Craig SImpson, Tax Partner at Bates Weston reflects on demergers and their tax implications in the article below, written for publication in Taxation magazine.
Key points
- Demergers are fun – each case with its own set of facts and problems to be solved.
- The basic proposition of a demerger is to split the activities of the company or group with the minimal of tax cost. The one sticking cost can be stamp duty or stamp duty land tax. Corporation tax, capital gains tax and income tax should be covered by the relieving provisions.
- CA 2006 brought the ‘capital reduction demerger’ to join its more popular friend the s 110 demerger.
- The statutory demerger is appropriate for separating trades and the capital reduction demerger for separating trades and non-trading businesses.
- Demergers usually take between two and six months to complete.
Demergers are great fun. Honestly, they are. Every case has its own facts and circumstances and problems to be solved. People just don’t appreciate the fun we have in the tax profession. This article is a reflection on my experience with some technical meanderings and practical observations of demerger transactions which I hope are useful to an interested audience.
A brief history of the art
To begin, we are focusing on the splitting of businesses or trades in a single company or group of companies.
Back in the day, liquidation demergers were all the rage, often referred to as a ‘section 110 demerger’. Excitement filled the office floor when a demerger project landed, providing an opportunity to get involved in some complex advisory work. We don’t get out much. Then the Companies Act 2006 presented a game changer in the demerger world. A limited company could reduce its capital without having to seek court approval. A liquidation was no longer required and there was another way to approach the demerger. And so, a new child was born, the capital reduction demerger. While the two heavyweight section 110 and capital reduction demergers did most of the lifting, the ‘statutory’ demerger was always in the background waiting patiently to be used if the right circumstances allowed.
So demergers come with a health warning. Proceed with caution. Given the values involved, a false move could trigger a big tax liability.
What type of demerger is appropriate?
The general rule of thumb is that a statutory demerger is appropriate for separating trades and the capital reduction demerger for separating trades and non-trading businesses. A demerger is used because of the relieving provisions that can be deployed to prevent a tax charge on the shareholders and the companies involved in the transactions.
The main reason we rarely see a statutory demerger is that the legislation does not allow for the reliefs to apply when there is a planned sale of one of the demerged trades. If that is the case, then diver ng to a capital reduction demerger (or liquidation) can still achieve the desired result. However, HMRC may take issue if the part of the business being sold is not a majority of the value of the pre-demerger group (more on this later).
With a capital reduction demerger, a new holding company will almost always be required. This is because most privately owned companies have a very modest level of share capital. It is therefore necessary for a holding company to be inserted above the group or singleton company with a share capital at least equal to the value of the part of the group being demerged. The importance here is the need to ensure there is not an income distribution to the shareholders on the reduction of capital step.
A demerger can include splitting activities of a company into new companies with mirrored shareholders, or a par on demerger where the shareholders are parting company and different groups of shareholders demerge into different companies to separate their interests.
This article focuses on capital reduction demergers.
A scheme of reconstruction
Before doing anything, it is vital to consider if there is a scheme of reconstruction within the definition of TCGA 1992, Sch 5AA. Without meeting this requirement, the demerger is dead in the water.
There are three conditions in the legislation and the first I consider is whether there are two or more businesses to separate. The businesses must continue after the demerger.
Some practical examples include:
a) a trade or trades;
b) a controlling interest in a trading or investment subsidiary can be treated as the business of the holding company;
c) a portfolio of stocks and shares;
d) a property letting portfolio;
e) a property held in the group and let to a trading company in the group. Note that if a property is just held in and used by the trading company or there is no rent charged in the group, this is unlikely to be a business. In this case commencing a rental business would be appropriate before demerging a property from a trade.
A business includes a trade and an investment business. An investment business (which involves the managing of investments too) is generally something more than just having cash on deposit. The American Leaf Blending Co [1982] BTC 8127 case is helpful as the ruling made the distinction that the bar for a business operated by a company is much lower than that of an individual. For example, HMRC would not accept a small number of properties let to third parties by an individual as a business for the purposes of incorporation relief (TCGA 1992, s 162). This should be contrasted with a company undertaking the same activity which would almost certainly be a business.
Broadly, the other two conditions for there to be a scheme of reconstruction are:
a) there needs to be an issue of ordinary shares by the transferee company to the shareholders of the transferor company on the demerger (not preference shares);
and
b) the entitlement to ordinary shares in the transferee is the same for all shareholders of the same class in the transferor.
These two requirements can be dealt with as part of the demerger steps plan design stage.
I have excluded commenting on the alternative to the business continuity requirement which is a compromise arrangement with members of a company. This is not something that is regularly seen in the context of privately owned companies.
Selling a minority part of the business
Why might HMRC take the stance to deny clearance for the sale of a minority part of the business? HMRC’s view may be that the smaller trade can be sold and the proceeds extracted by way of dividend. Clearly that is not an attractive proposition from a tax perspective. A demerger and a capital disposal would generally be better. There may be good commercial reasons packaging the trade in a new company to sell and HMRC may be accepting of this.
If there is only a standalone company containing the two trades then hiving down to a subsidiary prior to sale while on the face of it appears simple, there is no substantial shareholding exemption (SSE) for the vendor company, because a group has not existed for 12 months. This would mean taxable de-grouping gains on chargeable assets and intangibles transferred to the subsidiary would be triggered, meaning the tax position is diverted back to the position if the trade and assets had been sold.
Somewhat strangely, where a group has existed for more than 12 months, then it may be possible to hive down and claim SSE on the basis of the assets being used in the group for the previous 12 months (assuming that is, in fact, the case). So, a dormant subsidiary under a standalone trading company would be helpful in improving the tax position overall. For standalone limited companies with two trades or a trade and investment business it would make good sense to incorporate a dormant subsidiary. Remember that the group must be a trading group taking into consideration the 20% non-trading activities before SSE can apply.
It is worth noting that there is no longer a requirement to liquidate the disposing company for SSE to apply. So, if the vendor shareholder does not need the money personally then a sale of an SSE qualifying subsidiary would then allow for the holding company to carry on as an investment company going forward. The full cost benefit analysis is beyond the scope of this article.
What relieving provisions are we relying on?
The basic proposition of a demerger is to split the activities of the company or group with the minimal of tax cost. The one sticking cost can be stamp duty or stamp duty land tax (SDLT). This very much depends on the facts of the case but corpora on tax, capital gains tax and income tax should be covered by the relieving provisions on a properly designed and implemented demerger transaction.
In the absence of the relieving provisions there would be a tax charge:
a) at company level for the gain arising on the value of the assets leaving the company or group;
b) at shareholder level on:
a) any share for share exchanges to insert a company above the existing company or group;
b) on the capital reduction to spin out the demerged activities;
c) and the issue of shares by the receiving company.
In addition, HMRC has both personal and corporate transactions in securities legislation in their armoury to change the tax treatment of transactions from capital to income if they can show a tax avoidance motive.
Here are the legislative references and what they are relieving in basic terms for personal and corporate capital gains:
a) TCGA 1992, s 135 – the non-disposal fic on for a shareholder in a qualifying share for share exchange;
b) TCGA 1992, s 136 – the non-disposal fic on for a shareholder of the demerger step where there is a scheme reconstruction;
c) TCGA 1992, s 139 – the nil gain, nil loss treatment of the company disposal of the trade or business (or a controlling interest in a company undertaking a trade or business).
The transactions in securities legislation is contained in ITA 2007, Part 13 Chapter 1 for individuals and CTA 2010, Part 15 for companies.
There will also be other relieving provisions to consider on any pre demerger steps, such as intragroup transfers (TCGA 1992, s 171) and de-grouping charges (TCGA 1992, s 179). For any dividends in specie the relevant legislation on distributions is contained within CTA 2009, Part 9A and CTA 2010, Part 23.
Steps plan
This is the most valuable stage in se ng out the steps to achieve the demerger and analysing the tax implications.
Providing the steps plan to the lawyers will save me for them in devising the document list required to implement the transactions.
It is important to involve the lawyers in a practical discussion on what might be required from a legal perspective for the assets of the company. Common examples are:
a) change of control clauses in customer or supplier agreements; b) banking security arrangements and bank consent – opening bank accounts where required can be a headache;
c) assignment of leases or other finance agreements; and
d) regulatory matters.
The company law will be an important factor here. If the company has reserves, then moving assets at their book value by a dividend in specie is often the best op on. The transaction is only permitted if the distributing company has distributable reserves of at least the book value of the asset (ie the amount in the accounting records not the market value) (Companies Act 2006, s 845(2)(b)).
Valuation will also be an important factor to consider when inserting a new holding company above the existing company or group. Under company law it is important not to issue shares at a discount otherwise CA 2006, s 580 can apply. For example, say a new holding company issues 10m x £1 shares in exchange for 100% of the shares in Company A. Provided Company A is worth at least £10m there is no issue. But, if Company A were
only worth £8m then an allotment of shares has not been fully paid up (ie, issuing shares at a discount). The impact of this is that £2m could be demanded from the shareholders to meet the shortfall. This issue is likely to arise if the group got into financial difficulty and there was a liquidation. Clearly this is something to be avoided.
Don’t forget VAT
While all the attention has been on the direct tax analysis, VAT should not be le out of the party. An analysis of the VAT provisions of the pre-demerger movement of assets around the group and interaction with the requirement to register new entites for VAT and whether there is a need to opt to tax property interests involved in the transaction. It is easy to drop the ball on VAT.
HMRC clearance application
Once the steps have been designed and analysed then a clearance application should be prepared and submitted to HMRC.
The clearance application provisions applied for should be tailored for each demerger. In a vast majority of cases this will include:
a) TCGA 1992, s 138 that the provisions of s 137 will not prevent the application of TCGA 1992, s 135 and TCGA 1992, s 136. This covers the share for share exchange on inserting a new holding company (TCGA1992, s 135) and the demerger step (TCGA 1992, s 136).
b) TCGA 1992, s 139(5) that the provisions of s 139 will not be prevented from applying. This covers the corpora on tax relief on the transfer of the business. The Intangibles regime equivalent is contained in CTA 2009, s 831.
c) ITA 2007, s 701 that HMRC will not counteract the capital treatment of the transactions for the individuals; and
d) CTA 2010, s 748 that HMRC will not counteract the capital treatment of the transactions for the companies involved.
The clearance application should include:
a) an initial summary of the clearances being requested;
b) details of the companies, their activities and tax references;
c) the current group structure;
d) the shareholders of the parent company and their tax references;
e) details of the share classes, percentage ownership and the capital income and voting rights a aching to the share classes;
f) details of the proposed transactions and commercial rationale;
g) the detailed steps;
h) the post transaction structure; and
i) a closing paragraph confirming the clearances being requested.
The letter can then be submitted by email (reconstructions@hmrc.gov.uk ) and should be accompanied by the latest full set of financial statements and a statement in the body of the submission email that the client accepts the risks of communicating by email and confirming the email addresses to be used.
Fees
Demergers are complex and risky, the fees should reflect this. The type of objections you might hear from potential clients are ‘you have done this all before so it’s easy’, ‘HMRC has granted clearance so it’s straightforward now’. We know that is not correct and so our approach is always to carefully scope fees with interim billing signposts and being aware of scope creep and communicating well if we need to ask for more. This seems to work for us as we are a relatively small consulting firm.
Getting the right lawyers
One of the common misconceptions of clients is that once the clearance is granted implementation is the easy part. The clearance response from HMRC will specifically say that they are not confirming that the relieving provisions in the legislation apply.
HMRC is merely saying that it won’t apply an -avoidance to remove the effect of the tax relieving provisions of the transactions (typically TCGA 1992, s 135, s 136 and s 139) and that they won’t seek to counteract the capital treatment of the transactions and convert them to income for tax purposes (ITA 2007, s 698 and CTA 2010, s 746). That means that the legal implementation is of vital importance. So, a strong corporate lawyer with experience of implementing demergers will be a must.
Map out the accounting entries
For those who love a good spreadsheet, now is your me in the sun; mapping out the entries in the accounts is a necessity to ensure that the proposed steps plan actually works from an accounting perspective. In particular, a focus on the required level of profit and loss reserves for moving assets around the group by dividend in specie. This spreadsheet will also be very valuable to audit and accounts team in preparation of the financial statements.
Stamp taxes
Both during, and after, the demerger there will be a legal requirement to stamp stock transfer forms. Technically speaking, it is not possible to record the share transfers in the register of members unless the stock transfer forms are stamped if there is consideration involved in the transfer. There are typically two reliefs that are relevant to a demerger:
1) FA 1986, s 77 – This relief can apply to a share for share exchange where mirrored shareholdings exist before and after the exchange. Here the legislation requires the same classes and proportion of shares as owned by the transferors to be issued to transferees (ie a mirroring requirement, although the exact number of shares can be significantly higher as required to capitalise the holding company for the later demerger step).
A close look at s 77A an -avoidance is required. This sec on denies the s 77 relief where there is to be a change of control of the new holding company. Par on relief may apply but if it doesn’t then there is 0.5% stamp duty cost on the value of the shares issued on the exchange transaction.
2) FA 1986, s 75 – This relief applies on the demerger step whereby the recipient company issues shares to the transferor shareholders as consideration for receiving the demerged assets. Again, there is a mirroring requirement in the legislation but only with regard to the proportion of shares issued. The classes of shares issued can be different, albeit must be non-redeemable.
Where there is a partition demerger, ie, a splitting of activities between the shareholders in a way that the demerged entities are owned in a different proportion then a 0.5% stamp duty cost will arise. The full detail of all the qualifying conditions of the above reliefs is outside the scope of the article.
Where possible, assets should be moved around the group as dividends in specie prior to a demerger. A dividend in specie is not consideration for the purposes of stamp duty or SDLT. As a result, there should be no degrouping charges on the demerger step if there was no stamp duty or SDLT group relief in the first place. Watch for the pitfall in the legal drafting stating a dividend payment satisfied by the transfer of the asset. This is different to a dividend in specie of the asset itself. Also, the assumption of debt (say on a property transfer) would be a transaction that attracts SDLT and group relief would need to apply. There may either be arrangements to leave the group or an actual degrouping charge to consider in this scenario.
Timescales
Broadly a demerger can take anywhere between two and six months to complete. The faster end of the spectrum tends to involve the transfer of shares in a group company already containing the assets being separated. This reduces the amount of transactional activity before the actual demerger step. The longer transactions tend to involve moving trades into new entities. The quality of the HMRC clearance application will play a major part in shortening the process. HMRC is generally very efficient in their replies (thank you) and the record reply me recently has been 72 hours. That said, up to 30 days is the official promise and the more rounds of correspondence equals a slower process, so be very thorough in the information provided and detail the commercial rationale.
Conclusion
I will end as I began: ‘demergers are fun’. A problem-solving work out and technically challenging. They represent the opportunity to split a business without major tax cost. They are not controversial and represent normal tax planning. I hope I have convinced you to take on the challenge.
As always, you are reminded that this article is generic in nature and you should take no action based upon it without consulting your professional advisor.
