When 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. One of these methods is the share buy-back. Here we give a brief overview of share sales before exploring how share buy-backs work including tax benefits and other advantages; and key considerations for outgoing shareholders.
Share sales are commonly recommended by advisers to exit shareholders 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 may apply to reduce the assessable amount of the capital gains.
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 using this method, 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 using 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 other advantages like:
- Funding the transaction from the financial resources of the company rather than the continuing shareholders
- Avoiding the imposition of transfer 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 is 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 to undertake the acquisition. This can lead to Division 7A and Corporations Act issues. However, under a buy-back, company resources are used to fund the acquisition and the potential Division 7A issues are removed.
Depending on the State of incorporation and the nature of the underlying assets, transfer duty may apply on the transfer of shares. However, in most jurisdictions transfer 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 share buy-backs. 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 that are not otherwise being used, 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:
- The capital component; and
- the 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 most 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 share buy-backs having a dividend component which share sales do not. Determining the correct dividend and capital split is a critical step in understanding and evaluating the appropriateness of utilising share buy-back as part of shareholder exits.
Below is an example of how differing outcomes can arise for a shareholder looking to exit a private company.
Company A has two Australian resident individual shareholders who each own 50% of the shares on issue. The shares were acquired when the company was formed (more 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. The shares will be disposed of for market value consideration of $70,001.
The equity section of the balance sheet of the private company A is represented as follows:
All assets and liabilities of the company are recorded in the financials at their current market values. The company also has enough franking credits to fully frank all of its retained earnings. The applicable franking rate for dividends is 30% for this company.
It is assumed the exiting shareholder has no other income.
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.
|Cost base /capital component||(1)||(1)|
|Less: 50% CGT discount||(35,000)||–|
|Add: Dividend component||70,000|
|Add: Franking credits attaching to dividend component||–||30,000|
|Assessable income for exiting shareholder||35,000||100,000|
|Income tax at marginal tax rates||3,192||24,967|
|Less: Franking credits||–||(30,000)|
|Income tax payable (refundable) by exiting shareholder||3,192||(5,033)|
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 and Medicare Levy payable on this income, the share buy-back results in a refund of $5,033 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 total tax and Medicare Levy liability of $3,192 (after accessing the Low Income Tax Offset) 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 buy-back results in a superior tax outcome by more than $8,000 for the exiting shareholder in this example.
Different outcomes may eventuate if the shareholders have different income levels or if the shares were held in different structures, such as companies or self-managed super funds, and different potential outcomes should be explored in these circumstances.
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 revenue or capital losses
- The availability of franking credits in the private company
- The availability of sufficient financial resources in the private company, including whether any borrowings would be required to fund the share buy-back, and whether these borrowings would be considered to be business-related for the purposes of interest deductibility
- 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 that may be the most suitable to all entities involved in certain situations.
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.