All you need to know about demergers and the tax implications

In this article we discuss all things related to demergers and the tax implications that need to be considered. 

Where mergers represent the marriage of two companies or a group of companies, a demerger does exactly the opposite: a divorce of the same. A demerger involves the separation of a business, company, asset or income generating activity from its company of origin. While the word ‘demerger’ might be laden with negative connotations, it shouldn’t be.

A demerger may bring with it an assumption that a business relationship or arrangement is coming to an end, a conclusion due to fallout or insoluble difficulty. It is true that a demerger can occur in such circumstances. However, demergers are also a valuable tool in reorganising and restructuring a business where all is well.

As certain businesses experience growth, the need to restructure, streamline or even carve up the business may become more apparent. This could be due to a company anticipating a sale in the future, either of the whole business or an element of it or, because a business may need to separate its relevant profit centres to diversify the risk each poses to the value of the company as a whole.

The most common forms of demerger typically fall into one of two categories; “non-partition” and “split” demergers. A non-partition demerger may be seen in circumstances where an element of business is being separated from its company of origin, and the shareholders intend to retain their current shareholding in that business (and the part demerged) following the reorganisation.

Split demergers may occur when a company has been run by two (or more) shareholders with a common interest, but who now wish to divide the business between them and go their separate ways. This might be as a result of some form of disagreement or conflict or for other more benign reasons.

For tax purposes, a demerger will often rely on a number of tax reliefs which are aimed at removing or easing the potential tax burden on company reconstructions and reorganisations. The key definitions for Capital Gains Tax (“CGT”) purposes are in section 126 and Schedule 5AA of the Taxation of Chargeable Gains Act (TCGA) 1992.

Case Study

Here we will look at a split demerger:

In the situation described above, the shareholders (A and B) wish to split their property business evenly and operate them separately and independently – a split demerger involving a capital reduction is suitable for this scenario.

There are a number of ways in which the demerger might legally be achieved. The directors will want to ensure that the chosen approach will allow the demerger to proceed in a way that involves little or no tax cost. What is not always appreciated is that the tax consequences of a demerger carried out in the wrong way can be dire.

To give an idea of the extent of the potential tax cost, we can imagine the demerger taking place without regard to any taxes. The directors of Propco might take the simple step of transferring selected properties from Propco to a new company (‘New Co’) owned by B while Prop Co (together with the property it continues to hold) is retained by A. B’s shares in Prop Co might be cancelled or purchased by A for a nominal amount.

The tax consequences are far from obvious. After all, there is no real profit or gain being generated and no cash changes hands. Nevertheless, the tax consequences of that simple step will be as follows;

1. Prop Co will have made a disposal of the property it transfers to New Co. It will be taxed on any gain in the property (calculated by reference to market value);
2. New Co will be treated as acquiring the property (for consideration equal to market value) for the purposes of Stamp Duty Land Tax (‘SDLT’);
3. There may a VAT supply by Prop Co (if the property is opted to tax);
4. The will be a disposal by B on the cancellation or sale of his shares. He will CGT at 20% on any gain in the shares;
5. Perhaps least obvious, there will be a distribution by Prop Co to B. That will give a tax charge of up to 39.6% of the value transferred. The fact that the properties are transferred to a company does not alter that analysis.

It is theoretically possible (albeit unlikely) that the total tax costs could exceed the value of the assets involved in the transaction. That is true even though there is no real profit or gain and the average person might be hard pushed to identify anything that would justify a tax charge.

In the right circumstances the risk of almost any tax cost can be eliminated with the right legal approach. An example of a tax-efficient demerger will involve the following elements;

• The creation of a new holding company (‘Hold Co’) which will acquire the shares in Prop Co.
• Incorporation of a new company (‘New Co’) which will ultimately own B’s intended property interests).
• The creation (possibly but not essentially) of a new subsidiary (‘New Sub’) owned by Hold Co. As part of the process, B’s intended property interests may be transferred into New Sub, with New Sub then being demerged into New Co. The use of New Sub is not essential but may provide some advantages.

The shares owned by A and B will be sold to Hold Co in return for the issue of new shares by Hold Co. There is no CGT disposal by virtue of the relief afforded by section 135 TCGA.

B’s intended property interest will then be transferred to Hold Co or to New Sub. The distribution of property up to Hold Co (or to New Sub for nominal consideration) will not attract any tax charge, as both companies are in a capital gains group for corporation tax purposes, in accordance with section 170 TCGA. The distribution itself of the properties into Hold Co is treated as a no gain no loss disposal in accordance with section 171 TCGA 1992. If the transfer is by way of dividend, here is a requirement that the distributing company has sufficient cash reserves to frank the disposal. Hold Co then also receives an exempt distribution. This approach means there is no gain on the disposal of the property by Prop Co.

The share capital in Hold Co can then be reclassified. Assuming the current share capital in Hold Co comprises Ordinary £1 shares held equally by A and B, they can be reclassified such that A and B now each hold a separate class of  ‘A’ Ordinary £1 and ‘B’ Ordinary £1 shares. Under section 127 TCGA 1992, there is no tax consequence in the reclassification of shares from Ordinary to ‘alphabet’ shares.

Each class of shares will, typically, rank pari passu and carry equal rights to voting, dividends and capital with the only major difference being that the value of the ‘A’ shares will derive from Hold Co (or New Sub), and the value of the ‘B’ shares will derive from Prop Co. This will be achieved through the rights attaching to each share.

The next step is for Hold Co to undertake a scheme of reconstruction triggering relief under section 136 TCGA. This will involve all of the ‘B’ shares in Hold Co being cancelled meaning B no longer has any shares in Hold Co and there are now fewer shares in issue in Hold Co (a capital reduction). This approach ensures that there is no distribution and so no dividend tax charge.  In consideration for this, Hold Co will transfer the property destined for B (or Sub Co along with the property held within it) to New Co. For its part, and in consideration of the asset transferred to it, New Co will issue B with shares equating to the shares he originally held in Hold Co.

Normally, the cancellation of shares would constitute a disposal for CGT purposes by B. However, section 136(2) prevents there being a disposal. Instead, B is treated as exchanging their relevant holdings in Hold Co  for the shares  in New Co received by them in consequence of the arrangement.

As there has been a transfer of a business( in this case, that will either be the share capital of Sub Co or the properties transferred direct to New Co), section 139 TCGA prevents any charge to capital gains tax on the disposal of the shares or property. This is provided that Hold Co receives no consideration other than New Co assuming the liabilities associated with those shares or properties (in this case, any loans or mortgages in relation to the properties).

If Sub Co is used, that company will leave a group within 6 years of having received an asset on an intra-group transfer. That would normally create a ‘de-grouping charge’ under section 179(1) TCGA. The special rules in section 179(3)A-H will, however, be in play and the gain then becomes relieved under section 139(1) (referred to above).

In the scenario described, the intra-group property transfer should involve a ‘distribution’ for company law purposes and this will be sufficient to override the market value rule for SDLT purposes (section  54 Finance Act 2003) meaning that there will be no SDLT charge without requiring  SDLT group relief.

There is also no charge to Stamp Duty where the conditions for reconstruction relief are met.

In the case of VAT opted property, care will be required to ensure that the provisions relating to a transfer of a going concern are available or that, at the very least, any VAT charge can be recovered.

Other considerations

Clearance can be obtained from HM Revenue and Customs (HMRC) to ensure that certain of the reliefs mentioned above will not be overridden by special anti-avoidance provisions. In a case such as the one described, clearance should not be problematic. HMRC will need to be satisfied, broadly, that there is no tax avoidance motive. Ultimately, if the directors have a commercial objective, it is unlikely clearance will be denied.

A carefully designed demerger process may ensure that there will be no tax cost but only where there is proper drafting of legal documentation. Whilst the appropriate tax structuring is extremely important, an experienced solicitor can make the process much smoother in the round.

Demergers usually do not need to involve any tax cost. They are an effective method of restructuring a business in accordance with shareholders’ wishes  and the business’s commercial needs and can be used to meet a variety of objectives.

The tax rules may appear to provide a daunting obstacle to splitting a business. Broadly, however, where there is a commercial need for a demerger, the right planning can mean that the tax system need not be a barrier at all.