We have become familiar with businesses, as they expand, developing corporate structures such as groups, to better manage the various activities they undertake.
For example, one might have a holding company and underneath that holding company, various trading subsidiaries undertaking different activities. There may also be subsidiaries holding other trading and non-trading assets, whether properties or investments.
Why then might a company or corporate group look to demerge? Typical examples we come across include:
- There is a conflict between the current company shareholders and they want to go their separate ways, with one group of shareholders pursuing one trade, another pursuing a different trade. Rather than remain tied together through their ownership of the two businesses in a single company, a demerger can help them go their separate ways and, if not amicably, then give the separate businesses the chance to thrive rather than suffer the deadlock of warring shareholders.
- The relatively high costs of extracting funds from companies by way of dividend or salary means that many company owners decide to maintain those funds within a corporate wrapper and then reinvest them into other assets such as buy-to-let residential properties. While this can be an attractive route, it may have wider implications including the ability to claim Entrepreneurs’ Relief on a future disposal if the company has substantial non-trading activities or Business Property Relief for inheritance tax purposes of the activities of the company are wholly or mainly investment rather than trading. A demerger can be used to extract the non-trade elements of the company leaving the shareholders with two companies, one of which is trading, and with the possibility of claiming Entrepreneurs’ Relief and Business Property Relief, and the other is an investment company.
The problem with each of these is that they could each result in significant tax implications for the companies and shareholders involved. Fortunately, it is often possible to undertake such demergers without giving rise to adverse tax implications. The most common and familiar routes are statutory demergers and liquidation demergers but a third option, a capital reduction demerger, is growing in popularity.
A Statutory demerger is the simplest method of demerging but has a long list of criteria which a company will need to meet in order to qualify to use the statutory demerger route.
What is a Statutory Demerger?
Simply a statutory demerger transfers the chosen assets and liabilities of a particular trade of a company to another entity via a dividend in specie. A dividend in specie is a dividend that is paid by way of an asset as oppose to cash. Providing that the relevant statutory demerger criteria is met, the dividend in specie will be exempt from tax.
Corporation Tax Act 2010 s1081 stipulates that a number of requirements need to be met in order to be eligible for the statutory demerger, including the following
- Each company is resident in the UK or EU at the time of distribution
- The distributing company must be a trading company or a member of a trading group and remain so after the transfer. Likewise, the demerged subsidiary must be a trading company or member of a trading group at the time of the distribution.
- The demerger must be for the benefit of the trading activities.
- The distribution must be made from distributable reserves.
- The distributions must not be made as part of an arrangement for the avoidance of tax or the cessation or sale of the trade following the demerger. If there is a sale within five years, then clearance must be sought from HMRC.
- The shares issued by the transferee must not be redeemable and must represent the whole or substantially the whole of the issued share capital to the transferee.
- The distributing company must only retain a minority interest in the trades or subsidiaries transferred.
It is therefore often difficult for companies to qualify under the statutory demerger route.
There are circumstances in which a demerger utilising a liquidation under s.110 Insolvency Act 1986 can be a very powerful tool when other forms of demerger are not appropriate.
What is a liquidation demerger?
A section 110 liquidation demerger involves the liquidation of a parent company and the transfer of its assets to two or more companies. In consideration for the transfer of the assets that the liquidator distributes to them, each such company issues shares to the shareholders of the liquidated company in satisfaction of their rights on the winding-up. The parent company is then dissolved, leaving two or more companies, each holding part of the assets of the original parent company.
Pros and Cons of a liquidation demerger
The main advantage of this type of demerger is that it can be utilised in scenarios where it is not possible to use direct or indirect dividend methods either because they are impractical or the relevant tax reliefs cannot be obtained.
For example, and as mentioned above, statutory demergers cannot be utilised in situations where:
- the companies involved are not “trading” companies,
- a 75% group relationship does not exist between the distributing company and the company to be demerged
- the demerger is taking place in advance of a sale or float.
A company not having sufficient distributable reserves can be another issue.
The main disadvantage to this route is that a liquidator must be appointed, and the formal liquidation process followed. This incurs significant associated costs, as well as overcoming the reservations of many businesses of the implications for their reputations of undertaking a liquidation (even if it is a solvent liquidation).
Capital Reduction Demerger
What is a capital reduction demerger?
Prior to the Companies Act 2006, a capital reduction by a company was complex and costly and required court consent. Now it can be done relatively easily with a declaration of solvency by the directors making a statement that the company will continue to be able to satisfy its creditors over the coming 12 months as liabilities fall due.
Capital reduction demergers can be used when a company wants to split out its trades before a sale (albeit HMRC might deny clearance if it was immediately prior to a sale). Moreover, a capital reduction demerger does not rely on the company having sufficient distributable profits to pay a dividend equal to the net book value of the trade or subsidiary to be demerged.
How does a capital reduction demerger work?
A capital reduction demerger allows the restructuring of a company via a return of the shareholders’ capital.
Many companies will have been incorporated with little nominal share capital and, in many instances, the first step in a capital reduction demerger will be to insert a holding company above the existing company or group. The holding company acquires the existing company by way of a share-for-share exchange with the result that it has issued share capital of the holding company is equal to the market value of the existing company. This should then provide scope, subject to a declaration of solvency by the directors, for the new holding company to undertake a reduction in its share capital.
The holding company’s share capital can then be reorganised into two or more different classes, with each class of share carrying the right to the assets and liabilities of a different trade or subsidiary company. The holding company’s capital is then reduced by transferring the assets as a dividend in specie to a further new company and the shares relating to those assets are then cancelled. As a result, the trades or subsidiaries held by the original company are demerged into two separate companies.
Each of the requisite steps can be undertaken relying on well-established reconstruction reliefs and HMRC clearance can be sought (and is generally, though not always, given) to confirm that they should apply and the demerger can be implemented without giving rise to tax charges. In particular, no income tax charge should arise for the shareholders of the original company or holding company, provided the value of what is being demerged is no more than the capital reduced. The distribution is a capital distribution and therefore the reconstruction reliefs should apply and there is, moreover, no disposal by the original shareholders. Relief from stamp duty may be available; however, charges may arise if the new companies are not owned by the same shareholders as the original company.
Pros and Cons of a capital reduction demerger?
Unlike a statutory demerger, a capital reduction demerger does not rely on the existence of sufficient distributable reserves and, moreover, can be employed to separate activities which include both trading and non-trading activities.
It is likely to be particularly attractive in cases where a trade and property investments are held in the same company and the shareholders of that company would like to reorganise them into separate entities without incurring the costs and potential reputational issues of appointing a liquidator.
Enterprise Tax Consultants can advise on demergers
While demergers can be achieved with tax neutrality, they must be implemented with great care.
We can review your specific circumstances and goals and consider which route is most appropriate to your situation. Throughout it is essential to ensure that HMRC clearances are sought and received to ensure that the various tax reliefs are available.
Enterprise Tax Consultants have extensive experience with corporate structures. To discuss how demergers and other approaches might be used please get in touch.
Contact us for a no-obligation initial consultation with one of our chartered tax advisers about the types of scheme available.