CAPITAL REDUCTIONS
CAPITAL REDUCTION DEMERGERS
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CAPITAL REDUCTIONS
CAPITAL REDUCTION DEMERGERS
A Scrutton Bland Guide
CONTENTS
1
Introduction .......................................................................................................... 3
2
Capital Reductions and Capital Reduction Demergers in the Public Domain .... 4
3
Capital Reductions, Reserves and Distributions .................................................. 4
4
The Capital Reduction by Solvency Statement .................................................... 5
5
Capital Reductions to Redeem or Repay Share Capital ...................................... 6
6
Capital Reductions when a Reserve is Created .................................................. 8
7
Resolving the Dividend Block .............................................................................. 9
8
The Buyout of the Dissident Shareholder ............................................................ 9
9
Capital Reductions as Tools for a Demerger ..................................................... 10
APPENDICES
Appendix 1
Share Premium Accounts and the Merger Reserve ................................................. 22
Appendix 2
Transfers Intra-Group, Distributions in Specie and the Aveling Barford Doctrine ..... 24
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CAPITAL REDUCTION DEMERGERS
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1
Introduction
1.1
Part 17, Chapter 10 of the Companies Act 2006 (“CA 2006”), dealing with reductions
of capital, has now been in operation for some time. Sections 642 to 644 CA 2006
give to private companies the ability to carry out a reduction of share capital relatively
simply, using a solvency statement procedure. (This solvency statement procedure is
not available to public companies (Section 641(1)(a) CA 2006)).
1.2
The powers given to a private company with regard to the reduction of share capital
are broad: a company may not reduce its share capital by using a solvency
statement procedure if this would result in there being no shares other than
redeemable shares in issue (Section 641(2) CA 2006). Section 641(3) then reads:
“Subject to that, a company may reduce its share capital under this section in any
way.”
1.3
For the purposes of CA 2006 the term “share capital” embraces:
•
•
•
share capital;
share premium accounts (section 610(4), CA 2006); and
capital redemption reserve funds (section 733(6), CA 2006).
1.4
The CA 2006 also gives the facility for a reserve arising from a redenomination of
share capital from one currency to another to be reduced in a similar way to share
capital (section 626, CA 2006)
1.5
It does not cover other balances such as merger relief reserves or revaluation
reserves: such balances cannot be reduced unless they are first capitalised in some
way.
1.6
There are several situations in which capital reductions can provide practical
solutions:
•
•
•
•
1.7
when preference shares are to be redeemed;
when a return of capital is required for other reasons;
when dealing with transactions which might otherwise represent purchases or
redemptions of own shares out of capital;
for certain demerger transactions.
This extended note looks at various circumstances in which a capital reduction can
provide an appropriate answer for private companies.
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2
Capital Reductions and Capital Reduction Demergers in the
Public Domain
2.1
Capital reduction demergers are most clearly evident in reconstructions of a number
of public companies. They are therefore capital reductions requiring approval of the
Court. Examples from the last few years include:
•
•
•
•
•
•
the demerger of the Talk Talk broadband business from Carphone
Warehouse;
the demerger of Liberty plc into two listed groups;
the demerger of the electricity supply business from Andes Energia plc (an
AIM company) into Andina plc;
the distribution by Friends Provident of 47% of the share capital of F&C;
the demerger of Cookson Group plc into two listed trading groups;
the proposed demerger of Redstone into two separate trading entities.
2.2
The rationale for such demergers has been that of creating or releasing shareholder
value: there can be a belief that the market capitalisation does not reflect true value,
with insufficient recognition of the value in different parts of a group. It is anticipated
that the sum of the parts will be greater than the whole once two demerged entities
trade on the markets and the true value is unlocked. This belief is therefore a
challenge to the efficient markets hypothesis.
2.3
The distribution by Friends Provident of 47% of the share capital of F&C was a direct
demerger to shareholders; the others were indirect, with the demerged activities
being distributed to new holding companies.
2.4
The Liberty plc demerger was atypical in that it did not involve the use of a new
holding company in order to rebase the values for tax purposes: rather it took
advantage of very significant balances on share premium account, resulting from
large rights issues in the past, and these were sufficient to cover the value of the
entity being demerged.
3
Capital Reductions, Reserves and Distributions
3.1
The legal framework is primarily set out in Chapters 10 and 11 of Part 17, CA 2006.
These two chapters comprise sections 641 to 657 of CA 2006. However it is also
necessary to consider other aspects of company law including the creation of share
premium accounts, merger relief and the accounting alternatives involved. There are,
in addition, also questions of which profits are realised and which can be distributed.
3.2
There are two main ways in which capital reductions can take place:
•
there can be a reduction in the share capital, the share premium, the capital
redemption reserve or, rather more rarely, the redenomination reserve, with a
distributable reserve being created as a result of such a reduction; or,
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•
3.3
A Scrutton Bland Guide
there can be a reduction of share capital (possibly in conjunction with a
reduction of some or all of the share premium) with an equal and opposite
repayment to shareholders. This form of capital reduction does not create a
reserve.
Section 654(1) Companies Act 2006 reads:
“A reserve arising from the reduction of a company’s share capital
is not distributable, subject to any provision made by order under
this section.”
3.4
However, this was then varied in 2008 by The Companies (Reduction of Share
Capital) Order 2008 SI 2008/1915. This states that the prohibition in section 654(1)
does not apply and that a reserve arising from a capital reduction is to be treated as
a realised profit. This therefore means that any reserve arising is to be treated as
realised by statute, and the normal common law principles therefore do not apply.
3.5
The view that a capital reduction matched with a return of that value to shareholders
does not create a reserve is supported by TECH 02/10 as issued by the Institute of
Chartered Accountants in England and Wales (ICAEW) and the Scottish Institute
(ICAS); TECH 02/10 states in paragraph 2.8B:
“Section 654 and the Order are concerned with the status of any
reserve arising from the reduction of a company’s capital. They do
not apply to the extent that a reduction of capital takes the form of
a payment to shareholders so that no reserve arises.”
3.6
This interpretation is consistent with section 829, Companies Act 2006 which defines
“distributions”. Section 829(2)(b) states that a reduction of share capital, either by
extinguishing the liability of members (such as in respect of calls outstanding) or by
repaying paid-up share capital, are not distributions.
3.7
The fact that the capital reduction procedure was intended to include repayment of
share capital is demonstrated by the wording of section 641(4)(b)(ii) CA 2006, in
describing particular types of capital reduction: “repay any paid-up share capital in
excess of the company’s wants.”
4
The Capital Reduction by Solvency Statement
4.1
The provisions for a private company to use a solvency statement procedure are
generally set out in sections 641 to 644, CA 2006. There is a need for the following:
•
a check to ensure that there are no provisions in the company’s articles of
association restricting or prohibiting the reduction of the company’s share
capital (section 641(6));
•
a check to establish if the consents of the company’s bankers or any
significant trading partners are required;
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•
a solvency statement made by each of the directors that there is no ground
on which the company could be found to be unable to pay (or otherwise
discharge) its debts in full as at the date of the capital reduction and for the
following twelve months (section 643(1)). This must be made no more than 15
days before the date on which the shareholders’ special resolution is passed
(section 642(1)(a)). (This solvency statement is therefore similar in extent to
the declaration formerly required by private companies in respect of giving
financial assistance for the purchase of own shares under section 156,
Companies Act 1985. The procedure however differs as there is no
requirement for a supporting report by the auditors);
•
a special resolution of members (section 641(1)(a). This can be a written
resolution;
•
a statement of capital (section 644(1)(b). This can be a trap for the unwary, as
it requires the statement to refer to the capital of the company after the capital
reduction, rather than before (section 644(2));
•
a statement by the directors to the effect that the solvency statement was
made not more than 15 days before the date of the special resolution (section
644(5)).
5
Capital Reductions to Redeem or Repay Share Capital
5.1
Example 1
Shareholders of private trading companies may be advised that a large loan from a
director to such a company could be converted into preference shares or nonvoting
ordinary shares in order to improve the inheritance tax position of the shareholder
concerned. In such a circumstance the shares should qualify for 100% Business
Property Relief from inheritance tax, whereas the loans would not. However, there
may be a change of circumstances at a later date, and the shareholder may require
repayment of part of these funds.
As a slight variation on this theme, there are sometimes cases when companies
issue redeemable preference shares, with the full expectation that these will be
redeemed at a set future date, by which time the company may have a sufficient
capital base.
In both of these cases, assuming that there are adequate distributable reserves
available, the transaction can be dealt with in one of two ways:
•
there can be a conventional redemption of redeemable shares or purchase of
own shares at par, the redemption or purchase being from the distributable
reserves of the company; or
•
the same transaction can be achieved by means of a capital reduction.
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There can often appear, at first sight, to be little to choose between these two
alternatives: there is a clear requirement for a capital redemption reserve fund to be
created if the first option is used. (A company purchase or redemption of own shares
is not generally a capital reduction as the share capital is replaced by the capital
redemption reserve fund.) However if the company has significant reserves, that may
be no particular disadvantage.
As an aside, a very common failing can be to ignore the need to make a transfer to
the capital redemption reserve fund when redeeming or purchasing preference
shares. Such shares are now categorised on the balance sheet as debt, and
dividends on such shares are accounted for as if they were interest. However for the
purposes of the Companies Act such instruments remain as shares. In consequence
any dividends can only be paid out of distributable profits; in addition a transfer is
required to the capital redemption reserve fund to the extent that the redemption or
purchase is from distributable profits.
There are two advantages to a capital reduction in this circumstance: firstly there is
no requirement to make a transfer to the capital redemption reserve fund so that the
capital is maintained; secondly there is no stamp duty payable on a capital reduction.
There is an added advantage of a capital reduction if there are insufficient
distributable reserves: as we shall see in the next example, a redemption or
purchase of own shares out of capital is ponderous and costly. A capital reduction is
much to be preferred to this wearisome alternative.
If shares are being redeemed or purchased at par, and assuming that the par value
also represented the amount of new consideration originally given for the shares,
then the repayment of capital in these circumstances will not represent a taxable
distribution under the provisions of section 1000, Corporation Tax Act 2010 (“CTA
2010”).
The above interpretation is not controversial: it is confirmed in guidance issued by
HMRC in early 2013 entitled “Guidance on tax treatment of payments to individuals
and other non-corporates following share capital reduction” (the “HMRC Guidance”).
The HMRC Guidance states: “It follows that a payment which is a repayment of share
capital (including for this purpose share premium – section 1025 CTA 2010) following
such a reduction is not a distribution and so will not be chargeable to income tax.”
This therefore puts the receipt firmly into the realms of capital gains tax treatment.
It is therefore important to have a good understanding of the share capital history
before undertaking a capital reduction: if the share capital had been increased in the
past as a result of a bonus issue, the payment of par value to shareholders would not
all represent a repayment of new consideration.
5.2
Example 2
Sometimes simple mistakes are made: as an example from my own experience, a
parent undertaking transferred development land into a newly incorporated
subsidiary at valuation in exchange for 15 million £1 shares. There was a change of
plan and land with a value of £3 million had to be transferred back to the parent. The
blissful property solicitor, with a mind uncluttered with thoughts of company law,
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merely reversed part of the initial transaction and treated 3 million of the shares as
having been repaid. (This transaction took place some years before October 2008.)
The consequence of this situation prior to October 2008 was that the second leg of
the above transaction had no effect and was void as it did not comply with the capital
maintenance rules of the Companies Act 1985. It was necessary to undertake a
company purchase of own shares out of capital. The regulatory requirements for this
route remain onerous in the Companies Act 2006, including advertising in the London
Gazette and in a national newspaper.
I added to the general clutter in my own mind the fact that at that time the Morning
Star, the organ of the British Communist Party, was the least costly national
newspaper for such purposes. It was seemingly doing a roaring trade in statutory
advertisements.
Since October 2008 a capital reduction has offered a far simpler means of resolving
problems similar to those in the above example.
In the above circumstances, a capital reduction could now be undertaken using the
solvency statement procedure to support a special resolution. The new consideration
given for the shares would be returned. There would be no SDLT implications as the
companies were members of a 75% group.
6
Capital Reductions when a Reserve is Created
6.1
The attitude of HMRC to reserves created by capital reductions is set out in the
HMRC Guidance as referred to above. The HMRC Guidance states: “If, however,
share capital (including premium) is reduced and a reserve is created and treated as
a realised profit that treatment will be applied for tax purposes also. This may, for
example, arise in accordance with the Companies (Reduction of Share Capital)
Order SI 2008/1915, made under section 654(2) of the Companies Act 2006. This
means that:
6.2
•
a dividend payment out of the reserve which is a distribution permitted under
company law will be a dividend for the purposes of section 1000(1)A, and
•
any other payments out of a reserve of this type will be a distribution under
section 1000(1)B and thus potentially subject to the exceptions in subparagraph (a) and (b) where appropriate, as for instance where the reserve is
subsequently employed in a share capital reduction, such as a redemption or
repayment of share capital;
•
but no part of the reserve will be treated as representing a repayment of
share capital on the shares whose cancellation or reduction was the means of
creating it.”
It is therefore evident that HMRC take the view (with some stated exceptions) that
the identity of the sources of the reserve created by a share capital reduction is lost.
Dividends and distributions from such a reserve remain as dividends and
distributions for tax purposes. We can consider this by reference to an example in the
next section.
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7
Resolving the Dividend Block
7.1
Example 3
A company with a share capital of 100,000 ordinary shares of £1 (originally issued for
cash at par), ten equal shareholders and a revaluation reserve of £200,000, but with
a negative balance on profit and loss account, is acting as a dividend block at the top
of a group. It issues ten B £1 deferred shares with no dividend rights at a premium of
£19,999 each, using the revaluation reserve for this purpose. It then undertakes a
capital reduction using a solvency statement procedure:
•
the 10 B shares of £1 and the share premium account of £199,990 are
reduced to nil;
•
the 100,000 ordinary shares of £1 are reduced to 100,000 ordinary shares of
10p.
In consequence of this the company has created profits of £290,000. These profits
are deemed by statute to be realised profits.
The company then declares dividends from these realised profits. Despite the fact
that the source of these profits was a capital reduction, the dividends remain
chargeable as dividends under the provisions of Section 1000(1)A, CTA 2010.
If at a later stage there was a company purchase of 10,000 of own shares as held by
a shareholder for consideration of £30,000, and the conditions for capital treatment
were not met, £10,000 would represent the repayment of share capital and £20,000
would be taxable as a distribution. Again, the capital reduction would have been the
source of the distributable profits needed for the transaction, but this would have no
impact on the tax analysis.
The above transaction could alternatively have been undertaken using a second
capital reduction, rather than by means of a company purchase of own shares. The
tax analysis would be as detailed above.
8
The Buyout of the Dissident Shareholder
8.1
A qualifying company purchase of own shares remains a popular means of achieving
an exit for one of the shareholders when there is a dispute in the boardroom of a
private trading company.
8.2
A major advantage of a qualifying purchase of own shares is the prospect of capital
gains tax treatment. Amounts paid to the dissident shareholder in excess of the
amount of new consideration originally given for the shares will not be taxed as a
distribution provided that the various conditions are met. The conditions are given in
Sections 1033 to 1048, CTA 2010.
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8.3
A capital reduction can be used in conjunction with the provisions of Sections 1033 to
1048 CTA 2010: if there is a large share premium (or one can be created from other
reserves), but insufficient distributable reserves, it may be possible to undertake such
a transaction whilst avoiding both a purchase of own shares from capital and the
Advertising Editor of the Morning Star. Part of the share premium can be reduced
and a reserve created. As we have already seen this reserve is a realised profit (The
Companies (Reduction of Share Capital) Order 2008 SI 2008/1915). It may therefore
be possible to undertake a company purchase of own shares out of distributable
reserves in consequence of the capital reduction.
8.4
Such a transaction could possibly be undertaken as a capital reduction, rather than
as a purchase of own shares. The words in section 1033, CTA 2010 refer to “A
payment made by a company on the redemption, repayment or purchase of its own
shares”. A capital reduction is neither a redemption nor purchase of own shares, but
it is a repayment of its own shares.
8.5
In the event that the terms of Sections 1033 to 1048 CTA 2010 are not met (for
example as the shareholder has not held the shares for five years) then the amount
paid to him in excess of the new consideration originally received by the company for
the shares will be taxable on him as a distribution in the usual way that we would
expect.
9
Capital Reductions as Tools for a Demerger
9.1
Capital reduction demergers have the potential to occupy the ground which is
currently tenanted by section 110 Insolvency Act 1986, reconstructions. There are
several potential advantages to a capital reduction demerger, provided that the tax
concerns can be navigated:
•
•
•
9.2
the costs and possible disruption of liquidation are avoided;
the stamp duty costs are likely to be less;
only one part of the group makes an exit; this gives the tax professional far
greater flexibility in orchestrating the transactions, notably in relation to exit
charges.
The essential quality brought to a demerger by the liquidator in a section 110
reconstruction is the avoidance of an income tax distribution: section 1030 CTA
2010 (formerly section 209(1) Income and Corporation Taxes Act 1988) states with a
comforting certainty: “A distribution made in respect of share capital in a winding up
is not a distribution of a company for the purposes of the Corporation Tax Acts.” This
therefore places the amounts paid out by the liquidator firmly into the territory of the
Taxation of Chargeable Gains Act 1992 (“TCGA 1992”): sections 136 and 139 TCGA
1992 can apply, provided that the transactions together represent a reconstruction as
defined by Schedule 5AA, TCGA 1992. These are the central tax planks upon which
a reconstruction under the provisions of Section 110, Insolvency Act 1986 is built.
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9.3
Section 136 has the effect that the shareholder is deemed to make neither gain nor
loss, and is deemed to have retained the same asset, despite the fact that he has
given up shares in one company and received shares in another. The effect of
section 139 is that assets subject to tax on chargeable gains which are being moved
from one company to another are deemed to be transferred on the basis of no gain
and no loss arising to the disposing company. The acquiring company is deemed to
have received the assets at the capital gains tax base cost (including indexation) of
the disposing company.
9.4
If the group comprises trading activities it may be possible to carry out a statutory
demerger, using the reliefs in sections 1073 to 1099 CTA 2010. However this route is
not possible unless the demerger represents the splitting of two trading activities. The
separation of a trading business from a property investment business (or the
separation of two investment businesses) could not be undertaken using the
statutory demerger provisions.
9.5
If there is to be a reconstruction outside the statutory demerger sections and without
reliance on a liquidation of the holding company, there needs to be another
exemption from the CTA 2010 legislation relating to distributions.
9.6
The answer is to devise a structure which results in a return of capital for the
purposes of CTA 2010. This can be most readily achieved by a capital reduction. For
a private company this can be a capital reduction using a solvency statement
procedure.
9.7
We are illustrating some of the technical points concerned by use of an example:
9.8
Example 4
Sister and brother, Yvonne and Peter Wilby run two companies. They share
ownership but do not get on: unfortunately they are shackled together in a group
structure, by a father acting with the best intentions. They now wish to separate their
interests. Peter runs Pakenham Properties Limited (“Pakenham”), a property
investment company; Yvonne operates Yaxley Youth Limited (“Yaxley”), a training
organisation. These two companies each have 100 £1 shares and are both owned by
Wilby Holdings Limited (“Holdings”), in which Yvonne and Peter each have 50% of
the equity, namely 100 ordinary shares of £1 each. The only assets in Holdings are
the holdings in Pakenham and Yaxley.
Pakenham has a value of £2.6 million and Yaxley is valued at £2.4 million. After a
great deal of wrangling, they agree that there should be a transfer of value of
£100,000 from Pakenham to Yvonne’s interests.
The steps that are undertaken by Yvonne and Peter are set out below:
•
the 200 shares in Holdings are designated as 100 P and 100 Y shares, with
rights to the shares of Pakenham and Yaxley respectively. (This is expressed
as the Y shares having the rights to all assets other than the shares in
Pakenham);
•
Pakenham declares and pays an interim dividend of £100,000 to Holdings;
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•
Yvonne incorporates a new company to be called Wilby New Holdings
Limited (“New Holdings”).
•
New Holdings is placed at the top of the group, by means of a share for share
exchange. Yvonne exchanges her Y shares in Holdings for £2,499,999 million
Y shares of £1 in New Holdings and her single subscriber share is made fully
paid; Peter exchanges his P shares for £2,500,000 P shares of £1 in New
Holdings. The balance sheet of New Holdings has an investment in its
subsidiary undertaking of £5 million and this is represented by issued share
capital. The rights of the P and Y shares are identical to the P and Y shares
of Holdings.
•
the 100 shares held by Holdings in Pakenham are transferred to New
Holdings at market value of £2.5 million with the consideration being left on
loan account.
•
Peter incorporates a new company, Pakenham Holdings Limited (“P
Holdings”) to be his new holding company;
•
there is a capital reduction of New Holdings, using the solvency statement
procedure, and the 2,500,000 P shares are cancelled;
•
as part of the capital reduction, the parties enter into a three sided agreement:
Peter’s shares in New Holdings are cancelled, New Holdings agrees to
transfer its share holding in Pakenham to P Holdings; P Holdings issues
shares to Peter;
•
Yvonne retains ownership of the remaining shares in New Holdings, which in
turn owns Holdings which owns Yaxley.
We analyse the technical tax and accounting issues relating to the above steps
below.
9.9
Creation of Two Classes of Shares in Holdings
The change of the shares of Holdings into two classes of P and Y shares has no tax
consequences; there are no value shifting issues as the values of the two classes are
to be the same. This can only be done once the Articles have been changed, to state
the specific rights attaching to the two classes, to be defined by reference to the two
subsidiary undertakings. In fact, the rights of the P shares will be expressly defined,
and the Y shares will have all rights apart from those relating to the P shares.
9.10
Pakenham Declares and pays a Dividend of £100,000 to Holdings
This step represents the value equalisation agreed between Yvonne and Peter. As a
side-effect, it creates distributable reserves in Holdings, which are of some important
consequence later.
From an accounting perspective this reduces the distributable profits and cash of
Pakenham by £100,000. It creates distributable profits in Holdings of £100,000 and
also a cash balance of the same amount
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9.11
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Incorporation of New Holdings
The incorporation of New Holdings is similarly a relatively simple matter: it is
incorporated with one £1 ordinary share issued but unpaid in the name of Yvonne.
(This share is then designated as a Y share and is treated as fully paid at the time of
the share for share exchange.)
There is no accounting involved with this stage as the single share has not been
called.
9.12
Placing New Holdings at Top of Group
New Holdings issues 2,500,000 P shares and 2,499,999 Y shares: the existing
subscriber share is categorised as a Y share. The consideration is the 100 P shares
and 100 Y shares in Holdings as held by Peter and Yvonne. Section 127, TCGA
1992 applies, by virtue of section 135, and the shares in New Holdings are therefore
treated on the basis of two fictions for capital gains tax purposes: the first fiction is
that there has been no disposal; the second fiction is that the shares in New Holdings
are the same asset as the shares in Holdings. The result is that Peter and Yvonne
are treated as not having made a disposal and their base costs are transferred to the
shares in New Holdings.
New Holdings has an investment of the 100 P shares and 100 Y shares in Holdings.
The capital gains base cost of these shares is their market value of an aggregate of
£5 million, due to the operations of section 17, TCGA 1992. This section states that
transactions shall be deemed to be for a consideration equal to market value where
they are not a bargain made at arm’s length. Section 18 provides that transactions
involving connected persons are deemed to take place otherwise than at arm’s
length.
Under the provisions of section 1115(1)(a), CTA 2010, the value of the shares in
Holdings represents new consideration received by New Holdings. It is new
consideration as it is not provided out of the assets of New Holdings. Section
1117(4), CTA 2010 states that consideration is treated as provided out of assets of a
company if the cost falls on the company.
This is a critical step in the understanding of the operations of a capital reduction
demerger. We therefore need to pause and consider this point. The new
consideration received by New Holdings is £5 million, as this is the value that it has
received, in the form of the shares in Holdings, for the shares that it has issued. This
new consideration is not provided out of the assets of New Holdings as the cost
relating to this new consideration does not fall on New Holdings.
The insertion of New Holdings between the shareholders and Holdings should mean
that acquisition relief from stamp duty is available under section 77, Finance Act
1986 as the shareholdings in Holdings are exactly mirrored in the shareholdings in
New Holdings.
As there is a holding company already in place, it might be questioned as to why
there is a need to place New Holdings above Holdings before undertaking a capital
reduction demerger. The justification is that this means that the top company in the
group has received new consideration which equates to the current market value.
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Current market value needs to be the market value immediately before the
reconstruction takes place.
By way of example, if Holdings had been placed above Pakenham and Yaxley some
ten years ago, by means of a share for share exchange by a father desperate to hold
his family together, the new consideration received by Holdings would have equated
to the market value of the two companies at that point. Any growth in value of the two
companies since that time would not represent new consideration in Holdings.
The accounting within New Holdings is to recognise an asset of £5 million, with this
being matched with the issued share capital of New Holdings. There are no
accounting consequences to any of the other companies.
9.13
Transfer of Pakenham Shares to New Holdings
The transfer of the shares in Pakenham by Holdings to New Holdings for
consideration of £2.5 million is within the provisions of section 171, TCGA 1992, as a
transaction between companies in the same 75% group. The transaction therefore
takes place for the purposes of tax on chargeable gains on the basis of no gain, no
loss. The base cost of the shares of Pakenham held by New Holdings is therefore the
base cost as held by Holdings, with the addition of indexation.
The transaction is eligible for group relief from stamp duty under the provisions of
section 42, Finance Act 1930. This relief should not then be withdrawn under the
provisions of section 27, FA 1967 as Holdings and New Holdings remain in the same
group after the reconstruction.
It should be noted that Holdings has reserves of £100,000 following the receipt of the
cash dividend.
If the cash dividend had not been declared and paid, Holdings would have had no
distributable profits. This would have left the intragroup transfer of the shares in
Pakenham as an exposed transaction, as a result of the case of Aveling Barford v
Perion (1989 BCLC 626). There would be the prospect of the transaction being
challenged at a later date as a transfer at undervalue, with the possibility that the
transaction would be void as an unlawful distribution. The existence of positive
distributable reserves in Holdings removes this exposure. This point, and the Aveling
Barford Doctrine generally, is explained more fully below in Appendix 2.
The disposal by Holdings of its investment in Pakenham for proceeds of £2.5 million
means that it has made a profit of £2,499,900, as the investment was only included in
the balance sheet of Holdings at £100. However, under the provisions of TECH 02/10
this is an unrealised profit as New Holdings is not in a position to settle the
intercompany balance.
New Holdings has an investment in Holdings at a book amount of £5 million and it
also has an investment in Pakenham at a book amount of £2.5 million. As the
transfer took place for full consideration there is no need for an impairment provision
against the carrying value of the investment in Holdings: Holdings has replaced the
value of its investment in Pakenham with a sum due on intercompany account, with
no diminution in value.
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Peter Incorporates P Holdings
This is a straight forward step in the process. We assume that there will be one
subscriber share held by Peter, issued but unpaid.
There can be concerns if the subscriber share in P Holdings is issued to a company
formation agent. This is on the basis that the terms of Paragraph 2, Schedule 5AA,
TCGA 1992, require that the reconstruction does not involve the issue of ordinary
share capital of the successor company to anyone else, other than the shareholders
in the original company. This is therefore a risk which may be modest, but which can
be simply avoided.
There are no accounting consequences of this step as the single share issued has
not yet been called.
9.15
The Capital Reduction of New Holdings
The capital reduction is undertaken in accordance with CA 2006, s 641 to s 644.
Provided that there is at least one non-redeemable share in issue, s 641 (3) very
helpfully provides that a company may reduce its share capital in any way, as we
have already noted.
In this case the capital reduction takes the form of the cancellation of the P shares
and the transfer of the shares in Pakenham to P Holdings.
CTA 2010, s 1115(4) provides a general rule that no consideration derived from the
value of any share capital or voting or other rights in the company is to be treated as
new consideration. There are then three exceptions to this general rule given in s
1115(5): the first two relate to:
•
•
money or value received from a qualifying distribution; and
money received from a repayment of share capital.
These are exceptions to which we can readily relate: if a shareholder has received
either dividends or a return of capital in some form, these amounts will have been
taxed on the shareholder as appropriate. If these funds are then injected back into
the company in return for shares, section 1115(5) CTA 2010 effectively provides that
the amounts can represent new consideration despite the fact that they originally
derived from the value of shares in the company. If these exceptions were not in the
legislation, reinvestment of such amounts would not represent new consideration.
9.16
Example 5
Old Newton Limited pays dividends to its shareholders over a number of years.
These are made out of the assets of the company as the cost falls on the company
(section 1117(3) CTA 2010). Anna, one of the shareholders, retains these amounts in
a separate bank account relating to her investment in Old Newton Limited.
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At a later date the company requires more capital and makes a rights issue of
shares. All of the shareholders take up the rights, including Anna. The money that
Anna provides comes from her separate bank account. It therefore represents the
reinvestment of funds the cost of which has fallen on the company. However, due to
the operation of section 1115(5)(a), CTA 2010, the amount paid in by Anna still
represents new consideration.
The third exception is given in CTA 2010, s 1115(5)(c) and refers to the giving up of
the right to share capital on its cancellation. The cancellation of the P shares does
not cancel the new consideration embedded within those shares. A distribution of the
shares to P Holdings is therefore still potentially a repayment of capital.
This point is covered by the HMRC Guidance which states:
“Section 1115(4) to (6) CTA 2010 covers circumstances in which
amounts derived from the value of share capital may be treated as
new consideration. However, this is subject to exceptions at
section 1115(5) and where the exceptions apply, to a limitation at
section 1115(6). Section 1115(5)(c) applies to consideration
derived from the giving up of rights to share capital (or securities)
on cancellations or extinguishment, or on its acquisition by the
company.
HMRC’s view is that where share capital is reduced and taken to a
reserve as part of an arrangement for the reorganisation of the
company’s share capital, this will amount to the cancellation by
the company under section 1115(5)(c) providing this involves the
shareholder giving up the right to the share capital as part of the
reorganisation. Reorganisation for this purpose means a scheme
or arrangement that includes the cancellation of share capital in a
company followed by a fresh issue of shares. Application of the
reserve in these circumstances will be treated as new
consideration in relation to the fresh issue.”
The accounting for this stage is dealt with in the next section below.
9.17
The Three Cornered Agreement
The parties to the agreement are: New Holdings; P Holdings; Peter. The capital
reduction requires Peter to agree to the P shares in New Holdings being cancelled;
as consideration for this, New Holdings undertakes to transfer the shares in
Pakenham to P Holdings; P Holdings issues 2,499,999 further shares to Peter and
the subscriber share is treated as fully paid.
As we identified above that New Holdings has received new consideration of £5
million, we next need to consider what happens if a distribution is made in respect of
some of the shares representing the share capital. Section 1000 (1)(B)(a) CTA 2010,
specifies that any amount paid out of the assets of the company which represents
repayment of capital on the shares is not a distribution for the purposes of CTA 2010.
The capital reduction and the subsequent transfer of the shares in Pakenham result
in repayment of capital on the P shares of New Holdings. The transfer is therefore
not a distribution for the purposes of CTA 2010, s 1000.
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Provided that the conditions of section 139, TCGA1992 have been met, the base
cost of the shares of Pakenham in P Holdings is the same as the base cost in New
Holdings. Due to section 139, there is therefore no chargeable gain arising in New
Holdings on the disposal of its interest in Pakenham.
Provided that the terms of TCGA 1992, s 136 have been met, the base cost of the
shares held by Peter in P Holdings is the same as the base cost of the shares in New
Holdings which have now been cancelled. Peter is therefore not subject to a capital
gains tax charge.
There is stamp duty payable on the transfer of the shares in Pakenham from New
Holdings to P Newco. At a rate of 0.5% on £2,500,000, this amounts to £12,500.
There is no stamp duty payable by Yvonne. The stamp duty cost will normally fall
unevenly in a capital reduction demerger. In practice this inequality of cost will
perhaps be resolved between the parties when agreeing the precise terms of the
demerger.
As with the transfer of Pakenham to New Holdings, the transfer of this company by
New Holdings to P Holdings is also potentially exposed. On this occasion there are
no distributable reserves in New Holdings and the transaction could in theory be
found to be void and of no effect if the demerger was held at a later date to represent
a transfer at undervalue. This very real exposure could be resolved readily by a
declaration of a modest cash dividend from Holdings to New Holdings.
If there are concerns that New Holdings or P Holdings may prove to be a dividend
block, a further capital reduction can be undertaken in order to convert part of the
share capital into realised profits.
The balance sheet of P Holdings will have an investment in Pakenham, including the
stamp duty cost of £2,512,500 and an overdraft of £12,500. The net assets of
£2,500,000 will be represented by 2,500,000 shares of £1.
Following the capital reduction, the balance sheet of New Holdings will show an
investment in subsidiary undertakings of £5 million and an amount owing to Holdings
of £2.5 million. This will be represented by 2,500,000 Y shares.
9.18
Clearances
As with other transactions involving reconstructions, clearances under section 138,
TCGA 1992, under section 698 ITA 2007 and under CTA 2009, are advised.
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Some Alternatives
We explore below some alternative means of dealing with the detailed steps noted
above, together with comments on the tax and company law implications.
Cash Dividends
In this example we have assumed that there is a dividend declared by Pakenham to
Holdings of £100,000 as a means of equalising values. This had the welcome sideeffect of creating distributable profits in Holdings. As noted above, it is necessary for
there to be distributable reserves in both Holdings and New Holdings if the
transactions are to receive the protection offered by section 845 Companies Act
2006. This point is addressed in Appendix 2 below.
The Issue of Shares by New Holdings
In the examples we have assumed that the number of shares issued by New
Holdings is equivalent to the value of the new consideration received. There are
various other ways in which this step could be undertaken:
•
New Holdings could have issued 100 Y shares and 100 P shares on the basis
of a 1:1 share exchange. New Holdings could then have recognised a merger
reserve of £4,999,800. The investment in Holdings would be shown at £5
million;
•
as above, but with the merger reserve then being capitalised into a share
premium account. The investment in Holdings would be shown at £5 million;
•
New Holdings could have issued 100 Y and 100 P shares on the basis of 1:1,
without a merger reserve being recognised. The investment in Holdings would
be shown at £200.
We deal with the way in which each of these three alternative approaches would be
treated in the capital reduction below.
Section 1025 CTA 2010 is stated to apply if share capital is issued at a premium
representing new consideration. We consider that it is a question of fact as to
whether share capital is issued at a premium, which we take to mean at an amount
which is greater than the nominal value of the share capital. Although we are
debarred by section 612 CA 2006 from describing the amount of the surplus value as
a share premium, we do not consider that this changes the reality that the shares
have been issued at a premium above nominal value, and that the merger reserve
represents that fact from a tax perspective in the same way as a share premium
account.
The company law issues concerning share premium accounts and merger reserves
are considered in Appendix 1 to this paper.
If the financial statements are being prepared in accordance with UK GAAP, each of
the above options is available. Under IFRS it is generally necessary to create the
merger reserve and to recognise the investment in Holdings at fair value.
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The Transfer of Pakenham Shares to New Holdings
There are several alternative treatments for this step, including:
•
the shares could be transferred to New Holdings at book amount of £100, but
only once Holdings had received a dividend of £1; or
•
a cash dividend could be paid to Holdings of £100, thereby enabling Holdings
to make a distribution in specie of the shares in Pakenham to New Holdings;
or
•
the shares could be revalued to £2,500,000. This would then enable the
shares to be transferred up to New Holdings as a distribution in specie at full
value. The revaluation reserve would be deemed to be realised at the point of
the distribution.
The first option above cannot be followed unless there are positive distributable
reserves in Holdings. If this is not the case the transaction falls foul of the Aveling
Barford doctrine as the transfer would represent an unlawful distribution. This is
explained more fully in Appendix 2.
There were formerly concerns under the Aveling Barford doctrine regarding the
distributable reserves needed for the above alternative treatments. These concerns
have now been alleviated by CA 2006, s 845 (2)(a). This section provides that the
amount of the distribution above the book amount of the asset is to be treated as
zero for Companies Act purposes, provided that the company has distributable
profits.
We examine below, as alternative 4, the accounting implications of the first two bullet
point options above.
Intragroup transfers are often made by dividend prior to a reconstruction, so as to
avoid an additional layer of stamp duty costs. With a capital reduction demerger
these concerns can generally be avoided.
The Capital Reduction of New Holdings
We have referred above to three alternative ways in which New Holdings could be
placed above Holdings. We now deal with the implications for the capital reduction of
each of these routes. In each of these examples we are assuming that Pakenham
has been transferred to New Holdings for consideration of £2,500,000. We then deal
in the next section with alternative ways in which the transfer of Pakenham may have
been handled.
Alternative 1:
New Holdings could have issued 100 Y shares and 100 P shares on
the basis of a 1:1 share exchange. New Holdings could then have
recognised a merger reserve of £4,999,800.
If this route had been followed then it would be necessary to create a reserve of £100
on the reduction of the 100 P shares. The three cornered agreement would then
have had to be in the form of a dividend in specie declared by New Holdings, being
the shares in Pakenham.
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A merger reserve is a form of a revaluation reserve and it cannot be reduced as part
of a capital reduction as it does not fall within the definition of share capital for the
purposes of the CA 2006.
The dividend in specie would have been at a book value of £2,500,000. This would
be satisfied by the special reserve created of £100, and by the realisation of
£2,499,900 of the merger reserve. Under the provisions of section 846, Companies
Act 2006 a distribution in kind of a revalued asset results in the revaluation being
treated as realised for the purposes of computing distributable profits. As noted
above a merger reserve is a form of revaluation reserve.
Alternative 2:
New Holdings could have issued 100 Y shares and 100 P shares on
the basis of a 1:1 share exchange, as above. The variation is that
the merger reserve relating to the P shares is then capitalised into a
share premium account by the issue of one share at a premium of
£2,499,899.
This route then enables the 100 shares, the 1 B share and the share premium
account all to be reduced as part of the three-cornered agreement in which the
shares in Pakenham are transferred to P Holdings.
Alternative 3:
New Holdings could have issued 100 Y and 100 P shares on the
basis of 1:1, without a merger reserve being recognised. The
investment in Holdings would be shown at £200.
We need to remember that we are exploring the accounting and company law
considerations on the assumption that Pakenham is recorded on the balance sheet
of New Holdings at £2,500,000.
There would be a capital reduction of the 100 P shares. It would then be necessary
to transfer the shares in Pakenham to P Holdings at some amount.
We need to consider the possibility of doing this in the form of a dividend. UK GAAP
gives no guidance on the amounts at which dividends in specie should be recorded,
unlike IFRS. However, the most common treatment is to record such transactions at
book amount. However, it would not be possible under company law to use a reserve
of £100 as a means of distributing an asset stated at cost of £2,500,000.
The transaction could be undertaken as a three-cornered agreement for
consideration: the consideration for the cancellation of the 100 P shares is the
transfer of the shares in Pakenham to P Holdings. P Holdings then issues shares to
Peter.
This treatment would however mean that the financial statements of New Holdings
would then have a deficit on profit and loss account of £2,499,900. It would then act
as a dividend block and this would then have to be resolved by the declaration of a
dividend by Holdings to New Holdings.
Alternative 4:
We now look at some of the other accounting alternatives, assuming
that the shares in Pakenham had been transferred up to New
Holdings at an amount of £100.
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It would have been relatively simple from an accounting perspective to reduce the
share capital of New Holdings by cancelling the 100 P shares and by transferring the
Pakenham shares to P Holdings. Again, due to the threat from the Aveling Barford
doctrine, it would be preferable for New Holdings to have distributable reserves of at
least £1 before undertaking this step.
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Appendix 1
Share Premium Accounts and the Merger Reserve
For the purposes of the relevant parts of the Companies Act 2006 share capital includes
share premiums, capital redemption reserve funds and also redenomination reserves.
We therefore need to explore the situations in which share premium accounts are, and are
not, created. We need this understanding in order to approach capital reduction demergers
with some confidence.
It is a requirement of Section 610, CA 2006 that, if there is an issue of shares at a premium,
whether for cash or otherwise, then the aggregate amounts of the premiums must be
transferred to an account called the share premium account.
Section 612 qualifies the above: it has the rather confusing title of “Merger relief” but it has
nothing to do with mergers, and it is not a relief, as we shall see.
It applies, broadly speaking, when a company has secured at least a 90% equity holding in
another company by means of a share issue. If the equity shares are issued at a premium
section 612 states, “section 610 does not apply to the premiums on those shares.”
We will illustrate the practical effects of this by an example
Example 6
Companies A and B are owned by the same four shareholders in the same proportions.
They are advised that they should create a group structure. Company H is incorporated with
one share issued but unpaid: an agreement is drawn up whereby the four shareholders give
up their shares in A and B in exchange for the issue to them of shares in H on the basis of
one share in H for every share that they held in A and every share that they held in B. A and
B each has 100 ordinary shares of £1. A has a value of £100,000 and B a value of
£300,000. H issues 199 ordinary shares and the existing one subscriber share is treated as
fully paid.
The 200 shares in H clearly have a value of some £400,000 and have therefore been issued
at a premium of £399,800. However, due to the wording of Section 612, CA 2006 it is not
possible to recognise this amount as a share premium. It was originally thought that the
forerunner to section 612 was a relieving section: however, it is now part of generally
accepted accounting practice in the UK (“UK GAAP”) that Section 612 is not a relieving
section. Section 612 is worded to mean that it is not permissible to create a share premium
account in circumstances in which it applies. The words “does not apply” have their ordinary
meaning.
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There are two accounting alternatives under UK GAAP in respect of this situation:
•
H could show an investment in subsidiaries at £200, being £100 for A and £100 for B.
It would have an issued share capital of 200 ordinary shares of £1 and no other
shareholder funds; or
•
H could show an investment in subsidiaries at £400,000, being £100,000 for A and
£300,000 for B. It would have an issued share capital of 200 ordinary shares of £1
and it would also have a merger relief reserve, often shortened to merger reserve, of
£399,800.
In the second situation above the merger reserve is a non-statutory reserve and it is best
considered as a form of revaluation reserve. It is not a component of share capital as defined
for the purposes of section 641, CA 2006 and it therefore cannot be reduced in a capital
reduction. Therefore, although it appears to be very similar to a share premium account, it
behaves in a very different way.
If there is a requirement to carry out a capital reduction, including the merger reserve, it is
first necessary to convert the merger reserve into either shares or share premium as these
can then be reduced.
This can be achieved in several ways:
•
The merger reserve can be capitalised as a relatively small number of ordinary
shares, issued at a significant premium;
•
The number of shares issued can equate to the amount in the merger reserve, with
no premium being involved;
•
A single B deferred share can be issued with virtually no rights, but at a very large
premium. The merger reserve is then converted into one B share with the balance
being share premium.
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Appendix 2
Transfers Intra-Group, Distributions in Specie and the Aveling Barford
Doctrine
The Aveling Barford Doctrine sprang from the important case of Aveling Barford v Perion
Limited (1989 BCLC 626).
That case related to the transfer of a property in Grantham, Lincolnshire by Aveling Barford
Limited to Perion Limited for its book amount of £350,000. At this time it was professionally
valued at some £650,000 and it was sold some six months later for £1.526 million. The two
companies were ultimately controlled by the same person. Aveling Barford Limited had no
distributable reserves at the time of this transaction.
When Aveling Barford Limited became insolvent, a request was made to over-turn this
transaction. It was found in the above case that the transaction was void as an unlawful
distribution and was therefore an unlawful return of capital.
This is a decision to which we can all relate: although the transaction was not presented as a
distribution, it can be recognised that the excess value above £350,000 was in essence in
the nature of a distribution which the shareholder had directed to Perion Limited. As there
were no distributable reserves any distribution was unlawful.
We can perhaps explore the circumstances in which this transaction may have been lawful.
If Aveling Barford Limited had had distributable reserves of £1 then, making the sweeping
assumption that the transaction would not have fallen foul of the fiduciary responsibilities of
the directors in any event, the company could have revalued the property to its estimated
market value of £650,000. There would therefore be a revaluation reserve of £300,000. The
shareholder in the company could then have made a capital contribution of cash of
£350,000. This capital contribution would have increased the distributable reserves to
£350,001. The property, now standing in the books at £650,000, could then have been
distributed as a dividend in specie. The act of the distribution would have meant that the
revaluation reserve of £300,000 was treated as realised. The amount of the distribution
would have been covered by the distributable reserves (including for this purpose the
revaluation reserve (Section 276, Companies Act 1985, now section 846 CA 2006)).
What would have happened if the property had not been revalued, but had been transferred
at its book amount of £350,000? There would then have been some uncertainty: the book
amount of the property was £350,000 and the distributable reserves were £350,001. The
question that had to be answered in those circumstances was whether the distributable
reserves to cover such a distribution in specie needed to be £350,000 or the estimated value
of £650,000.
This uncertainty cast a long shadow of doubt over various transactions within groups of
companies, not merely formal distributions: there was no clear ruling as to the impact on the
transfers of assets if those transfers took place at less than market value.
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This was a question to which there was no certain answer until the introduction of the
Companies Act 2006. The point has been well explained in the explanatory notes to sections
845 and 846, Companies Act 2006, as included on the www.legislation.gov.uk website:
“The concern behind this section is that, following the decision in the
Aveling Barford case, it is unclear when intra group transfers of assets
can be conducted by reference to the asset’s book value rather than its
market value (which will frequently be higher than the book value).
The case of Aveling Barford Limited v Perion Limited 1989 referred to a
transfer of an asset intra-group at undervalue at a time when the
transferring company did not have distributable reserves. Such a transfer
was held to be an unlawful distribution.
This decision led to some uncertainty as to the level of reserves that were
required when undertaking a distribution in specie. Was it sufficient to
have distributable reserves equivalent to the book amount of the asset to
be distributed, or was it necessary to have reserves equivalent to the
open-market value of that asset?
This uncertainty was clarified by section 845, CA 2006. This section
provides that the amount of the distribution above the book amount of the
asset is to be treated as zero for Companies Act purposes.”
Since that time the Aveling Barford Doctrine has been revisited in the Supreme Court case
of Progress Property Co Limited v Moorgrath Group Limited (2011 2 BCLC 332). In that case
a transaction between a company and its shareholder was not overturned. The transaction
being challenged was held to be an arm’s length sale negotiated in good faith, although with
the benefit of hindsight the company had made a bad bargain.
The two cases can be distinguished by reference to the intentions of the parties at the time
of the transaction. In Progress Property Co case the Court was apparently convinced that it
was not the intention at the time to enter into a bad bargain.
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