Demergers: structures and tax reliefs

United Kingdom

Whatever the reason a company or group wishes to demerge, it must understand the tax reliefs that go with the alternative structures that are available – as well as the terminology.

When a company or group demerges it divides an activity or business it has been carrying on into one or more companies (or groups of companies) that are in separate – but not necessarily different – ownership. There can be many reasons for doing this. Separating businesses or activities that are not compatible into separate vehicles, for example, could ensure that the value of each underlying activity or business is fully reflected in the share price. Alternatively, there may be a commercial need to divide a jointly-owned group or to break up a group or company in order to facilitate the sale of part of a business or activity.

Leaving aside court schemes, there are three basic structures for demergers, each with its attendant tax reliefs, and it may even be possible to combine the structures or adopt a hybrid form. It is possible to apply for advance clearance from HM Revenue & Customs that the tax reliefs apply. Consent is generally obtained within 30 days.

Direct demerger – structure

Also known as a straight or direct statutory demerger (as it relies on provisions in the Taxes Act), a direct demerger is the simplest of the structures. It involves the payment of a dividend in specie by a company (the distributing company) to its shareholders of the shares in a subsidiary (the demerged company). In order to be able to declare a dividend the distributing company must have sufficient distributable reserves, and its articles of association are likely to require shareholder approval of the dividend. The consent of creditors may also be needed.

Direct demerger – tax reliefs

For shareholders receiving the dividend:

  • if the dividend fulfils the conditions set out in section 213 of the Taxes Act it will be classed as an exempt distribution and on its receipt individual shareholders will not suffer any income tax or be regarded as disposing of their shares in the distributing company for the purposes of capital gains tax. Instead, shares in the distributing company and shares in the demerged company are treated for tax purposes as a single holding acquired by shareholders when they acquired their shares in the distributing company.
  • corporate shareholders receiving the dividend will not suffer any corporation tax on income and may (where conditions are met) opt for the same “no disposal” treatment as individual shareholders. Alternatively, they may be able to apply the substantial shareholdings exemption to any gain. The substantial shareholdings exemption may apply to gains made on the sale of shares in a trading company by a company which is itself a trading company, or the holding company of a trading group, where the shares disposed of entitle the shareholder to 10% or more of the rights in the company whose shares are sold.
  • it is usually possible for the dividend to be structured so as to avoid stamp duty arising on the transfer of the shares in the demerged company.

For the distributing company:

  • provided the dividend is an exempt distribution it will not trigger shadow advance corporation tax if the distributing company has surplus advance corporation tax.
  • on the payment of the dividend the distributing company will make a disposal of the shares in the demerged company at market value for tax purposes and a gain subject to corporation tax may arise if the base cost of the company in the shares is lower, unless the substantial shareholdings exemption can apply.

For the demerged company, the dividend will result in its leaving the distributing company’s group. Where this happens by reason only of an exempt distribution, relief is given for any degrouping charges that may have arisen in the demerged company.

Indirect demerger – structure

This is also known as a three-cornered or indirect statutory demerger. A dividend in specie is declared by the distributing company in favour of its shareholders, but the dividend is satisfied not by a direct distribution by the distributing company to the shareholders but instead by its transferring shares in the demerged company or the assets of the demerged trade to a newly formed company. The new company then issues shares to the shareholders of the distributing company. As with a direct demerger, the distributing company must have sufficient distributable reserves and shareholder approval and creditor consents may be required. Unlike a direct demerger, however, an indirect demerger can be used to demerge assets (albeit to the new company rather than directly to shareholders) as well as shares and, in addition to other tax reliefs, there is relief for any corporation tax on chargeable gains that arises in the distributing company.

Indirect demerger – tax reliefs

For shareholders receiving shares in the new company:

  • as with the direct demerger, if the dividend fulfils the conditions set out in section 213 of the Taxes Act it will be classed as an exempt distribution and on its receipt individual shareholders will not suffer any income tax.
  • corporate shareholders will not generally pay corporation tax on dividends received from other UK resident companies.
  • if the demerger meets the statutory definition of a scheme of reconstruction in schedule 5AA of the Taxation of Chargeable Gains Act 1992 the shareholders will not be regarded as making a disposal of shares in the distributing company for the purposes of tax on chargeable gains. Instead, shares in the distributing company and shares in the demerged company are treated for tax purposes as a single holding acquired by shareholders when they acquired their shares in the distributing company.

For the distributing company:

  • provided the dividend is an exempt distribution it will not trigger shadow advance corporation tax if the distributing company has surplus advance corporation tax.
  • if the demerger meets the statutory definition of a scheme of reconstruction the distribution of shares or assets by the distributing company will not result in the distributing company realising a gain for tax purposes. Instead, the distributing company is treated for tax purposes as if the shares or assets in the demerged company or trade were transferred for a consideration that does not give rise to a gain or a loss, and the new company inherits the distributing company’s base cost in those shares or assets. In the case of shares, the distributing company may, if conditions are met, be able to apply the substantial shareholdings exemption.

For the demerged company where shares have been distributed, the dividend will result in its leaving the distributing company’s group. Where this happens by reason only of an exempt distribution, relief is given for any degrouping charges that may have arisen in the demerged company.

For the new company:

  • the distribution of shares in the demerged company or assets of the demerged trade may trigger a liability for stamp duty, stamp duty land tax or stamp duty reserve tax. Relief from stamp taxes is available if certain conditions are met. Restrictions on the application of these reliefs to non-UK incorporated companies were removed in the 2006 Budget.
  • in the case of a transfer of assets of a demerged trade, the treatment of any losses available for carry forward and capital allowances associated with the trade will need to be considered.

Liquidation scheme – structure

This is also known as a section 110 scheme (referring to provisions in the Insolvency Act), and involves the liquidation of the distributing company. In the course of the liquidation the assets (including shares in subsidiaries) of the distributing company are transferred to two or more newly formed liquidation companies. In consideration of the transfer of the distributing company’s assets, the new companies issue shares to the shareholders of the distributing company in satisfaction of their rights on the winding up of the distributing company.

The involvement of a liquidator necessarily extends the time taken to effect the demerger and probably adds to the cost, but this method is useful where the distributing company has negative or insufficient distributable reserves, and is available where the distributing company cannot declare an exempt distribution in a statutory demerger because the relevant conditions are not met. It can also be used to divide the activities of a company or group prior to a third party sale.

It may not be feasible to liquidate an active company, and it is therefore common to insert a newly formed parent company into the group structure above the distributing company. The new parent company is then liquidated. This means additional steps to the structure and may require additional shareholder approvals and creditor consents. For example, it may be necessary to proceed by way of a takeover offer, so as to be able to squeeze out minorities under the Companies Act compulsory acquisition provisions (or under new regulations where the Takeover Directive applies). This will not work unless the offer is accepted in respect of at least 90% of the shares that are the subject of the offer.

Liquidation scheme – tax reliefs

The insertion of the new parent company above the distributing company in the group structure can be achieved in a number of ways. Typically, it involves the shareholders in the distributing company exchanging their shares in the distributing company for shares in the new parent company.

  • For tax purposes, it is likely that the shareholders will avoid a charge to tax on gains arising as a result of the disposal of shares in the distributing company by obtaining rollover relief. The relief treats the exchange as involving no disposal of the shares in the distributing company and treats those shares and the shares in the new parent as the same asset for tax purposes and as if the shares in the new parent company were acquired when the shares in the distributing company were acquired.
  • The next step is to ensure that the new parent company receives a transfer of all of the assets of the distributing company that are to be demerged. This transfer may be treated for tax purposes as taking place at a consideration that gives rise to neither a gain nor a loss for the distributing company, and the new parent company inherits the base cost of the distributing company in the assets. Group relief may be available to prevent stamp duty, stamp duty land tax or stamp duty reserve tax arising on the transfer.

On liquidation of the new parent company, the shareholders will receive a dividend in satisfaction of their rights on the winding up that will be satisfied by the issue of shares in the newly formed liquidation companies.

  • Dividends received in respect of share capital on a winding up are expressly excluded from the scope of income tax and, if the liquidation falls within the definition of a scheme of reconstruction, the shareholders will not be regarded as making a disposal of their shares in the new parent company. Instead, the shareholders’ shares in the new parent company and the shares that they receive in the liquidation companies will be treated for tax purposes as the same asset and as if the shares in the liquidation companies were acquired when the shares in the new parent company were acquired.
  • The payment of a dividend by the new parent company in its winding up does not result in its being regarded as making a disposal of the assets distributed such that a gain subject to tax arises. Instead, the assets are regarded as having been transferred by the new parent company for a consideration that results in neither a gain nor a loss, and the liquidation companies inherit the new parent company’s base cost in the assets.
  • There is no specific relief from degrouping charges that may arise in any of the companies involved in a liquidation scheme. Care therefore needs to be taken to anticipate the triggering of any degrouping charges so that, by planning, the charges can be removed, limited or sheltered.
  • The transfer of shares or land in a liquidation may attract stamp duty or stamp duty land tax. Specific reliefs are available if conditions are met. On a transfer of assets the availability of any losses going forward, and the treatment of capital allowances, must also be considered.

Court scheme

A combination of factors or circumstances may make these structures unattractive – for example, technical difficulties with reserves, non-accepting shareholders preventing the squeeze-out following a takeover offer in a liquidation scheme, or stamp duty costs.

A court-approved scheme of arrangement in accordance section 425 of the Companies Act may be the solution. Although it can be more complicated (with ramifications in terms of  timing and cost), a court scheme will in general utilise some of the reliefs described above and takes advantage of the court’s power to get round problems that may otherwise be insurmountable. Just the fact, for example, that the squeeze-out of minorities can be achieved with only 75% shareholder approval may make all the difference.

This article first appeared in our clearly corporate bulletin July 2006.  To view this publication, please click here to open a new window.