What is a demerger by way of share capital reduction?

A demerger, in general, is where parts of a business are split from each other. There may be a number of reasons to implement a demerger including to reduce risk by separating out different business activities or when preparing for a sale to a third party where only part of the business is going to be sold.

For example, a company may use a demerger to separate the main trading activities of the company from its property investment activities, thereby allowing these two distinct elements of the business to be run independently of each other.

There are numerous different types of demerger and the best option for your company will depend on a number of different factors including your company’s distributable reserves, the value of the business and the applicability of the relevant tax reliefs.

It is essential that you seek expert tax advice from the outset to ensure you are provided with the full range of potential options and are given guidance as to the most tax advantageous option for both the shareholders and the company.

As part of this advice, your tax advisers will submit a Clearance Application to HMRC for the whole transaction which outlines the proposed structure and the tax reliefs you intend to rely on.

Specialist legal advice will also need to be obtained in order to implement the various steps.

How is a demerger different to a demerger by way of share capital reduction?

A demerger by share capital reduction may be an attractive option for a company where it does not have sufficient reserves required for other demerger options.

We have set out below an illustrative example of this type of demerger and the main steps that are involved.  It is important to note that there may be a number of additional steps depending on the specific facts and a detailed step plan will be prepared by your tax advisers and lawyers..

Example

We will use the example of Company X, which has two subsidiaries; Subsidiary A and Subsidiary B. Company X is owned 50:50 by two shareholders; Shareholder A and Shareholder B. The aim of the demerger is for Shareholder B to own Subsidiary B and Shareholder A to own the remainder of Company X including Subsidiary A.

Steps:

1. A new company is incorporated by Shareholder A and Shareholder B (Newco).

2. Company X is acquired by Newco by way of a share-for-share exchange.

Both Shareholder A and Shareholder B will exchange their shares in Company X for new shares in Newco with an equivalent value.  This is known as a share-for-share exchange and after this step; Newco will hold all of the shares in Company X with Shareholder A and Shareholder B holding the same proportion of shares in Newco as they previously held in Company X.

There is potential tax relief for stamp duty at this step but it will depend on the individual circumstances and you will need to obtain specialist tax advice as to whether this relief will be granted.

3. Subsidiary B is transferred to Newco.

This transfer can be carried out in a number of ways including by way of a dividend in specie (a dividend where assets are transferred rather than cash) or a sale by Company X of its shares in Subsidiary B.

The specific transfer mechanism will again be dependent on the individual facts including whether the company has sufficient distributable reserves and which mechanism would be the most tax advantageous.

After this step, Newco will hold the shares in Subsidiary B along with the shares in Company X.

4. New share classes.  

Newco will then create two different classes of share; A shares and B shares. The A shares will only be entitled to the profits and assets of Company X (and indirectly Subsidiary A) and the B shares will only be entitled to the profit and assets in relation to Subsidiary B.

The shares held by Shareholder A in Newco will be re-designated as A shares and the shares held by Shareholder B in Newco will be re-designated as B shares.

5. A new company (Holdco) is incorporated by Shareholder B. 

6. Transfer of Subsidiary B and Share Capital Reduction.

The B shares in Newco will be cancelled (which is known as a share capital reduction) and the shares in Subsidiary B will be transferred from Newco to Holdco.

In exchange for this cancellation and transfer, Shareholder B will be issued an equivalent number of shares in Holdco.

As part of the share capital reduction, the directors of Newco will be required to make a solvency statement to confirm that Newco is solvent and that it will remain solvent for the next year.

It is essential that legal and accounting advice is sought before the directors make this solvency statement.

After the demerger, only Shareholder A will hold the shares in Newco which in turn holds the shares in Company X (which in turns holds the shares in Subsidiary A).  Shareholder B will hold the shares in Holdco which will hold all of the shares in Subsidiary B.

A demerger like this is not an option for all companies and each demerger is different so it is vital to always seek further tax and legal advice from the outset.

We have advised on a number of demergers by way of a share capital reduction so if you would like more information, please contact Joe Hartland.