Demergers – Back to the Future?

HMRC is consulting on changes to the taxation of capital distributions that could significantly affect how corporate groups implement demergers. While aimed at preventing tax avoidance, the proposals may remove one of the most commonly used demerger structures.

Why do businesses demerge?

Businesses may demerge for a variety of commercial reasons, including separating higher-risk activities, attracting investment, resolving shareholder disputes within family businesses, or preparing part of a group for sale.

Current popular demerger method

The most popular method of a demerger involves a reduction of share capital to provide a tax neutral reorganisation and splitting of the group in two. Capital reduction demergers typically involve inserting a new holding company and using a reduction of share capital to separate the business into distinct groups on a tax-neutral basis.

The end result will be two holding companies that each own at least one trading company, and hopefully no company or shareholder will pay any tax.

The government and HMRC collect their tax, including any applicable capital gains, when someone sells one of the demerged companies. The capital reduction demerger effectively delays any tax liability and avoids a “dry” tax charge (creating a tax liability with no underlying cash generated from a transaction).

Consultation proposals

The consultation proposes restricting the creation of share premium on a new holding company. If implemented, this could effectively remove the capital reduction demerger route, despite HMRC stating that legitimate commercial restructurings are not the target of the changes.

What are the alternatives to a capital reduction demerger?

Reduction in share capital demergers only became popular when other changes to tax legislation reformed earlier restrictions on reducing share capital. Previously, companies had to carry out demergers either through statutory demergers (as allowed by tax legislation) or through a liquidation demerger (using section 110 of the Insolvency Act 1986, which gave rise to the term “section 110 demergers”).

Statutory demergers

Historically, statutory demergers have been less popular because of strict eligibility requirements, in particular, a statutory demerger cannot be used where a future sale is anticipated. The consultation proposes relaxing some restrictions, but would then introduce a five-year period following a statutory demerger during which a sale could trigger the clawback of tax reliefs.

Section 110 demergers

Section 110 demergers involve a solvent liquidation and distribution of subsidiaries to shareholders. Although additional liquidation costs arise, companies widely used them before capital reduction demergers became the preferred option, particularly when they anticipated a future sale.

What does this mean for businesses?

While the consultation remains at an early stage, the proposals could significantly change the way businesses approach demerger planning. In particular, restricting the creation of share premium on a new holding company could remove the capital reduction demerger route that has become one of the most commonly used structures.

Statutory demergers and Section 110 demergers would remain available as alternatives, although each comes with its own requirements and considerations. Businesses considering a demerger within the next two years may therefore wish to review their plans sooner rather than later, particularly if they want to preserve access to the current structures.

Please contact Debra Martin or Andrew Morris should you wish to discuss a reorganisation of your company or business.