What is a reduction of capital demerger and how can you use it?

HMRC
Planning
Tax

What is a reduction of capital demerger?

A reduction of capital demerger is a corporate restructuring method that allows a company or a group of companies to separate out different business activities, including trades, investment businesses or property.

This separation is completed without the involvement of a liquidator, making it a more streamlined and cost-effective alternative to a Section 110 (s110) demerger. However, unlike a s110 demerger, with a capital reduction demerger the original company still exists, as it doesn’t undergo liquidation, and for some shareholders and directors this may be more preferable to a s110 demerger.

When is a capital reduction demerger used?

The most common scenario that our demerger experts see for a reduction of capital demerger arises when clients wish to demerge a property business from a trade. This approach provides a way to separate these distinct activities within a group, typically when the goal is to reduce risk (segregating the property from the trading risk) or create more focused entities (in terms of management and accounting).

What is the process of a reduction of capital demerger?

Like the name suggests, the key aspect of this type of demerger is that it involves a reduction in a company’s capital to facilitate the distribution of the demerged business. This is achieved through a scheme of reconstruction.

Typically, a new holding company is inserted into the group structure by means of a share-for-share exchange. This therefore allows the creation of necessary capital reserves for the demerger. Following this, the holding company reduces its share capital and in consideration distributes the demerged business to a new company held by the shareholders of the holding company.

As part of the implementation of the demerger, directors must sign a solvency statement, declaring the company solvent. All directors will be required to agree on this decision, as the statement is a critical part to the process.

Obtaining clearance from HMRC is strongly recommended to proceed with the demerger, and it can take HMRC up to 30 days to respond. Our Tax experts can assist with the clearance and will also write a report of the process to ensure shareholders and directors are fully aware of all the steps, and the possible consequences of these steps on each party. Depending on the complexity of the demerger and the legal team involved, the process can be completed relatively quickly, although you should typically expect it to take at least a few months.

After the implementation paperwork is completed, you will need to consider additional tasks such as transferring contracts, setting up new contracts, opening new bank accounts, and the handling of other operational matters. Stamp Duty relief claims are also likely to be needed, and these will be submitted post-completion.

If the demerger involves the transfer of properties, a conveyancing solicitor will be required to ensure the legal transfer of ownership.

Capital reduction demerger example video – non partition demerger

Transcript

Our first example is of a non-partition demerger in which the demerged subsidiary is separated from the group without change to the current shareholders.

Holding Company (H Co.) is owned by Shareholders Y. The Holding Company owns Subsidiaries A and B, whether the subsidiaries are a trade, investment business or simply hold property.

The first step in a reduction of capital demerger is the addition of another Holding Company. Here, Holding Company 1 (H Co. 1) has acquired H Co. It is still owned by Shareholders Y, and still owns Subsidiaries A and B.

The acquisition has occurred by a share-for-share exchange, meaning that Shareholders Y of the original H Co. have ‘swapped’ their shares for new shares in H Co.1. The reason this is done is to create reserves, as there need to be enough reserves to reduce the capital of the original H Co later in the process. Therefore, the value of the shares that are issued to Shareholders Y of H Co.1 are equal to the value of the original H Co.

Step two will see that the shares from H. Co 1 are redesignated into ‘ordinary A’ shares and ‘ordinary B’ shares (still both owned by Shareholders Y). The ‘ordinary A’ shares will have rights to Subsidiary A, and the ‘ordinary B’ shares will have rights to Subsidiary B. The A shares should be the value of Subsidiary A, and the B shares should be the value of Subsidiary B. For example, let’s say H Co. is valued at £10million, and that £4million of this figure originated from Subsidiary A, and the remaining £6million originated from Subsidiary B. When the share-for-share exchanged occurred, £10million of share capital (the exact value of H Co.) would be put into H Co.1. When these shares are redesignated to H Co.1 shareholders, £4million would be ‘ordinary A’ shares and £6million would be ‘ordinary B’ shares.

In step three, New Co. is incorporated. This New Co. is owned by the same shareholders – Shareholders Y. In this example, we have chosen to demerge Subsidiary B, and therefore the next step will see that Subsidiary B is distributed to New Co.

The final step sees that H Co.1 will reduce its share capital and cancel out the ‘ordinary B’ shares. In consideration, New Co. will now own Subsidiary B, and these shares (£6million worth of shares in this case), will be issued to Shareholders Y. H Co.1, which has issued ‘ordinary A’ shares, is still owned by the same shareholders, Shareholders Y, and subsequently owns the original holding company and Subsidiary A.

Capital reduction demerger example video – partition demerger

Transcript

In the case of a capital reduction partition demerger, this will result in a change of control as well as segregation of the demerged subsidiary from the group.

Holding Company (H Co.) is owned by Shareholders X and Y. Shareholders X hold 40% of the shares, and Shareholders Y hold 60% of the shares. The Holding Company owns Subsidiaries A and B, which could each hold a trade, investment business or property.

The first step in a reduction of capital demerger is the addition of another Holding Company. Here, Holding Company 1 (H Co. 1) has acquired H Co. Holding Co.1. is now owned by Shareholders X and Y, and H Co. still owns Subsidiaries A and B. The acquisition has occurred by way of a share-for-share exchange, meaning that Shareholders X and Y of the original H Co. have ‘swapped’ their shares for new shares in H Co.1. Shareholders X and Y have the same proportion of shares in H Co.1 as they originally had in H. Co.

The next step is for H Co.1 to re-designate its share capital into Ordinary A and ordinary B shares, where the Ordinary A shares essentially have rights to only Subsidiary A, and the ordinary B’ shares the rights to only Subsidiary B. Typically, the number of Ordinary A shares should be equal to value of Subsidiary A and the number of Ordinary B shares to the value of Subsidiary B (as it is assumed for this example that H Co is a passive holding company). Assuming the total value of H Co. is £10 million, and Subsidiary A is worth £4m and Subsidiary B £6m, the reclassified shares would be held so that Shareholders X own the Ordinary A shares and shareholders Y own the Ordinary B shares.

This is a very crucial step as you need to ensure that no value has been shifted.

In this partition demerger example, New Co. is incorporated which is owned by Shareholders Y.

In the final step, H Co.1 will reduce its share capital and cancel the ‘ordinary B’ shares. In consideration, H Co. 1 will distribute its shareholding in Subsidiary B to New Co., which in turn will issue new shares to Shareholders Y.

H Co.1 and its 100% subsidiary, Subsidiary A, are now owned wholly by Shareholders X, and NewCo and its 100% subsidiary, Subsidiary B, are now owned wholly by Shareholders Y.

Whilst it appears that Shareholders X, or Shareholders Y (in the case of a non-partition demerger), have been left with not only the original holding company, but also the new holding company, it is important to note that this structure can be cleared up once the demerger is complete to remove any unnecessary holding companies, as otherwise they will likely just be dormant holding companies.

Although the examples above highlight reduction of capital demergers in their simplest forms, the reality is that they often involve far more complex arrangements. These may include issues like the division of assets and liabilities, obtaining regulatory approvals, cross-border considerations, and the setting up of independent management teams for each new entity, and not forgetting the importance of ensuring no value is shifted – all of which introduce additional complexity.

Is a reduction of capital demerger the best option?

Choosing this option is completely dependent on the objectives of the shareholders, directors, the commercial rationale and the specific businesses being demerged. Whilst it can offer a more efficient process compared to a s110 demerger, due to its cost and speed, it does leave the original company intact. For some, this could be a benefit, and for others, a drawback. The original company will have a history which, unlike for the s110 demerger, remains in place. However, this company can still be struck off after the demerger should these shareholders and directors wish.

Directors and shareholders should also carefully consider whether a demerger is necessary at all. In some situations, declaring dividends may achieve the same objectives at a lower cost. In the case of property held, this decision often depends on the value of the property, the business activities involved and the ultimate goals of the demerger. Sometimes, the cost of the demerger would be more expensive than the tax you may have to pay.

What are the potential risks and considerations for a reduction of capital demerger?

All tax planning involves an element of risk. The reduction of capital demerger is a method adopted regularly and tax specialists work together to ensure any issues are considered during the process.

If not properly implemented, all of the following taxes will need to be considered. However, many of the risks can be mitigated by obtaining advanced clearance from HMRC.

Income Tax

The current additional rate on dividends is 39.35%, and there is a risk that HMRC will seek to impose an Income Tax charge on distributions received by the shareholders.

Corporation Tax and Capital Gains Tax (CGT)

When disposing of assets to a connected party, such as transactions between a company and its shareholders, then there is a deemed market value rule which may result in a charge of Corporation Tax on any gain arising, computed by reference to the market value. The main rate of Corporation Tax on the disposal of these assets is currently 25%, and for additional and higher rate individual taxpayers the CGT rate is 24%.

*In most cases it should be possible to fully mitigate Corporation Tax and CGT.

Stamp Duty Land Tax (SDLT) and Stamp Duty on shares

Claims for relief can be made after the transaction. For partition demergers, and in some other rare cases, Stamp Duty on shares and/or SDLT liability should be expected.

Inheritance Tax (IHT)

Consideration should be given to whether the company is included in the shareholder’s estate and do they qualify for Business Property Relief. The splitting of a company, or a trade, may result in the business becoming less efficient for IHT purposes without proper planning.

Other risks include:

Corporate Tax and SDLT degrouping charges, on assets previously transferred in a group.
Protection of losses
VAT

We will fully review the proposed transaction from a tax perspective and would always strongly recommend our clients get clearance from HMRC to mitigate risk.

Are there any cross-border considerations?

This article focuses on demergers within the UK and therefore adheres to the relevant UK tax and legal frameworks. Multinational companies operating across multiple jurisdictions should be aware that the tax and legal regulations may vary significantly in other regions. Multinational groups seeking to demerge part of their business will need to work with tax advisors and legal teams in each respective jurisdiction involved to ensure compliance and minimise any overseas liabilities.

Closing thoughts

The long-term success of a reduction of capital demerger depends on the original objectives of why the company wanted to demerge. For instance, if the demerger was done to separate a riskier aspect of a business, its effectiveness can be measured by evaluating the risk exposure post-demerger.

This is an effective and potentially tax-efficient solution for companies looking to separate distinct activities within a group. Whilst the process is generally streamlined and avoids the needs for a liquidator, it is not without its complexities.

Engaging with experienced legal and tax professionals is essential to ensure a smooth process and mitigate any issues that may arise. With careful planning and clear objectives, a reduction of capital demerger can be a strategic move that supports long-term business objectives, offering both flexibility and efficiency in the corporate restructuring landscape.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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