be concerned with the detail of the legislation in its own right, the content and style of the legislation are relevant to the general debate over the simplification of taxation law. The legislation which was originally published on 5 December 1996 is straightforward in relation to repurchases and redemptions. These can be readily defined. However, it is particularly complex in relation to special dividends. A dividend is defined as falling within the provisions if
(a) arrangements are or have been made by virtue of which any one or more of the specified events is or was made referable (in some way and to any extent) to, or to the carrying out of, a transaction in securities; and
(b) that transaction is a transaction completed on or after 8 October 1996 or some or all of those arrangements are arrangements made on or after that date.
The specified matters are then defined as
(a) whether the distribution is made; (b) the time when it is made;
(c) its form, and (d) its amount.
Arrangements are then defined as meaning arrangements of any kind whether in writing or not. Transactions in securities have been defined in earlier legislation and mean just about any transaction in relation to securities.
The basic charging provision is difficult to understand and capable of very wide interpretation. It may catch not only the transactions described above which the Revenue finds offensive, but also a wide number of other situations. The Revenue has, to a certain extent, anticipated the breadth of the new provisions by introducing exclusions, but the wording of the exclusions is very tightly drafted and they do not cover all the situations where the basic rules may inadvertently apply. Furthermore, the legislation contains measures that have retrospective effect.
The government published the legislation in advance with the stated objective of maximising the opportunity for its consideration, and unfortunately the Revenue
has been less receptive to amendments to rectify the defects than it should have been. There are fundamental flaws in the Revenue’s approach to drafting. If the ambit of a tax measure is drawn widely with exclusions, one can find that a number of perfectly innocent transactions are swept into the measure but do not find themselves let out by any of the exclusions because either nobody thinks of them or the Revenue and Parliament cannot be bothered to do anything about it at the time the legislation is enacted. If the exclusions have to be broad, many offensive transactions can be brought within the exclusions and therefore the measure does not achieve its intended effect. Such a drafting approach penalises the unwary and allows escape routes for the well-advised.
Whether or not the provisions will apply will depend on whether there can be said to be arrangements. This is a vague term and there will be uncertainty as to the status of a dividend. Whilst uncertainty and the consequent scope for flexibility in interpretation are not necessarily bad things, they are, however, undesirable in what is essentially a withholding measure and where the underlying policy behind the measure is unclear. The company has to determine whether the dividend it is paying is franked or a FID. This does not make much practical difference to the amount of ACT that the company has to pay, but it does affect the certificates that the company gives its shareholders, and it is the shareholders who are affected by whether a dividend is a FID or franked. Any correction of mistakes is therefore going to be extremely difficult, and it is not clear how any dispute as to whether the new provisions apply will be resolved in practice. They will generate conflict between the company and its shareholders. They are also a very blunt instrument for the Revenue as they affect all shareholders, regardless of their guilt.
VIII. SIMPLIFICATION
This measure has been introduced at the same time as the government is seeking to simplify the tax system and in particular to rewrite tax in modern English. One would have greater confidence that rewriting the tax law in modern English would have a significant effect if contemporary tax law, such as this, were actually easier to understand. However, this measure highlights one of the features of the UK tax system that has been adding to its complexity — the tendency to develop legislation in piecemeal fashion. Legislation has been introduced to deal with specific issues current at the time, and as times and circumstances have changed, there has been a tendency to add to the existing legislation without any fundamental appraisal of the overall system in a contemporary context. Rather than a rewrite, the tax system of this country, like a garden that has grown rampant, is in need of a good prune.
As has been argued above, there is no strong reason for repurchases and redemptions to be regarded as income. The tax law would have been simplified by repealing the requirements for repurchases and redemptions to be treated as distributions. This would have allowed quite a considerable amount of ancillary
legislation to be repealed (for example, sections 210–211 and 219–229, Income and Corporation Taxes Act 1988 (‘ICTA’)). The Revenue would still have its residual powers under section 703 ICTA to treat repayments of capital to shareholders as income if companies sought to use repurchases as a means of tax avoidance.
As a result of the changes, companies would not have the difficulties of computing the amount of distribution arising which is often far from straightforward in practice. The difficulties in relation to both public and private trusts caused by the mismatch of treatment between tax law and trust law would have been removed at a stroke.
Whilst the Revenue has sought to attack exempt funds by making the tax credit non-recoverable, it is not as if there are no measures in the UK tax legislation that prevent recovery of the tax credit by exempt funds or exploitation by dealers of the tax credit. Sections 235–237 ICTA prevent recovery of the tax credit. Sections 731–736 ICTA contain provisions to prevent exempt funds and dealers purchasing dividends. The Revenue can also deny repayment of the tax credit by applying its considerable power under sections 703–709 ICTA to attack artificial transactions in securities.
Instead of seeking to change the tax treatment of certain dividends in a way that affects all shareholders, regardless of their guilt, the Revenue could have replaced the existing rules in sections 235–237 and 731–736 with a new measure that essentially recategorises as capital purchased dividends in the hands of exempt funds and dealers. This would have simplified the Revenue’s powers into one measure and would have dealt also with dividends that do not fall under the new rules. Whilst there would certainly be complexity in the detail of how one defined a purchased dividend, there would be the advantage of greater conceptual clarity in what the measure is designed to achieve. A shareholder would only need to examine the detail of the measure if he bought shares and there followed the receipt of an exceptional dividend. Since the measure would be seeking to deny a tax benefit, it would only seriously prejudice those persons who bought the shares with the objective of the tax benefit.
IX. CONCLUSIONS
The government needed to take action to change the taxation treatment of share repurchases. However, it would have been better advised to have denied the availability of a tax credit by removing the ACT charge on repurchases. This would have given UK companies a level playing field to fight take-overs and would have simplified the tax system.
The government has also sought to deny the availability of tax credits on certain dividends. The legislation on dividends is confusing, and is giving rise to practical problems for companies in determining whether or not the new provisions will apply. There is little cause for changing the treatment of dividends generally.
The Inland Revenue’s efforts would be better directed towards denying the tax credit to shareholders who seek to take advantage of their privileged tax status to recover the tax credit. The opportunity could have been taken to reform a whole series of piecemeal anti-avoidance measures and produce a single coherent measure that was directed against the concept of a purchased dividend.
This legislation on share repurchases illustrates a general problem with the UK tax system. The Revenue is not solving problems in policy terms that fit most coherently and logically within the UK tax system. This, far more than the words used in the legislation, is contributing most to the complexity of the UK tax system.
