Treasury Shares Guide

8/6/2019 Treasury Shares Guide

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Treasury SharesA GUIDE TO THE COMMERCIAL AND TECHNICAL ISSUES

THE ASSOCIATION OF

INVESTMENT TRUST COMPANIES


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Contents

Foreword 5

Executive summary Key potential benefits of treasury shares 8

Key features of treasury shares 9

Issues for board consideration 10

Introduction 12

SECTION ONE

Treasury shares - commercial issues 14

Background 14 Considerations for strategy 14

SECTION TWO

Selling treasury shares at a discount- the principle 25

Introduction 25

Share buy-backs and treasury salesas an overall strategy 26

Conclusion 32


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Selling treasury shares at a discount- the practice 33 Obtaining shareholder approval 33

Communication 36

Who manages the use of treasury shares? 37

Split capital trusts 37

Management/performance fees 37

SECTION THREE

Treasury shares - technical issues 39 Company law 39

The Listing Rules 42

Taxation 42

The Takeover Code and the SubstantialAcquisition Rules 44

Accounting 44

NAV calculations 47


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Something less than a year ago, an individual (clearly falling into the

category of high net worth), approached the AITC to explain why

he, as a potentially significant investor in the sector, had effectively

dismissed it for the foreseeable future.

The background was that he, having done his research, was in a

position to make various substantial investments in a number of

funds run by a particular fund manager that he liked the look of.

He had no strong view on the unit trust versus investment trust

question but, on balance, he was leaning towards investment trusts

on account of the attractive discounts a number of the identified

possible candidates were trading at, one in particular.

[By way of background, this particular trust had bought back shares

in the past in an attempt to narrow its discount, though this process

had been curtailed in more recent times as stock market falls had

begun to have a significant impact on its TER. Indeed, as further

falls happened, its reduced size was even threatening its viability.Arbitrageurs were beginning to circle.]

Being a long-term, committed investor, one unlikely to be a forced

seller, any widening of the discount was not a major concern.

He sat at his screen, the price of the particular trust was right and he

was in a position to deal. The trouble was that, on trying to make his

first investment, he was informed by his broker that he was not able

to satisfy his order at the price quoted on his screen. Not satisfied

with this response, the individual had approached the fund managerto see if there was anything it could do.

The fund manager explained that the trust concerned was a relatively

small trust and that liquidity was an issue given the order size being

placed. During the conversation, the investor mentioned the unit

trusts that he might also be interested in. The fund manager made

it clear that there was no problem satisfying an order of the same

size within the range of unit trusts, that it would be able to arrange

it so that any front end load that smaller retail investors would pay

would be waived and that the deal could be done and dusted within

a matter of days.

Foreword

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The upshot was that, having been frustrated along the way in trying

to deal in investment trusts at what he considered was a fair price,

the investor simply placed the deal with a unit trust instead.

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A model for the future?

One of the most concerning things about the above scenario is that

there are so many losers and so few winners:

the broker loses out because he has not been able to place a deal

on the terms that the client wants to do business. There is the

direct financial impact from losing the commission on the actual

trade itself, but also the risk to an ongoing relationship.

the particular trust concerned loses out on the immediatedemand for its shares, but also on the prospect of having a

long-term committed shareholder on its share register.

the industry as a whole loses out, as the experience of this

individual left him with a view that the investment trust industry

as a whole was simply not for him.

Even the manager could have lost out completely if the individual

had not been interested in any of the unit trusts it managed.

But why should this position change in the future? Indeed, it is a

common complaint from IFAs that they are approached by the AITC

arguing the merits of investment trusts, then approached by

management groups arguing the merits of individual trusts, but

when they come to place deals with anything other than the largest

trusts, problems of this nature crop up. Much the same applies to

private client stockbrokers, some of whom have set minimum levels

of marketability which individual trusts must meet if they are to be

included on their buy lists.


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This problem is likely to get worse as IFA firms, as has been the

case with private client stockbrokers, continue to consolidate.

As the days of the one man band IFA disappear, deal sizes are likely

to increase, making the need to be able to satisfy sizeable demand

quickly, easily and fairly even more important.

It is always possible to point the finger in the above scenario.

The cynics would argue that, from a fund managers perspective,

a deal to buy shares in investment trusts adds nothing to funds under

management. How likely is it that the fund manager bent over

backwards to facilitate this deal, especially when there is an easy

deal to be had with its unit trusts which will add to funds under

management? But the information provided by the manager was

objective and accurate. There simply was no way of satisfying the

investors demand with the tools at its disposal. And you can hardly

blame the manager for satisfying an order from its range of unit

trusts, as the customer had already expressed an interest in these

funds, and no manager in its right mind is going to turn downbusiness when the alternative is that it will do no business at all.

Others would question the role of the client or the broker. If he had

gone to the right person, if he (or the broker) had known how to

play the market better, if he had been properly advised etc, he could

have got round these problems, or kept them within manageable

proportions, and got the shares he wanted.

Maybe this is true. But he didnt and he wasnt.So he couldnt and he didnt.

This paper hopes to show how, amongst other things, treasury

shares could help change this position.

Ian Sayers

Technical Director, AITC


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Key potential benefits of treasury shares

1) Increased control over the investment trusts share capital

structure, arising from the ability to buy back shares temporarily

into treasury for possible sale at a later date (as opposed to

having to cancel them).

2) A reduction in discounts and/or discount volatility as a result of agreater ability to balance supply and demand for a trusts shares.

3) Increased demand from retail investors by enhancing the

attractiveness of Savings and Investment Schemes, ISAs etc.

In particular, the option of satisfying demand from such schemes

more frequently and in smaller lots than is economically possible

by way of purchases in the secondary market.

4) The ability for investment trusts to sell treasury shares without the

imposition of stamp duty.

5) The ability to raise funds for new investment opportunities other

than through gearing or the sale of other investments.

6) Improving liquidity by satisfying demand for shares through the

sale of treasury shares as opposed to purchases in the

secondary market.

7) Managing and optimising gearing levels more efficiently through

changes in the companys capital structure as opposed to otheroptions (e.g. the repayment of debt).

8) Greater NAV enhancement for long-term investors than may be

possible through share buy-backs for cancellation alone.

Executive summary


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Key features of treasury shares

1) Treasury shares will permit an investment trust, having carried

out a share buy-back, to hold up to 10% of its share capital in

treasury. A buy-back into treasury is conducted in the same way

as a buy-back for cancellation.

2) An investment trust can hold treasury shares indefinitely and thenchoose, at a later date, either to cancel them, or sell them for

cash at a price generally no less than 10% below the mid-market

price at the time the sale takes place.

3) Until they are sold, treasury shares carry no voting rights or rights

to dividends. In most respects, they essentially cease to exist.

4) Treasury shares come with pre-emption rights and therefore

trusts wishing to sell treasury shares back onto the marketgenerally (as opposed to all shareholders proportionately on

equal terms) will require shareholders to waive these

pre-emption rights.

5) For most legal, regulatory and accounting purposes, shares

bought back into treasury are treated as if they have been

cancelled, and any sales of treasury shares are treated like a

new issue. Therefore, no tax is payable on any profits arising on

the sale of treasury shares (nor any relief available for losses) and

no stamp duty is payable by investors acquiring treasury shares.

6) The Listing Rules will require full disclosure of transactions in

treasury shares.

7) The use of treasury shares should have no impact on the ability

of an investment trust to obtain approval under s842 and can be

ignored for these purposes.

8) It is intended that investment trusts will be asked to producetreasury NAVs in circumstances when they intend selling treasury

shares at a discount.


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Issues for board consideration

1) The AITC believes that treasury shares should generally not be

considered a new strategy, in isolation to share buy-backs, but as

part and parcel of a broader strategy relating to the control over

the supply of shares to the market.

2) Treasury shares, in conjunction with buy-backs, could be animportant part of strategies aimed at:

Enhancing NAV by selling treasury shares at a premium (page 15)

Reducing discount volatility (page 16)

Enhancing the attractiveness of Savings and Investment Schemes,

ISAs etc. (page 17)

Balancing supply and demand (page 20)

Dealing with other problems associated with the closed-endedstructure (page 20)

Counteracting the problems associated with shrinkage (page 21)

Improving liquidity (page 21)

Managing gearing (page 23)

3) Boards may also wish to consider the possibility of enhancing NAV

by selling treasury shares at a discount, but at a lower discount

than that at which they were bought back (page 25 onwards).Unlike share buy-backs for cancellation (which give rise to a

one-off NAV enhancement), the repeated use of buy-backs and

treasury share sales offers potentially unlimited NAV

enhancement opportunities.

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4) Boards considering selling shares at a discount may wish to

consider whether they should impose further parameters on

treasury shares such as:

Ensuring that buy-backs and sales of treasury shares are NAV

enhancing on the roundtrip (page 34)

Prescribing a life for treasury shares (page 35)

Prescribing a maximum amount of treasury shares that may besold in any one year (page 36)

5) The AITC does not consider that restricting the sale of treasury

shares to times when this would give rise to an absolute profit will

often be appropriate (page 35).

6) Boards should communicate their strategy for their use of

treasury shares clearly to ensure that shareholders agree to waive

their pre-emptions rights (page 36).

7) Boards should establish who will manage what aspects of any

buy-back and treasury share strategy (e.g. the Board, the broker,

the manager) and then ensure that each party is fully aware of

what is expected of them (page 37).

8) The use of treasury shares is likely to be harder for split capital

investment trusts than conventional trusts due to the impact the

sale of one particular class of treasury share could have on the

entitlements of other share classes (page 37).

9) Boards should consider what impact, if any, the use of treasury

shares should have on any management/performance fee

arrangements (page 37).

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12

On 1 December 2003, company law will, for the first time, permit

companies to buy back their shares and hold them in treasury for

possible future sale. Prior to these changes coming into force,

companies buying back shares have to cancel them immediately.

The process by which these legal changes have been brought about,

in particular in relation to investment trusts, has been a lengthy and

at times a difficult one, most notably when, in December 1999, the

Government announced its decision to press forward with treasury

shares, but decided that investment companies (which most

investment trusts are) should be excluded from the legislation.

As the AITC believes that the use of treasury shares could be a major

benefit for investment trusts and their shareholders, it launched an

intensive campaign to get investment companies included.

This included rallying support from stakeholder groups and engaging

with potential opponents to the measure, as well as making

representations to both the DTI and the Treasury. The campaign took

over two years to be resolved but was ultimately successful.Having now secured the option for investment trusts to use treasury

shares, the industry now has some time to consider how, in practical

terms, they may best be used in shareholders interest. As treasury

shares are a new development, this paper takes the form of a Guide

to Issues, rather than Best Practice Guidance, and seeks to raise

issues that Boards will want to consider before they choose to use

treasury shares.

This guide should be read in conjunction with the earlier Report onShare Buy-backs by ITCs(which forms Appendix 6 of the AITCs

Handbook for Directors of Investment Trusts), as well as the report

Secondary Liquidity in the Investment Trust Sector, published

separately by the AITC in May 2002. These are referred to

subsequently as the Share Buy-backs Report and the Liquidity

Report. Frequent cross-references to these other reports have

therefore been made.

Introduction


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This guide is broken down into three main sections:

Section 1 discusses the commercial benefits, risks and

considerations that may be associated with the use of

treasury shares;

Section 2 discusses the principle and the practical

implications of selling treasury shares at a discount to the

current NAV; and

Section 3 summarises the technical issues relating to

treasury shares (in terms of company law, the Listing Rules,

taxation, the Takeover Code and Substantial Acquisition

Rules, and NAV calculations).

Cross-references have been made between the three sections where

it is considered helpful to the reader.

Conclusion

If the industry grasps the opportunity that treasury shares represent,

the AITC believes that treasury shares could offer significant benefits

to investment trusts and their shareholders, perhaps even more than

was the case when share buy-backs were introduced.

As a trade association, we can suggest many ways in which

treasury shares could be used for the benefit of our Members

shareholders we can also highlight possible issues of concern.

However, ultimately it is up to Boards, considering the specific

circumstances of their own trusts, to make the case for treasury

shares so that shareholders permit them to use them to their fullest

potential and then for Boards, in conjunction with their managers,

brokers and other parties, to deliver on these undertakings.

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Background

What are treasury shares?

Currently, when an investment trust buys back its shares, it must

cancel them (i.e. they cease to exist). The companys share capital,

and funds under management, are therefore permanently reduced.

The treasury shares legislation, when it comes into force on1 December 2003, will permit an investment trust, having carried out

a share buy-back, to hold up to 10% of its share capital (or 10% of a

particular class of shares) in treasury.1

When shares are held in treasury, they effectively go into a state of

limbo. Although they still exist (the registered shareholder being the

company itself) and are shown as issued share capital on the

companys balance sheet2, they do not carry any voting rights,

dividends on them are suspended and they have no entitlements on a

winding-up. Once bought back into treasury, the company can hold

them indefinitely and then choose, at a later date, either to cancel

them, or sell them at a price generally no less than 10% below the

mid-market price at the time the sale takes place3.

It is perhaps worth stressing that treasury shares can only come into

existence after a share buy-back has taken place. It therefore follows

that trusts which have a policy of not buying back shares, and which

maintain this policy in the future, will not be able to make use of

treasury shares.

Considerations for strategy

The issues that treasury shares raise depend upon the purposes for

which they are used. Some reasons for using treasury shares (which

in part build on the suggestions made in respect of share buy-backs

in the Share Buy-backs Report), depending on the individual

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1 See also page 39 for a discussion of the company law position2 See also page 44 for a discussion of the accounting position3 See also page 42 for a discussion of the Listing Rules requirements

SECTION ONE

Treasury shares commercial issues


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circumstances of the trust, are:

a) Enhancing NAV by selling treasury shares at a premium

b) Reducing discount volatility

c) Enhancing the attractiveness of Savings and Investment

Schemes, ISAs etc.

d) Balancing supply and demand

e) Dealing with other problems associated with the closed-

ended structuref) Counteracting problems associated with shrinkage

g) Improving liquidity

h) Managing gearing

The frequent references to the Share Buy-backs Report are not

simply a means to avoid repetition, but reflect the fact that the AITC

believes that the use of treasury shares should not, in most cases,

be seen by trusts as a new strategy, considered in isolation to a

trusts strategy in respect of buy-backs. This is logical, as treasury

shares can only come into existence after a buy-back. Rather, the

use of treasury shares should be viewed as part and parcel of a

broader strategy relating to the benefits of investment trusts having

far greater control over the supply of their shares to the market.

Enhancing NAV by selling treasury shares at a premium4

This is perhaps the most straightforward of the possible strategies,

as few commentators would have any concerns about a trust issuing

shares at a premium to NAV. The usefulness, however, is likely to be

limited by the number of trusts able to sell treasury shares regularly

at a premium. In addition, though there are a number of trusts which

do currently issue shares at a premium, the enhancement of NAV is

often an incidental (and relatively minor) benefit of the share issue

rather than the intention of the share issue (see next section).

Historically discounts have tended to be far more significant in

absolute terms than premiums and therefore the potential for any

NAV enhancement is likely to be more limited. A trust buying back

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4 See also share Buy-backs Report (SSB) page 6, para (c)


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10% of its shares at a 10% discount (which is a relatively modest

discount by historical standards) will enhance NAV by approximately

1%. Issuing 5% of its shares at a 5% premium (quite a high premium

by historical standards) enhances NAV by less than 0.25%.

However, as discussed later, the AITC believes that oppportunities for

NAV enhancement exist even if treasury shares are sold at a discount,

providing they are sold at a discount lower than that at which they

were bought back.

Reducing discount volatility5

Some Boards actively adopt share buy-back and issuance strategies

with a view to keeping the discount within a target range, say from a

3% discount to a 3% premium (though it is rare for a trust to publicly

state this as a policy). In these cases, although shares are only issued

when the trusts shares are standing at a premium, and therefore

will marginally enhance NAV, this is not the main purpose for issuingthe shares.

Such a strategy can be particularly appropriate for tracker trusts

(though these are relatively rare in the investment trust

industry) where it is important for the returns received by

shareholders not to under or outperform the chosen index by too

great an extent. Where share price performance is concerned, the

greater the swings in the discount, the greater the tracking error.

Where NAV performance is concerned, a tracker should (in theory)always underperform its index due to the costs it incurs.

The marginal uplifts in NAV that arise through buying back shares at

a discount and issuing them at a premium could reduce this

underperformance. Such a strategy could also be important for

fund of funds type arrangements, where the prospect of discounts

on top of discounts would exacerbate the problems associated with

discount volatility.

Traditionally, share issuance powers have been limited to 5%

in accordance with guidelines agreed by institutional shareholders.

165 See also SSB page 6, para (b)


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However, there is no legal requirement for the trust to limit the

amount of shares being issued in any one year to 5%. Whether

institutional shareholders will be prepared to permit investment

trusts to use treasury shares to provide even greater flexibility in this

area will, of course, depend on the terms under which the Board

proposes to sell them and how well they can convey the benefits

under the terms proposed.

Enhancing the attractiveness of Savings and Investment Schemes,

ISAs etc.

The creation of wrapper products (such as Savings and Investment

Schemes, ISAs, Investment Trust Personal Pensions etc, referred to

collectively as Savings Schemes) can be an important source of

demand for the shares of investment trusts. By their nature, they are

also extremely important for any investment trust wishing to shift its

shareholder base over the medium to long term from the institutional

to retail. Over the years, management groups have made greatefforts to make such Savings Schemes attractive and easily

accessible, through low minimum contributions levels, low charges

and great flexibility.

However, in spite of the progress made, investors still

sometimes have concerns over the operation of such schemes.

These concerns tend to fall into one of three categories:

they are suspicious of Savings Schemes that deal on fixeddays, even if fairly regularly, on the grounds that the market

will see them coming. Some investors have tracked their

Savings Schemes over many months, years even, and believe

that they can prove this to be the case (though often an

explanation of discrepancies can be explained away by the

fact that the investor is using close of day prices, or mid

market prices, in their analyses).

they believe that management groups who deal in bulk, and

infrequently, do so because it is more convenient for them,

but that this will result in them achieving a worse price than

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if they dealt in smaller and more frequent lots (ignoring the

fact that any additional admin costs that would arise by

dealing in smaller lots would probably result in higher costs

for the Savings Scheme, unless the trust is prepared to

pick this up).

they are upset if the price moves against them in the period between

contributing the money to the Savings Scheme and the day it is

actually invested (forgetting the times when it works in their favour).

They want dealing to be done immediately.

Clearly, some of these concerns may be unfounded (though this does

not mean that they should be ignored altogether) and in some cases

the reality may be precisely the opposite of what the investor

instinctively believes to be the case. As the Liquidity Report

comments, bulked orders may well result in a better stock market

price for the investor6.

There is obviously a balance which needs to be drawn between the

service level that the management group provides (where the

customer wants the highest possible level of service) and the cost of

providing that service (which the customer wants to be as low as pos-

sible). The advantage of treasury shares is that, providing manage-

ment group systems are up to speed, shares could potentially be sold

much more frequently, and in smaller batches, into Savings Schemes

at a price which would more readily be perceived as fair by investors.

1% products

The current Government, rightly or wrongly, has indicated that it

considers costs of 1% per annum to be a benchmark for what

represents fair value for consumers (though it is currently

reconsidering its position on this). CAT Standard equity ISAs and

Stakeholder Pensions come with a cap on charges set at 1% per

annum. The future range of Sandler Stakeholder products, and

Child Trust Fund, are likely to come with similar charge caps.

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6 Liquidity report (LR) pages 27-28(III. Problems encountered by savings plans)


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Currently the presence of investment trusts within such 1% products

is extremely limited.

In reality, there are many other reasons, aside from the charge cap,

which have made it difficult for investment trusts historically to enter

this market. The AITC is currently lobbying to overcome these but,

even for products outside the 1% world, the 1% level may become a

benchmark which Savings Schemes will wish to meet even if they are

not being offered in designated CAT or Stakeholder Products.

One particular problem with such products is that, in determining

whether the 1% cap has been exceeded, stamp duty (currently 0.5%)

must be taken into account. This makes it extremely difficult for

trusts with a TER at or above 0.5% to fall within the 1% cap. The sale

of treasury shares, however, does not attract stamp duty and

therefore this increases the possibility of investment trust shares

being used in such products. Care will have to be taken, however, to

ensure that all buyers of shares are treated fairly. If, for example, aninvestment trust has a supply of 100,000 treasury shares available,

but orders for 110,000 in the Savings Scheme, the question arises as

to whether the stamp free treasury shares should be allocated on a

first come, first served basis (if there are lump sum orders as well

as regular contributions) or whether the benefits of stamp free

purchases should be spread evenly across all purchases in a given

period. Care will also need to be taken to explain the position to

buyers who may feel disconcerted if one month they buy shares with

no stamp duty payable but next month they have to pay it.

It could also be potentially damaging to the reputation of the industry if,

for example, it was subsequently discovered that treasury shares were

habitually used to satisfy demand from major IFAs/private client

stockbrokers but regular monthly Savings Schemes were satisfied

through purchases through the secondary market, or indeed vice versa.

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Balancing supply and demand

Most of the issues relating to this strategy are covered in the Share

Buy-backs Report7. Clearly, a trust which considers that its

shareholder register has an overhang of institutional shareholders

who are largely sellers of their shares, and future demand is likely to

come from retail investors, is likely to concentrate buy-backs on

removing institutional shareholders from the register (whilst still

treating all shareholders fairly) and selling treasury shares

through retail distribution routes (e.g. Savings Schemes, IFAs, private

client stockbrokers).

Dealing with other problems associated with the

closed-ended structure

Again, many of the issues raised concerning the movement from a

rigidly closed-ended structure to a more open-ended one are

discussed in the Share Buy-backs Report8.

Although much is made of the merits of the closed-ended structure

versus the open-ended structure (mostly on the grounds of fund

managers having to sell investments at less than ideal times to meet

redemptions) this is a double-edged sword. Managers of unit trusts

with a steady inflow of funds may be able to acquire an investment

more cheaply by using these additional funds than a closed-ended

fund which may have to sell other investments, thereby incurring

costs, to fund the purchase.

In the venture capital sector, the use of the limited partnership

structure has often been considered preferable not simply due to the

problems associated with the discount, but also due to the ability to

raise funds from, and return funds to, investors more efficiently than

in a closed-ended fund. Treasury shares may help by providing the

managers of closed-ended venture capital funds with a mechanism

which enables them to return funds to shareholders when an

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7 SBB page 7, para (d)8 SBB page 7-8, para (e)


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investment is realised (e.g. through a tender offer) but then to hold

some of the shares in treasury should a new investment opportunity

arise. The benefits to Venture Capital Trusts specifically may be

limited by the fact that one of the major tax benefits that comes with

an issue of new shares (i.e. income tax relief at 20%) is not available

on the sale of treasury shares9.

Counteracting the problems associated with shrinkage

As the Share Buy-backs Report makes clear, some of the advantages

associated with buying back shares at a discount can be reduced, or

even eliminated, by disadvantages in other areas (e.g. higher TERs,

an increase in the effective level of gearing, a reduced commitment

by brokers and other suppliers10 or even the prospect of the

shrinkage creating forced sellers when major shareholders have set

rules regarding the maximum percentage of a company they can

hold, or minimum size requirements for investee companies11).

Clearly, the ability to sell treasury shares could have a beneficialimpact on all these areas.

Improving liquidity

As the case study discussed earlier demonstrates, there is anecdotal

evidence that even private shareholders have been put off the

investment trust sector due to their inability to deal in quantity

within the touch.

Obviously, individual circumstances vary and some larger

management groups comment that liquidity is rarely a major issue

and business that cannot be satisfied via the market can generally be

placed where there is a will. However, the greater the obstacles that

need to be overcome, the greater the chance that business which

should be accommodated by investment trusts simply goes

elsewhere. Telling customers that there are problems which can be

overcome is generally second best to removing the problems in the

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9 See section 3, page 4310 SBB pages 8-9 para (f)11 SBB page 7 para (d)


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first place. There are also concerns that, because a purchase of

shares in the secondary market does not add to funds under

management, there is less incentive for managers to facilitate

such deals.

Some commentators have questioned whether there is a liquidity

problem in the investment trust sector at all. This is an interesting

angle, given how many people on the buy side say there is.

Sometimes it is tempting simply to quote the old adage If people

think there is a problem, there is a problem.

Perhaps the view that there is no liquidity problem stems from the

fact that any issues raised are no different from any other listed

company. Try and place a 1m buy order for a 50m listed

manufacturing company and no doubt much the same problems can

arise. But investment trusts are not conventional operating

businesses, they are not perceived as such and people do not buy

them for the same reasons as other listed companies. Just becauseother listed companies have liquidity problems is no reason for the

investment trust industry not to improve its own position if it can.

Real-time information on bid and offer prices is a relatively recent

development and people naturally believe, if they cannot deal within

these prices, that they have, in some way, lost out. As they say, how

many other markets exist where people may be told that the more

they want to buy of the product, the more they will have to pay per

unit? If, in the case study, the trust had placed previously boughtback shares into treasury, the order could potentially have been

satisfied through the broker or the fund manager within the touch,

with the added advantage that the sale would have increased the size

of the company, thereby alleviating some of the problems that had

arisen due to its shrinking asset base.

How many other successful businesses selling into a retail market,

and seeing sales suffer, adopt the line that the problem lies with the

consumer, or some other party, not with them? Even if this is a

reaction, those that persist with this attitude, and more importantly

let it influence their business strategy, generally do not survive.

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Investment trusts are different. They can be riskier and more

complicated. Few consumers, even wealthy ones, have the skill,

knowledge or desire to get their heads around all the complications.

Rather than tell customers that they can get round these barriers if

they put the extra effort in, a better approach must surely be to

remove as many of these barriers as possible.

One phrase that has been used in the context of treasury shares is

that an investment trust could become its own market maker of last

resort. Such comments have probably served to increase concerns

on the part of the market making community, notwithstanding the

fact that there may be increased opportunities within their broking

arms to match supply and demand for shares. The withdrawal of

three major market makers from the investment trust sector shows

that market making is a commercial business and that market

makers do not consider that they owe the investment trust industry

a living.

If market makers consider that their business in investment trusts is

under threat, then it is possible that they will react by widening

spreads, reducing their capital commitment or withdrawing from

the market altogether. If this happens, many of the benefits of

treasury shares in improving liquidity will turn out to have been

counterproductive. The term of last resort is, of course, relevant.

Suggestions that investment trusts will be able, through the active

use of treasury shares, simply to bypass the market makers

altogether is obviously not true and treasury shares may be used tosatisfy demand when liquidity otherwise is not available. The 10%

limit on shares that can be held in treasury should also act as a

natural limiter on the amount of business that could be done

in this way.

Managing gearing

Typically, trusts gear up and down in response to investment

opportunities, or the lack of them. Gearing is usually changed by

increasing or reducing debt and more rarely by issuing new equity or

making buy-backs. Changing the equity base of the trust is seen as a

major step rather than an operational expedient. Treasury shares23


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could allow the equity base of the trust to be changed as easily,

perhaps more so, as its debt level, which will give greater operational

flexibility in the way managers fund their investments and deal with

cash from disposals.

In particular, the use of treasury shares could make it easier for

trusts to optimise their gearing levels. The recent examples of

problems in the Splits sector demonstrates the difficulties that trusts

can experience if they begin to run close to, or breach, their banking

covenants. However, if such concerns cause Boards and managers

to adopt a lower level of gearing than they believe is warranted on

pure investment grounds, then one of the major advantages of

investment trusts may be underutilised. The ability to sell treasury

shares may help a trust to optimise its gearing level or,

alternatively, provide a more flexible way of reducing gearing at

the appropriate time.

Conclusion

As the above indicates, there are many ways in which the active use

of treasury shares could help improve the attractiveness of the sector.

However, the ability for treasury shares to do so will be extremely

limited if the sale of treasury shares is limited only to those times

when the share price is trading above net asset value per share.

As the question of selling treasury shares at a price below net asset

value per share is perhaps the most controversial issue of all, it is

considered worthy of a separate discussion.

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In the past, Boards have almost universally only issued new shares

when trading at a premium. Some clearly feel that they are obligated

to do so and would be failing in their duties to shareholders if they

were to issue shares at a discount. As the Liquidity Report identified,

views on this issue vary enormously12.

As with all controversial issues, it is easy for interested parties on

either side of the debate to be sucked into entrenched and extreme

positions. The advent of treasury shares should provide an

opportunity to discuss this issue in an open and constructive manner,

recognising that there are valid concerns on the part of those who are

likely to view such a development with suspicion.

To deal with one fairly straightforward point, legally Boards can sell

shares at a discount. Indeed, the Listing Rules specifically provide for

this eventuality where issuing new shares is concerned, simply

requiring shareholder approval before it can happen13. It would be

bizarre if the Listing Rules were to specifically authorise a course of

action which was automatically a breach of directors duties.

Secondly, when people say that it is not acceptable for trusts to sell

treasury shares at a discount, it is tempting to ask them what

discount they are referring to. There are so many different

calculations of NAV (diluted/undiluted, debt at par/market value,

including/excluding income etc) that it is quite possible that some

trusts may have already issued shares at a premium to one measure

of NAV, but at a discount to another.

Nor is it always the case that a purchase of shares at a discount is

NAV enhancing. The Share Buy-back Report refers to the fact that

some trusts buy back shares at discounts as low as 0.2% and issue

25

12 LR pages 42-4313 Listing Rule 21.21

SECTION TWO

Selling treasury shares at adiscount the principle

Introduction


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at similar premia14. Without further information, it is impossible to

be categorical but, if this true, then such a buy-back would actually

appear to be NAV diluting rather than enhancing, as stamp duty of

0.5% would be payable on the buy-back.

As indicated previously, trusts adopting such an active strategy are

likely to be trying to hold the discount within a very narrow range

(perhaps a tracker trust or fund of funds wishing to avoid double

discounts). The almost infinitesimal dilution that arises by buying

back shares at a 0.2% discount is almost certainly worth sacrificing

for the benefit of the trust not moving to a wider and more intractable

discount. For a trust trading at around par, the detriment suffered by

shareholders if the shares were to move to a 5% discount hugely

outweighs any marginal dilutions in NAV (which will partly, if not

totally, be recovered if the trust issues shares later at a small

premium). There appears to be some evidence that it is easier to

prevent a trust moving to a wider discount than it is to move a

discount back once it has been established.

Share buy-backs and treasurysales as an overall strategy

Arguments against selling treasury shares at a discount tend

to focus on the sale of treasury shares in isolation. However,

as the example above of a trust buying back shares at a very small

discount (which is effectively dilutive), but recovering some of this

when issuing shares at a small premium indicates, another approach

is for buy-backs and treasury share sales to be considered as two

parts of one overall strategy. Although the AITC believes that NAV

enhancement is only one issue amongst a number that Boards will

want to consider, the benefit of NAV enhancement differs from

some of the other benefits that share buy-backs offer in that it is

demonstrable and certain. It is therefore worth considering any

impact that treasury shares may have on this benefit in some detail.

14 SBB page 7 para (e)

26


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So, for example, whilst the AITC would generally consider that it

would be difficult, other than in extreme circumstances, for a Board

to justify a buy-back of shares into treasury at a 10% discount and a

sale of these shares at a 15% discount, the position is less clear for a

buy-back at 15% and a sale at 10%. Some commentators would

argue that it would always be correct for the trust to cancel the

shares and take the maximum uplift. In reality, the position will not

always be as clear cut.

The earlier section on the possible problems associated with

shrinkage identifies concerns some Boards have felt that, whilst

attracted to the possibility of buying back shares in an attempt to

narrow discounts and enhancing NAV at the same time, they did not

consider that these benefits outweighed the potential dangers for

shareholders associated with permanently shrinking the asset base.

If a Board is unwilling to buy back shares at a 20% discount due to

such problems, then the full 20% NAV enhancement will be foregone.If, on the other hand, the prospect of being able to sell treasury

shares back out at a 10% discount in the reasonably near future is

sufficient to tip the balance in favour of a buy-back, then it must be

more appropriate to see the buy-back and sale combined as an NAV

enhancement for shareholders which would otherwise have been

foregone. The example below demonstrates that, all things being

equal, a trust that buys back shares into treasury at a 20% discount

and sells at a 10% discount is in a better position than if the buy-back

had never taken place. It also demonstrates that this is true even ifthe treasury shares are sold at a price which is lower than that at

which they were bought back.

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Example15

A trust with 100m of net assets and 50m 1 (nominal) shares in

issue, currently trading at a 20% discount, decides to buy back 10%

of its shares into treasury. It does not consider it would be in

shareholders long-term interests to buy back shares solely for

cancellation but commits to not selling treasury shares back at a

discount greater than that at which they were bought back. A year

later, its assets have fallen by 15% but its discount has narrowed to

10% and it decides to sell all its treasury shares at the prevailing

market price.

Immediately prior to the buy-back, the companys balance sheet,

basic NAV and share price are as follows:

000

Net assets 100,000

Share capital 50,000

Reserves 50,000

100,000

Basic NAV 200.00p

Share price 160.00p

15 This example should be read in conjunction with the comments andanalysis in section three in respect of the accounting presentation of

treasury shares and the calculations of basic and treasury NAVs forstatistical purposes. However, the key issue in terms of the example is thatthe basic NAV will be calculated by reference to the number of shares inissue but excluding any held in treasury.

28


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The share buy-back will cost the company (ignoring other

associated costs such as brokerage, stamp duty etc) 5m x 160p =

8m. Immediately after the buy-back the companys balance sheet

and basic NAV are as follows:

000

Net assets 92,000


Reserves 42,000

92,000

Basic NAV 204.44p

Immediately before the sale of treasury shares, the companys

balance sheet, basic NAV and share price are as follows:

000

Net assets 78,200


Reserves 28,200

78,200

Basic NAV 173.78p

Share price 156.40p

29


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The sale of treasury shares will therefore raise 5m x 156.40p =

7.82m. After the sale of treasury shares the companys

balance sheet and basic NAV looks as follows:

000

Net assets 86,020


Reserves 36,020

86,020

Basic NAV 172.04p

Although the sale of treasury shares is, in one sense, dilutive,

if the original buy-back had never taken place, the trusts NAV would

have only moved in line with the growth or fall in net assets, namely

falling by 15% to 170p. In other words, the trusts basic NAV has

increased by 2.04p more through the use of treasury shares than if

the trust had done nothing. The fact that the sale of treasury shares

was conducted at a price lower than that at which the shares were

bought back (ie. a sale at 156.40p as opposed to the price paid on the

buy-back of 160.00p) does not change the analysis.

However, it is possible to go further than simply saying selling at adiscount may help to obtain an NAV enhancement that would

otherwise have to be foregone. It is possible that selling at a discount

might help to create NAV enhancements for long-term investors

which are greater than that which could be achieved through share

buy-backs for cancellation.

In the above example, some commentators might argue that the sale

from treasury should never have taken place, as it has reduced the

NAV from 173.78p to 172.04p. This, of course, ignores the fact that theNAV would, in the circumstances described, never have reached

173.78p if the shares had had to be bought back for cancellation, as

30


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the board had already decided that it would not be in shareholders'

interest to buy back shares if cancellation was the only option.

However, leaving this aside for the moment, committing to a share

buy-back strategy under which a trust must always maximise its NAV

enhancement (which, in practical terms, for most trusts, is likely to

be the same thing as arguing that all share buy-backs should be for

cancellation) means that any tranche of shares bought back gives

rise to a one-off NAV enhancement. However, with treasury shares,

the possibility exists that any NAV enhancement (albeit a lower one

than could be obtained through cancellation) could be repeated in the

future, perhaps many times over. In other words, a greater one off

NAV enhancement that would arise on a share buy-back for

cancellation could be exceeded by repeated smaller NAV

enhancements through the purchase and sale of treasury shares.

By way of example, and ignoring any movement in the underlying

assets, a buy back for cancellation of 10% of a trusts shares standing

at a 20% discount will enhance the basic NAV by 2.22%. If, on theother hand, the trust buys back the shares into treasury at a 20%

discount, then sells them at a 10% discount, then repeats the process

at the same 20%/10% discount levels, it will enhance NAV by 2.41%.

The counter-argument, of course, is that a trust buying back shares

for cancellation can repeat the process simply by buying back more

and more shares. However, there is a finite number of times this can

be done, and a small/medium sized trust buying back shares for

cancellation regularly in meaningful numbers may well find it hascreated more significant problems for itself than it has resolved.

Treasury shares, in theory at least, are unlimited in terms of how

often, and how much, they can enhance NAV for long-term

shareholders. However, this will only be the case in reality if they can

be sold at a discount.

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The Share Buy-backs Report also emphasises16 that, in any strategy

aimed at discount and/or discount volatility reduction, the trust is

likely to have to commit to buying back shares on a regular basis and

to be prepared to commit to this strategy for some time. Again, if the

only option is to cancel any shares bought back, it may be difficult for

many trusts to make such a commitment.

Conclusion

The above analysis demonstrates that the principle of selling shares

at a discount is not as black and white as it has sometimes been

presented. What is important is not whether, as a mathematical fact,

investment trusts are able to sell treasury shares at a price below the

current NAV, but how they will use these powers and whether they

can demonstrate that this is in shareholders interests.

32

16 SBB page 15


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Selling treasury shares at a

discount the practiceShareholders concerned with the prospect of investment trusts

selling treasury shares at a discount can be reassured by the fact

that they have ultimate power to prevent it happening at all if they

so wish.

Obtaining shareholder approval

Treasury shares come with pre-emption rights (this, along with the10% limit, are the two key protections that company law provides).

This means that, unless shareholder approval is obtained, treasury

shares, when sold, would have to be offered to all shareholders on

equal terms. Clearly, given the suggestions made earlier as to how

treasury shares could be used, the failure of shareholders to waive

their pre-emption rights would be a fatal blow to any meaningful

use of treasury shares.

Shareholders, therefore, have the ultimate say and it would be

dangerous for Boards to assume, given the statements made by

institutional and other shareholders, that they will obtain this

approval if they are not prepared to make any commitment as to how

they will use treasury shares. Investment trusts with substantial

institutional shareholders would therefore be well advised to discuss

their strategy for the use of treasury shares with shareholders in

good time to ensure their approval is forthcoming.

Clearly, one major concern on the part of shareholders will be the

question of how, and to what extent, treasury shares might be soldat a discount. It may therefore be likely that, in order to obtain

shareholder approval to waive their pre-emption rights, Boards will

wish to self-impose further parameters in respect of the sale of

treasury shares over and above those imposed by law and regulation.

Possible parameters that a Board might wish to consider are:

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Ensuring that buy-backs and sales of treasury shares are

NAV enhancing on the roundtrip.

This could involve the Boards undertaking, for example:

to sell treasury shares at a discount lower than the average

discount at which they were bought back (e.g. by calculating

a weighted average discount at the time of each buy-back,

and then selling treasury shares at a lower discount than

this, or recording the individual discount on each buy-back

separately and ensuring that these individual lots of shares

are sold at a lower discount than they were bought

back at); or

to prohibit the buy-back of shares at less than a certain fixed

level of discount and the sale at greater than a fixed level of

discount, perhaps with a clear margin between the two

(e.g. by prohibiting buy-backs at less than a 10% discount andprohibiting sales at greater than a 5% discount).

Of the two types of approach, the former may be more attractive, as a

trust may not wish to publicly state the absolute level of discounts at

which it is likely to be buying and selling its own shares, for fear

of giving too clear a signal to the market. The latter approach might

work better as parameters which Boards instruct brokers and

managers to operate within, and which can be changed from time

to time as the Board sees fit.

Note: although we refer to this approach as being NAV enhancing on

the roundtrip, the AITC would not advise Boards to make an absolute

statement that the use of share buy-backs and sales out of treasury

will always be NAV enhancing. Although it is likely that this would be

true in the above scenarios, Boards should understand the difficulty

of proving this if challenged. Treasury shares have no time limits and

it is possible that some positions could be developing and unwinding

over many years.

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Prescribing a life for treasury shares

There is no legal requirement for a maximum life for treasury shares

(and no obvious reason why there should be). They can, however, be

cancelled at any time. The basis of calculating treasury NAVs17 will

take into account any dilutive impact that the sale of treasury shares

back onto the market may have. In other words, part of any NAV

enhancement will not crystallise for some NAV performance

reporting at the time of the buy-back into treasury. Boards may feel

that if, after 12 months since a buy-back, opportunities have not

arisen to sell treasury shares under the parameters established,

the shares should be cancelled to lock in this NAV enhancement.

Only selling treasury shares at an absolute profit

Although this has been suggested on a number of occasions, the

AITC can see no obvious reason why the price at which treasury

shares can be sold, on its own, should be a determining factor indeciding whether treasury shares should be sold. The example given

on page 28 shows that the sale of treasury shares at a loss can still

be in shareholders interest.

By way of an even more clear cut example, (accepting that this would

be a rare event), a trust has shares with an NAV of 1, trading at 90p,

and decides to buy back 10% of its shares. The NAV of this trust then

falls to 25p, rallies to 50p, and demand for the trusts shares

increases so much that the shares begin to trade at 52p in themarket. Clearly, any sale of treasury shares will be NAV enhancing,

even though each share sold will be making an absolute loss of

38p per share.

For shareholders who stay the full course, the question is not simply

whether the shares have gone up or down in price, but whether the

use of share buy-backs and treasury share sales has put them in a

better position than they would have been otherwise, which is the

case in the above example.

17 Section 3, page 4735


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Prescribing a maximum amount of treasury shares that may be sold

in any one year

Although there is a 10% limit on the amount of treasury shares that

may be held in treasury, there is no limit on the amount of treasury

shares that may be sold in any one year. For example, if the trust has

put in place the normal 15% buy-back authority, it is possible for a

trust to buy back 10% of its shares into treasury, then sell these, then

buy back a further 5% and sell these.

Communication

The Share Buy-backs Report emphasises the importance of

communication in any share buy-back strategy18. The same applies

in respect of treasury shares.

Where institutions are concerned, it is likely that the Pre-emption

Group will wish to consider how their guidelines should change as

a result of the introduction of treasury shares. Even after the

Pre-emption Group has given its views, Boards are likely to wish

to consult with major shareholders to discuss the specifics of their

own strategies.

Where private investors are concerned, it is still the case that much

confusion surrounds the use of buy-backs. Many ask why the

company cannot put the money to better use and it is clear from

such comments that they have not appreciated that, assuming that

the manager has put the best possible portfolio together, a share

buy-back can amount to buying this perfect portfolio at a price

below its current market price. This is one reason why it has been

argued that funds raised through gearing could perhaps be best used

to buy back shares where a trust stands at a reasonable discount19.

18 SBB page 10-12, para 219 SBB page 6, para (c)

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Treasury shares could add to their concerns, simply by virtue

of them being a further complication. If, however, they can be

convinced that treasury shares will only be used in a manner which,

combined with buy-backs, is NAV-enhancing overall, and if they are

assured that the price they will pay (if they acquire treasury shares)

will be no worse than the prevailing market price, and avoid stamp

duty as well, then these concerns may well recede.

Who manages the use of treasury shares?How many brokers to use?

Many of these questions are discussed in the Share Buy-backs

Report20 and apply equally to the use of treasury shares.

Split capital trusts

The use of treasury shares by split capital trusts is complicated by

the fact that any sale of treasury shares to one particular class of

share could have a material impact on the entitlements of other

share classes. However, as much the same issue arises with share

buy-backs, the use of treasury shares by split capital trusts is likely

to be far less common than by conventional trusts.

Management/performance fees

As indicated before, one of the major differences between a sale of

treasury shares to investors and a purchase by investors in the

secondary market is that the sale of treasury shares will increase

funds under management. Both Boards and managements will wish

to consider the implications of the sale of treasury shares on their

management/performance fee arrangements. For example,

if a performance fee is set by reference to NAV performance,

20 SBB page 12-17, Considerations for enactment37


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consideration should be given as to whether this NAV performance

should be calculated in the future by reference to a basic NAV or a

treasury NAV.

The question of who manages the buy-back and treasury sale

strategy is relevant here. If the strategy is in the control of the

manager, shareholders might be concerned if a substantial number

of shares were bought back into treasury at the very end of the

performance fee period, enhancing NAV and thereby generating a

higher performance fee, and these shares were then sold back onto

the market immediately after the end of this period, thereby boosting

funds under management.

On the other hand, if control of the sale of treasury shares is in the

hands of the Board and its brokers, managers with a performance

fee based on NAV total return are likely to be concerned by the

possibility of their outperformance being diluted by the sale of

treasury shares at a discount.

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39

The following is intended as a brief summary of the technical

considerations that are likely to be of most interest to Boards of

investment trusts and is for general guidance only. It is not intended

to be an exhaustive analysis of the relevant legislation and

regulations and Boards should therefore take advice before acting

on anything contained in this guidance. It should also be noted that,

at the time of writing, many of the rules discussed were still in the

process of consultation and therefore may change as a result of

this process.

Rule of thumb

As a general rule, changes to company law and other regulations will

treat shares in treasury as if they had been bought back and

cancelled. So, for example, where current rules impose obligations

on parties (including the company itself) by reference to whether

certain percentage limits of the companys share capital have been

exceeded (e.g. notification of interests), these percentages will infuture be calculated by reference to the companys issued share

capital excluding any shares currently held in treasury.

Company law

The company law regulations come into force on 1 December 2003

and therefore, in theory, an investment trust could buy back shares

into treasury from this day onwards. Realistically, it is likely that the

AGM for December 2003 year end companies will be the earliest

point at which shareholder approval will be sought for the use of

treasury shares, with actual buy-backs into treasury taking place

some time after.

A company can only hold it own shares as treasury shares after it

has acquired them by way of a buy-back (including tender offer).

The legal requirements relating to the process of buying back shares

into treasury are largely identical to that of buying back for

cancellation (e.g. the requirements for distributable profits).

In other words, a company buys back its shares in the normal way

and then either cancels them or holds them in treasury. If the

SECTION THREE

Treasury shares technical issues


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40

company decides to hold shares in treasury, the companys own

name is entered into the share register. The shares cannot be held

by anyone else (e.g. a nominee or a subsidiary). Keeping track of

how many shares are held in treasury will therefore be a

straightforward matter, a position which will be bolstered by the

disclosure requirements of the Listing Rules21.

A company may only hold shares in treasury if they are listed

on the London Stock Exchange. This should present no problem for

investment trusts, unless exceptionally they have any class of shares

which are not listed. The suspension of a listing of shares does not

affect the ability for them to be held in treasury. However, if a

companys listing is cancelled, then any treasury shares must also

be cancelled immediately.

Maximum holdings

A company may not hold more than 10% of the nominal valueof its share capital in treasury at any time. If the company has more

than one class of share capital, the 10% limit is applied to each share

class separately.

Voting and other rights

All voting rights on treasury shares are suspended. A company

cannot therefore vote its treasury shares on any resolution that the

Board puts to shareholders. Any attempt to do so is treated as void.

In addition, no distributions (including dividends and any distributions

on a winding up) may be made in respect of treasury shares.

Sale of treasury shares

As a general rule, treasury shares may only be sold for cash (or cash

equivalents). So, for example, an investment trust will not be able to

issue treasury shares in return for an in specietransfer of shares into

its portfolio.

21 See page 42


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41

Proceeds of sale

If the proceeds of the sale of treasury shares are less than or equal

to the price paid for them (the price being the weighted average

price) then the full amount of proceeds is treated as a realised profit.

If the proceeds of the sale of treasury shares are greater than

the price paid for them, the excess is transferred to the share

premium account.

There is no guidance in the regulations as to whether the amount

recognised as a realised profit is revenue or capital in nature.

The identification of revenue and capital profits is of crucial

importance to investment trusts, given the legal provisions that exist

in respect of how such profits may be distributed. However, as the

profit arises in respect of the acquisition and disposal of something

which is, in legal terms, a capital asset (notwithstanding the fact that

the tax regulations and accounting rules will not recognise treasury

shares as assets), it is assumed that this profit should be treated as

capital in nature. This is likely to mirror the treatment on the

buy-back itself, for which capital profits are invariably used.

Pre-emption rights

Treasury shares come with pre-emption rights and therefore, unless

shareholder approval is obtained, treasury shares would have to be

offered to all shareholders on equal terms. Shareholders can choose

to waive their pre-emption rights and it is envisaged that investment

trusts wishing to make use of treasury shares will seek suchapproval, probably within the limitations to be agreed with the

Pre-emption Group.

Notification of interests

In relation to the requirement to notify interests of more than 3% or

more of a companys issued share capital, the relevant percentage is

calculated by reference to the companys issued share capital but

excluding any of these shares which are currently held in treasury.So, if a shareholder holds 1.4m shares in an investment trust with

50m shares in issue, of which 5m are held in treasury, the relevant

percentage is 3.11% (i.e. 1.4m divided by 45m).


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42

The Listing Rules

Price-sensitive times

As with share buy-backs, the Listing Rules will prevent treasury

shares from being sold at price-sensitive times.

Investment companies already benefit from a potential exemptionfrom the Listing Rules which permit them, in certain circumstances

and with prior approval of the UK Listing Authority, to buy back

shares in close periods. The exemption will be extended to the sale

of treasury shares.

Disclosure

A company will be required to disclose details of all transfers

of shares in and out of treasury, and any cancellation of shares heldin treasury, at the time of the particular transaction. It must also

disclose the number of shares held in treasury following any of these

transactions.

Price

The basic rule is that treasury shares cannot be sold at a discount of

more than 10% to the mid-market price at the time of the sale.

This rule can be disapplied in certain situations (if, for example, anoffer is made to all shareholders on the same terms).

For investment trusts, the issue of the discount at which treasury

shares may be sold is far more likely to be considered by reference to

the NAV than share price.

Taxation

The basic framework of the tax legislation applicable to treasury

shares is that, if a company buys back shares, holds them in treasury

and then sells them at a later date, it will be treated for tax purposes


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as if it had bought back the shares, cancelled them and then made

an issue of new shares. As a result, no taxable profit (or relievable

loss) arises on the sale of treasury shares.

Section 842 considerations

In order to be approved as an investment trust, a company must

satisfy seven conditions on an annual basis. The holding of shares in

treasury, and sale of shares from treasury, would appear only to have

implications for one of the seven conditions, namely that no holding

in a company must represent, on acquisition, more than 15% of the

investment trusts investments. This raises two questions:

does a holding of treasury shares constitute a holding in a

company subject to the 15% limit; and

are treasury shares investments for the purposes of

measuring whether any holding in a company exceeds the15% limit (i.e. part of the denominator)?

The tax legislation provides that, where a company acquires treasury

shares, the shares are not to be treated as the acquisition of an asset

and that shares so acquired are to be treated for tax purposes as if

they had been cancelled. The Inland Revenue have indicated that, as

a result, treasury shares should not be considered a holding in a

company subject to the 15% limit and also should not be considered

as investments for the purposes of measuring whether this limit hasbeen exceeded.

This is administratively the most convenient position and means that,

by and large, the use of treasury shares should have no impact on a

companys status as an investment trust.

Venture Capital Trusts

The 20% income tax relief that is available to private investors on the

issue of new shares in a Venture Capital Trust is not available on the

acquisition of treasury shares.

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The Takeover Code and theSubstantial Acquisition Rules

In line with the rule of thumb set out on page 39, treasury shares

are generally excluded from the calculation of the relevant

percentages under these rules.

Accounting

The accounting treatment for treasury shares is almost certain to be

in line with International Accounting Standards, which treats the

price paid for treasury shares as a deduction from shareholders

funds and does not permit them to be shown as an asset of

the company.

Example 1

A company issues 100m 1 (nominal) shares at 1.50 per share.

After a number of years its balance sheet looks as follows:

000

Net assets 200,000


Share premium 50,000

Reserves 50,000

200,000

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The companys shares have an NAV of 2 per share and its shares are

trading in the market at 1.80 (i.e. a 10% discount) and it decides to

buy back 10% of its shares and hold them in treasury. Ignoring other

costs, this will cost the trust 18m (10,000,000 shares at 1.80 per

share). After the buy-back into treasury, the companys balance

sheet will look as follows:

000

Net assets 182,000



Reserves * 32,000

182,000

* Note : it is not clear at the time of writing whether this net figure would

need to be shown separately as 50m reserves with a debit of 18m for

the purchase of treasury shares.

Where NAV calculations are concerned, it would clearly be

nonsensical for the trust to calculate its basic NAV on the basis of

100m shares in issue (which would give an NAV of 1.82). The NAV

should be calculated on the shares in issue, but not held in treasury(i.e. 90m), giving a basic NAV of 2.02 (see later for a discussion

of the basis of calculation of treasury NAVs).

Example 2

The same facts as above but the trusts assets grow by 50% over the

next few years and the trust begins to trade at a 5% premium.

The trust therefore decides to sell 5% of its issued shares (currently

held in treasury) at the prevailing market price.

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Before the sale the trusts balance sheet would look as follows:

000

Net assets 273,000



Reserves 123,000

273,000

The trusts basic NAV is 3.03 (273m divided by 90m shares in

issue but not held in treasury) and its shares are trading in the

market at 3.18.

The sale would raise 5,000,000 x 3.18 = 15.9m, of which 9m(5,000,000 x the weighted average price paid of 1.80) will be credited

to realised reserves and the balance of 6.9m will be credited to

share premium account.

After the sale, the companys balance sheet would look

as follows:

000

Net assets 288,900



Reserves 132,000

288,900

The trusts basic NAV is now 3.04 (288.9m divided by the 95m

shares in issue and not held in treasury).

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NAV calculations

By way of background, the AITC currently calculates six measures of

NAV for the purposes of its Monthly Information Release (which is

aimed primarily at professional users). Different NAVs are calculated

to include/exclude income and to reflect dilutions that may arise on

the conversion of warrants and convertibles. For the purposes of the

Monthly Information Service (which is aimed more at privateinvestors) the NAV shown will be the lowest of the six NAVs

calculated, as the AITC believes that, if only one NAV is to be

presented, it should be the most conservative. In this section, the

term basic NAV has been used to refer to the NAV which is

calculated on an entirely undiluted basis, and excluding income.

If treasury shares are never to be sold at a discount then, as

demonstrated in the examples above, the only difference between the

calculation of NAVs from that used at present is likely to be that thetotal number of shares used to calculate NAV per share should

exclude any shares held in treasury. If, however, treasury shares are

capable of being sold at a discount, the question arises as to how

NAVs should reflect this fact, if at all.

One option would be for all the NAVs currently calculated to take the

full uplift in NAV on the buy-back and only reflect any dilution on the

sale. The AITC, however, considers that it would be imprudent to

report NAVs on the basis of an uplift in NAV which could (at least in

part) evaporate the very next day. At the same time, it believes that

any dilution should represent a realistic possibility.

In order to meet the basic principle, it is proposed that Members

should be asked to calculate additional treasury NAVs on the

assumption that all treasury shares are sold at the current market

price except as follows:

if the current market price is above the basic NAV per share (i.e. at a

premium), then the treasury shares would be treated as if they weresold at a price equal to the current NAV (in practical terms, the

result of this is that treasury shares could simply be ignored).

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if the Board has set parameters which mean that treasury

shares could not be sold at the current market price, the

shares would be treated as being sold at the minimum price

at which they could be sold (subject to this price not being

above the current NAV).

Examples

A company buys back shares into treasury at a 20% discount to NAV.It has set a policy which means that it will not sell treasury shares at

a price below a 10% discount to the basic NAV at the time of sale.

Current Basic NAV Price at which

Share Price treasury shares

treated as sold for

treasury NAVs

1) 70p 100p 90p

2) 95p 100p 95p

3) 105p 100p 100p

In the above example 1), when the share price is 70p, it is not considered

appropriate for this to be taken as the price at which treasury shares are

treated as sold for NAV purposes, as this would be an unrealistic

estimate of the maximum dilution that could occur, as the trust would

not permit treasury shares to be sold at this price. In example 3), it is

not considered prudent to take an additional NAV enhancement above

that which would arise on cancellation (which is an option any time and

therefore a certainty) until it has actually crystallised.

It is proposed that the AITC Monthly Information Release would present

treasury NAVs in addition to those currently given and that the Monthly

Information Service would continue to show the lowest NAV of these.

The AITCs Statistical Committee is considering the above

proposal and will issue more detailed guidance in due course.48


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Documents

Treasury Shares Guide