Richard Coombs, Tax partner at Bates Weston delves into demergers.
He’s a firm advocate of the benefits a demerger can bring, but believes the benefits are best explained by looking at the problems a demerger is trying to fix.
He begins with a question often posed by clients:
“Why does everyone tell me I need a demerger?”
Business owners considering restructuring their company are often asked to consider a demerger as an option. Googling the term bombards them with numerous technical articles about the different types of demerger, what risks to look out for and how the firm writing the article can help.
This is all well and good but, from experience, many business owners don’t realise why they have a problem in the first place, and so the suggestion of a complex (and therefore sometimes expensive) solution to a problem they didn’t realise they had can be confusing.
In this article I will try to explain how problems arise and why trying to resolve them using anything other than a demerger can often lead to significant tax charges. A couple of case studies will be the easiest way to demonstrate the issues.
Demerger Case Study 1 – valuable business premises not wanted by the buyer
This is a very common scenario. Let us assume that Brick Limited operates its business from a factory that was purchased many years ago for £100,000 and is now worth £500,000. A buyer has come along and wishes to buy the whole company but does not want the factory. It could be that they simply do not have the cash to buy the company with the factory and so would prefer to lease it back from the vendor, or they may have their own premises nearby and wish to consolidate both businesses into one. Either way, the deal won’t go ahead if the property is still in the company when it comes to buy it.
A typical client may be forgiven for thinking that the solution is easy. They will simply buy the property for what they paid for it from the company (£100,000) and leave the money outstanding so that it can be repaid from the proceeds of the share sale. Logically, this sounds sensible – there will be no gain on the disposal and any Stamp Duty Land Tax (SDLT) on the property will be based on a relatively low figure.
Unfortunately, tax and logic don’t always go hand in hand. The problem here is that the transaction between the company and the company’s owner is a transaction between connected parties and therefore the tax legislation imposes its own rules. Specifically, for corporation tax purposes, the property is deemed to have been sold at its current market value. So, even though £100,000 was paid for the property to extract it, for corporation tax purposes it is deemed to have been sold for £500,000. So that is a £400,000 gain and therefore £100,000 tax liability at the current corporation tax rate of 25%.
But that is not the end of it. The company owner has managed to buy something out of the company for £100,000 when it was worth £500,000. They have therefore received value of £400,000 from the company and this will be taxed as a dividend. At the highest rate of tax this would result in additional income tax on the owner of £157,400 (based on the additional rate for dividends of 39.35%).
In addition, even though the property has now been removed from the company, the debt of £100,000 owing to it will increase the value of the company, and therefore the price paid by the buyer, by this amount. This will result in either an additional £10,000 or £20,000 CGT depending on whether Business Asset Disposal Relief applied or not.
The one thing the client did get right was the SDLT. Assuming the property was not mortgaged then the SDLT would be based on the £100,000 price paid, so a small saving there. However, overall the client will have generated additional tax charges of at least £277,000, i.e. more than half of the value of the property.
So now the problem has been identified, the benefits of a demerger can be better understood. Specifically, with appropriate planning, it should be possible to demerge the property into a new company free of any corporation tax, capital gains or SDLT, thereby saving at least £277,000. The other major benefit is that HMRC clearance can be obtained on the proposed transaction before embarking on any the restructuring steps, meaning certainty of tax treatment.
Demerger Case Study 2 – removing a new business stream
This is a recent real case. A client already ran a successful medical related business through their limited company but had come up with an idea to use a web-based version of their business which could be scaled up significantly with some additional investment.
The new investor only wanted to invest in a new standalone company, in order to avoid any legacy issues that may arise in the existing business. I was assured by the client that the new business model was in its very early stages and therefore had no value and so the business could be sold to a new company for £1.
In principle, this again sounds logical. If the company really doesn’t have any value then it can be sold for £1 and there are no real tax issues to consider. The problem was that in the same breath that the client explained the business had no value, he told me that the investor was going to invest in a pre-money valuation of £1m. This of course immediately sets a benchmark for the actual value and HMRC would have very little difficulty in arguing that a disposal of £1m worth of goodwill in the existing company had occurred, meaning a corporation tax liability of £250,000.
Again, HMRC could also argue that £1m worth of value had been removed from the company by the shareholder and treat this as a dividend, meaning potentially another £393,500 of income tax.
So here we are looking at a potential tax cost of £643,500 on something that the client considered was really only worth £1.
Again, a demerger was the answer here. Structured correctly, various corporation tax and capital gains tax reliefs can be claimed which meant that whatever the value of the new business (£1 or £1m), there would be no corporation tax in the company or income tax on the shareholder. Essentially, it was an insurance policy against the value being “wrong”, as whatever value was correct, the various reliefs would ensure that no upfront tax charge would arise – instead the base costs of the business acquired by the Newco and the shares issued by the Newco to the shareholder would all be adjusted accordingly so that the gain only arose on a future sale of the business or shares.
Conclusion
These are only two examples of where clients can make very expensive mistakes and where a demerger would have resolved all of the issues. Hopefully it goes to show why demergers are indeed often the “silver bullet” required to extract otherwise problem assets from a corporate environment.
One word of warning though, demergers can be complex and getting them wrong can be even more expensive than the “no planning” versions above. It is therefore vital to ensure that you get proper tax and legal advice before undertaking one.
If you would like to discuss a particular situation that you think a demerger may resolve, please feel free to contact Richard Coombs or Craig Simpson
This guidance is generic in nature and does not constitute advice. You should take no action based upon it without consulting ourselves or your own professional advisor.
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