There are three main ways of effecting a demerger, namely by: dividend in specie; reduction of capital; or liquidation under the Insolvency Act 1986 s 110. There are special income tax and chargeable gains tax reliefs which may apply if the demerger is by way of a distribution in specie, but not for non-trading companies/groups or where done to effect a change in ownership of any entity involved. Chargeable gains tax reliefs can apply to demergers by reduction of capital or liquidation reconstruction. There are further reliefs from stamp duty and SDLT that may be applicable. Tax clearances should be sought in advance.
In this article, we consider the tax implications of the different types of demerger structures that UK companies typically adopt to split their activities into two or more separate companies.
There are many reasons why a demerger may be attractive. Splitting the businesses could be seen as a way to unlock shareholder value. Alternatively, a demerger could be undertaken with a view to focusing management, to ring-fencing liabilities attached to a particular business, or as a precursor to the disposal of a business.
A demerger will include at least two, and possibly three or more, companies. The company wishing to demerge a subsidiary or business unit is referred to in this article as the original company. A company which acquires a business entity from the original company, and issues shares to some or all of the shareholders of the original company, is referred to as the successor company. Any company transferred (directly or indirectly by the transfer of its parent) by the original company to its shareholders or a successor company is referred to as a demerged company. A direct demerger is where shareholders receive shares in the demerged company. An indirect demerger is where shareholders receive shares in the successor company (which will own the demerged company or business).
This article focuses on demergers where the successor or demerged company or business will become owned by all the shareholders of the original company. Partition demergers (more relevant in practice to private companies), where the original business is split between two or more groups of shareholders, are outside the scope of this article.
The three main ways of effecting a demerger are by:
In order for a demerger to be wholly tax efficient from a UK tax perspective, all of the following requirements must be met:
Shareholders
For shareholders, the key concern is avoiding any taxable distribution on the receipt of shares in the demerged or successor company. If a demerger can be brought within the ‘exempt demerger’ relief provisions in CTA 2010 Part 23 Chapter 5, then no distribution will arise (see further below). The receipt of shares by shareholders may (if not subject to income tax) constitute a capital distribution and so a chargeable disposal by a shareholder of the shares in the original company. In the case of a direct demerger within the ‘exempt demerger’ relief provisions in CTA 2010 Part 23 Chapter 5, rollover relief will apply under TCGA 1992 s 192 (see below). Otherwise, to avoid any CGT, the demerger will need to fall within the provisions in TCGA 1992 s 136.
The company
A demerger will involve a disposal by the original company. The original and successor companies will generally not be members of a group for the purposes of taxation of chargeable gains. The demerger transaction will be prima facie deemed for tax purposes to be the market value of the assets transferred. To avoid any chargeable gain, either the shares being transferred will need to qualify for the substantial shareholdings exemption (SSE) or the demerger will need to fall within the ‘scheme of reconstruction’ rollover relief provisions in TCGA 1992 s 139.
In addition, the demerged assets may consist of or include companies and those companies may well have acquired assets from other members of the group which will not be demerged under transactions to which TCGA 1992 s 171 applied. A charge to tax under TCGA 1992 s 179 would prima facie arise on the demerger. However, following changes introduced by the FA 2011 (which, in certain circumstances, effectively impose the degrouping charge that would previously have arisen on the exiting company on the transferring company making the disposal) that charge is now likely to add to or (if a loss) reduce the consideration received by the original company on the disposal of the demerged company. If SSE is then available, or if the original company has sufficient base cost in the demerged company, there would be no tax leakage by virtue of TCGA 1992 s 179 (although other clawbacks and degrouping charges in the tax code may still apply). Otherwise, if the demerger can be brought within the ‘exempt demerger’ relief provisi
ons in CTA 2010 Part 23 Chapter 5, then no s 179 charge will arise because of TCGA 1992 s 192 (see below). In other cases, careful structuring will be required to avoid any degrouping charge.
Stamp duties
To the extent that the demerger involves a transfer of shares or real estate assets, a potential charge to stamp duty (and SDRT) or SDLT will arise. However, it should be possible to structure many demergers to fall within the special reconstruction related reliefs in FA 1986 s 75 (stamp duty) and FA 2003 Sch 7 para 7 (SDLT) that apply in relation to such transfer taxes. In relation to land only, a clawback SDLT charge could potentially arise when a demerged company leaves a group, and the demerged company has previously acquired real estate or an interest therein from a group company which is not part of the demerger (or which is demerged separately) within the three years preceding the demerger under a transaction to which SDLT group relief applied (FA 2003 Sch 7 para 3).
VAT
There will generally be no VAT charge on any of the steps required to implement a demerger, because the assets transferred will usually either be shares (and so exempt from VAT) or a business transferred as a going concern (and so outside the scope of VAT). It may also be possible to utilise the VAT grouping rules, to the extent that a transfer of assets not constituting a transfer of a going concern is necessary prior to the demerger.
In order to effect a demerger by a dividend in specie, the original company will need to have distributable reserves at least equal to the book value of the shares being transferred. To avoid a number of the tax issues described above, demergers would normally only be effected by way of a dividend in specie if the exempt distribution provisions in CTA 2010 Part 23 Chapter 5 are capable of applying.
There are many restrictions and requirements which must be complied with or met before a demerger will qualify as an exempt demerger. Whilst limited space means we cannot set out each of these conditions, one very significant restriction that advisers should bear in mind is that these provisions will not apply to non-trading businesses or when arrangements are in place at the time of the demerger to sell the demerged or successor company or any other company involved in the demerger.
In addition, the exempt distribution provisions will not apply if the demerger is implemented for the purposes of making a ‘chargeable payment’. This is effectively a payment/transfer of value by a company to its members which is made for non-commercial reasons or which forms part of tax avoidance arrangements and which is exempt or not taxable as an income distribution. Further, any chargeable payment made within five years of the exempt demerger will cause a retrospective withdrawal of relief from any degrouping charge under TCGA 1992 s 179 (TCGA 1992 s 192(4)) and may give rise to a tax charge (though the FA 2011 changes referred to above may effectively negate any such charge).
It is possible to apply for advance clearance that the requirements for the exempt distribution provisions are met (CTA 2010 ss 1091–1094). A clearance application letter should contain all the information outlined in HMRC’S SP 13/80. Given the complexity of the requirements, applying for a clearance will be advisable in all cases and it is usual at the same time to apply for any relevant TCGA 1992 clearances.
Direct demergers
If the exempt demerger relief applies, this would avoid any income tax or CGT for shareholders and exempt any degrouping charge for the demerged company under TCGA 1992 s 179 (though the potential impact of any degrouping charge should now be considered in light of the FA 2011 changes referred to above).
Whilst there is no specific direct demerger relief for the original company, a chargeable gain will not arise in its hands, to the extent that the demerged company constitutes a substantial shareholding, or the indexed base cost of the demerged assets is higher than their market value, or there are capital losses available to absorb any gain which arises. If it is not possible to avoid a chargeable gain in the hands of the original company in one of these ways, a demerger by way of a direct income distribution is unlikely to be desirable and an indirect demerger structure is usually adopted.
On a direct demerger, no charge to ad valorem stamp duty should arise, as a distribution in specie is not a conveyance on sale for stamp duty purposes. Care is needed to avoid the distribution in specie creating a debt to be subsequently satisfied by the transfer as then stamp duty will be due.
No specific relief from a withdrawal of SDLT intra-group relief is available for such demergers. To the extent that a clawback charge would arise in respect of a historic intra-group transfer of land, it may be possible to structure the transaction so that the demerged company owns the intra-group vendor at the time of the demerger (so that the intra-group vendor and intra-group purchaser remain members of the same group after the demerger).
Indirect demergers
As with direct demergers, exempt demerger relief should avoid any income tax for shareholders and exempt any degrouping charge for the demerged company.
An indirect demerger should constitute a reconstruction for the purposes of TCGA 1992 Sch 5AA and so will be within TCGA 1992 ss 136 and 139, if the other requirements of those sections are met (which they should generally be in the context of such demergers). Consequently, no chargeable disposal should arise for the shareholders or the original company (so therefore an indirect demerger structure is used if a direct demerger would result in a chargeable gain for the original company).
The stamp duty and SDLT reconstruction reliefs are capable of applying to such demergers. To the extent that a demerged company is transferred by the original company to the successor company, no stamp duty charge will arise, provided that FA 1986 s 75 applies. To the extent that any demerged assets transferred by the original company to the successor company include real estate assets, no SDLT charge will arise provided that FA 2003 Sch 7 para 7 applies.
Clawback of SDLT intra-group relief previously obtained under FA 2003 Sch 7 Para 3 can be avoided on an indirect demerger, provided that the purchaser under the historic intra-group transfer leaves the group pursuant to a transaction to which FA 1986 s 75 applies. This specific relief may itself be withdrawn if the successor company subsequently sells the demerged company within three years.
A recent example of this type of structure is the 2011 demerger by Punch Tavern PLC of its Spirits business to a new company, Spirit Pub Company PLC.
A demerger can also be effected through a reduction of capital, either ‘directly’ or ‘indirectly’. It is often desirable to insert a new holding company above the original company, to ease any creditor issues which may otherwise arise on the reduction of capital. A new holding company will also be required if the share capital of the original company is not large enough to cover the market value of the demerged company or business. This is necessary in order to avoid an income distribution for shareholders. In the typical reduction of capital demerger structure, a new holding company would be inserted by a court-approved scheme of arrangement and this itself should be tax-neutral for the shareholders and the company (see the example below).
A reduction of capital has the advantage that it is not necessary to meet the requirements for the exempt distribution provisions. It is also an attractive structure for companies that do not have sufficient distributable reserves to effect a dividend in specie.
The tax analysis on a typical indirect reduction of capital demerger is as follows:
This type of structure was adopted by Cookson PLC on the spin-off of its performance materials division from the engineered ceramics and the precious metals processing divisions in 2012.
This involves the original company (or a new holding company) being put into voluntary liquidation under IA 1986 s 110 and the transfer by the liquidator of shares and/or assets to successor companies. A liquidation demerger therefore involves at least two transfers of business units, because the original company ceases to exist and must be replaced by a second (or third, or fourth, etc) demerged company to which assets must be transferred. Such structures are not now often used, because the reduction of capital structure is preferred, but in substance the tax analysis to be adopted in relation to such a demerger is similar to that adopted for indirect demergers by way of a reduction of capital.
