Understanding demergers – The ins, outs, and tax implications

What is a demerger?

A demerger is a corporate restructuring process where a company (or group) is divided into two or more separate entities. The separated parts can then operate independently, be sold, or be liquidated. There are various commercial and even personal reasons why companies may want to demerge. The most common reasons are:

• Exit planning – demerging non-trade assets ahead of a future sale or ahead of bringing in a new shareholder.
• Succession planning – families may wish to separate different components of the business into different entities to facilitate succession planning.
• Disputes or disagreements – stakeholders can have irreconcilable differences, and a strategic separation provided by a demerger allows each area of the business to pursue independent paths.
• Ringfence liabilities – a demerger can be used as a tool to mitigate risk. There may be an aspect of the business (be it a trade or asset) which carries high risk and so threatens the other business. For example, a lender may be able to offer more preferential loan terms to a property business than a more high-risk trading business.
• Rapid growth – if a business is developing rapidly, it may not be practical or efficient for each growing aspect of the business to subsist within the same entity.
• Liquidation – there may be a part of the business which is failing and needs to be separated from the “healthy” portion of the business so it can be liquidated.

What types of demergers are there?

For tax purposes, any type of arrangement which results in the shareholders removing value from their shareholding is at risk of being treated as a distribution for income tax purposes.

To prevent an extraction from being taxed at income tax rates, the entire reconstruction is often structured as one of the following types of demerger:

• Capital reduction demerger
• Liquidation demerger (also known as a Section 110 demerger)
• Statutory demerger

The decision as to which demerger mechanism to use will vary and be dependent on the specific facts and requirements of each transaction.

Note that in all cases it is highly recommended HMRC clearance should be sought to obtain assurance that the transaction is being carried out for bona fide commercial reasons such that critical tax reliefs will be available.

Capital Reduction Demergers

For owner managed businesses, the capital reduction demerger is most popular as it provides flexibility where other methods do not.

The mechanics are such that the current shareholders receive new share capital for the full value of the current businesses combined. Then there is a reduction of the share capital equal to the value of the business to be demerged and subsequent cancellation of a corresponding amount of shares.

The cancelled share capital is then returned to the original shareholders by transferring the business to be demerged to a new company, which in turn issues shares to the original shareholders.

Under Part 26 of the Companies Act 2006, private companies can reduce their share capital without court approval.

Tax Implications

When structured and implemented correctly, a capital reduction demerger can be fully tax neutral if:

• The demerger has been effected for bona fide commercial reasons.
• The demerger is a “reconstruction” for Stamp Duty/Stamp Duty Land Tax and Capital Gains Tax purposes.
• The shareholdings and shareholders are mirrored before and after the reconstruction.
• There are no VAT considerations, or the transfers are a transfer as a going concern.
• De-grouping charges for Capital Gains Tax and Stamp Duty Land Tax are relieved.
• The share capital in the target group is sufficient to reduce the capital, such that there is no taxable income distribution in the hands of the original shareholders.

The tax implications are very complex, and professional advice is a necessity to avoid potential pitfalls.

Liquidation Demergers

Broadly, a liquidation demerger results in the company to be demerged being put into liquidation. This means appointing a licensed liquidator who will take control of the business.

Generally, a holding company is inserted on top of the existing group/company and, when the holding company is liquidated, the subsidiaries are distributed to the new companies set up by the shareholders. The holding company will then cease to exist.

It may be that the business to be demerged is not in a separate entity, in which case a new subsidiary can be set up and the business to be demerged can be hived down.

Tax Implications

There are a few different ways a liquidation demerger can occur, but typically the demerger can be tax neutral if:

• The demerger has been effected for bona fide commercial reasons.
• The demerger is a “reconstruction” for Stamp Duty/Stamp Duty Land Tax and Capital Gains Tax purposes.
• There are no VAT considerations, or the transfers are a transfer as a going concern.
• De-grouping charges for Capital Gains Tax and Stamp Duty Land Tax are relieved.
• The holding company is in liquidation prior to any distributions – so distributions are capital and can be relieved by Capital Gains Tax reliefs.

The tax implications are very complex, and professional advice is a necessity to avoid potential pitfalls.

Statutory Demergers

There are three different types of statutory demergers:

• Direct statutory demerger (type 1).
• Indirect statutory demerger – trades transferred (type 2).
• Indirect statutory demerger – shares transferred (type 3).

Direct statutory demergers involve a dividend in specie by the target company of the subsidiary to be demerged to its shareholders.

On the other hand, indirect statutory demergers involve a dividend by the target company of a subsidiary or business assets to another company which, in turn, issues shares to the original shareholders.

Direct statutory demerger

Indirect statutory demerger

Tax Implications

Generally speaking, for the distributions to qualify as “exempt distributions”:

• The companies must be UK resident.
• The distributing and demerged subsidiary company must be trading.
• The distribution must be for the purpose of benefiting the trading activities of the former group.
• For a direct demerger, the shares issued must be non-redeemable and represent the whole of the issued share capital of the transferee.
• For an indirect demerger, the distributing company must only retain a minority interest in that transferred.

The tax implications depend on whether the demerger is a direct or indirect demerger. For example, for indirect demergers, the distributing company can fall within the reconstruction provisions and find relief there, whereas, for direct demergers, the distributing company must rely on the substantial shareholding exemption to find relief.

Accordingly, a careful analysis of your position and which demerger route is best to take is critical. Professional advice is a necessity to avoid potential pitfalls and HMRC clearance should be sought.

Choice of demerger route

Demergers are usually triggered for commercial reasons however this alone is not enough to ensure tax efficiency or neutrality. The right steps in the right order are needed.

As such, careful consideration as to the commercial and tax implications should be given. When undertaking a demerger, it is rare that there is a tax not unturned and, as a consequence, tax planning is bespoke.

Liquidation demergers are typically a less popular non-statutory option than capital reduction demergers, due to the practical and perceived effects on reputation associated with a liquidation, as well as the cost and time necessary to appoint a liquidator and follow the liquidation process.

However, public companies require a court order to reduce share capital. In such (and indeed other) situations, a liquidation demerger may be more effective than a capital reduction demerger.

The statutory demerger route cannot apply to non-trading businesses or where arrangements are in place at the time of the demerger to sell the demerged or successor company. In addition, a tax charge can arise if certain events take place within five years after a statutory demerger. In practice, these rules can make statutory demergers unattractive.

Finally, company law should be considered – clear communication between all advisors and parties to the transaction is essential to ensure the process runs smoothly.

How can we help? 

If you are considering undertaking a demerger, it’s important that you obtain full, comprehensive advice. We would be happy to schedule an initial call with one of our experienced tax consultants to discuss your options. 

If you have any queries on any of the information in this article, or need help with regards to demergers, please contact a member of the team to see how we can help.

Disclaimer: This article is for informational purposes only. Independent tax advice is recommended before enacting a demerger.