Demerger Mania - Martin Dawson guides readers through the maze of demerger legislation.

Demerger Mania
Martin Dawson guides readers through the maze of demerger legislation.
Demergers have increased in popularity since the early 1990s with the well documented ICI/Zenneca split. It is, however, a strategy that the smallest family owned company/group is equally at liberty to adopt.
The legislation in force today was introduced in 1980 on the back of an Inland Revenue press release dated 20 June 1980, and fast on the back of the Chancellor's Budget statement on 29 March 1980 in which he said that such legislation was being introduced to 'facilitate the splitting up of a family company or group,... and to enable businesses to be run more dynamically under independent management'.
Cutting through the legislation, a demerger is simply a transaction which has the purpose and effect of dividing the business activities carried on by a single company or groups of companies, between two or more companies or groups of companies. The legislation, however, aims to effect the division between existing shareholders and does not permit a new controlling shareholder to become involved.
For the purpose of this article, I will concentrate on a typical owner managed business scenario with which many practitioners will be familiar. Similar mechanisms are available to quoted companies but often, with larger numbers of shareholders, the practical considerations to effecting the appropriate demerger will be different.
Let us assume that there are two equal shareholders, Alex and Brian who own ManCo Holdings Ltd which in turn wholly owns two trading subsidiaries, David Ltd, a successful sports entertainment company and Dwight Ltd, an equally successful public relations company.
Alex and Brian have made the commercial decision to split their existing group into two individual sub-groups, both owned equally.
In very simple terms no special corporate régime exists – a demerger can be effected by no more than a distribution in specie from the distributing company of the assets to be demerged (usually shares in David or Dwight, but equally it could represent the trade and assets of either).
Authority for a company to make a distribution in specie must be given in the company's Articles of Association – this is usually found at paragraph 120 of Table A of the Schedule to the Companies Regulations 1995.
Other accepted methods exist to effect the demerger (e.g. company buy-back of shares), but these have not been explored by this article.
In reality, the average practitioner is only ever likely to deal with three methods of partitioning the group in the example. I will cover each of these under the headings of direct demerger, indirect demerger and finally (less frequently encountered in the family company arena) a liquidation.
Direct demerger
A direct demerger is effected by the distributing company (ManCo) making a distribution in specie of its shares in the demerging company (Dwight) directly to all or any of its members.
In the example, assuming common shareholders, the transaction would appear as Figure 1.
Figure 1



Section 213(3)(a), Taxes Act 1988 provides the appropriate statutory (tax) authority for the process.
The distribution in specie will be an exempt distribution for the purposes of the Taxes Act providing that:
the demerging subsidiary is at least a 75 per cent subsidiary; and
the conditions of section 213(4) to (12) are met.
A fully detailed analysis of the provisions of section 213(4) to (12) is beyond the scope of this article, but in principle the following key conditions must be met:
only trading activities (not investment) can be separated out;
the shares must constitute the whole, or substantially the whole (the Revenue interprets this as meaning greater than 90 per cent) of the distributing company's holding of the ordinary share capital of the demerging company;
the distributing company and the demerging company must be United Kingdom resident at the time of the demerger;
the distribution must be made wholly or mainly for the purposes of benefiting some or all of the trading activities;
the distribution must not form part of a scheme (or arrangement) the main purpose of which is the avoidance of tax (including stamp duty).
In essence, the rationale of the legislation is to allow a trading company or group to reorganise its trading activities between existing members for commercial reasons. It does not permit the partitioning of a trading activity from an investment activity, permit a change of control of a company or a tax avoidance scheme.
Tax analysis
Individual shareholders
The shareholders in ManCo would normally be treated as receiving a capital distribution, and hence making a part disposal of their share holding in accordance with section 122(1), Taxation of Chargeable Gains Act 1992.
However, section 192(2) confirms in the case of a direct demerger (only) that:
the distribution will not be a capital distribution, therefore section 122 will not apply; and
sections 126 to 130 will apply, with the necessary modifications, to treat the shares of the distributing company and the demerged company as the same asset, and hence the original cost of the ManCo shares will be apportioned across the holdings.
Distributing company (ManCo)
ManCo has made a chargeable disposal of its shareholdings in Dwight and in accordance with section 17(1)(a), Taxation of Chargeable Gains Act 1992 this will take place at market value.
There are no provisions in the legislation to relieve this capital gain specifically, therefore in the absence of any capital losses for ManCo or any other tax mechanism for reducing the capital gain (for example by the declaration of a pre demerger dividend) a corporation tax charge will arise.
This is an unfortunate flaw in the legislation, and it is often a reason why a direct demerger is considered unattractive. Hence an indirect demerger may provide the solution.
One final point to consider is that of degrouping charges under section 179. Again, section 192(3) comes to our aid and confirms that where Dwight leaves the group by way of an exempt distribution, no degrouping charge will arise. Readers should note, however, that if a chargeable payment is made within five years of the demerger this will not be the case – see section 192(4).
Indirect demerger
An indirect demerger is effected by the distributing company (ManCo) transferring either:
a trade (or trades); or
shares in one or more companies that are 75 per cent subsidiaries, to
a NewCo in exchange for the issue of shares by NewCo to all (or any) of the members of NewCo. In the example, assuming that Dwight (as opposed to the trade of Dwight) was demerged, this would be illustrated as shown in Figure 2.
In this situation, section 213(2)(b), Taxes Act 1988 provides the appropriate statutory authority with the same provisions applying, i.e. section 213(4) to (12), Taxes Act 1988.
Figure 2



Tax analysis
Individual shareholders
Unlike the situation involving a direct demerger, there is no specific legislative provision that exempts Alex and Brian from making a part disposal of their shares in ManCo in accordance with section 122, Taxation of Chargeable Gains Act 1992. Protection will therefore need to be sought from elsewhere.
Shareholder reconstruction relief can be found within section 136. Provided the demerger amounts to a reconstruction or amalgamation, then section 136 will operate to treat the base cost of ManCo as spread across both holdings.
Distributing company (ManCo)
At first glance the situation would appear to be no different from that of a direct demerger: ManCo has made a chargeable disposal of its shareholding in Dwight. However Taxation of Chargeable Gains Act 1992 confirms that:
where a scheme of reconstruction or amalgamation is involved; and
ManCo transfers the whole or part of its business to NewCo; and
ManCo receives no part of the consideration for the transfer (other than NewCo taking over the liabilities of Dwight, in whole or part); and
the transaction is effected for bona fide commercial reasons and does not form part of a scheme or arrangement, one of the main purposes of which is the avoidance of tax;
then the disposal between ManCo and NewCo will take place at such a value that that gives rise to neither a gain nor a loss (see section 139(1) (company reconstruction relief)).
It is interesting to note, however, that section 139 applies to the transfer of a company's business, yet in the example ManCo has distributed its shareholding in Dwight, as opposed to the trade and assets (i.e. the business).
Similar rules apply in connection with degrouping charges as with the direct demerger. Initial protection will be given, but again a charge will arise if a chargeable payment is made within five years.
Liquidations
Before the introduction of the demerger legislation in 1980, a liquidation was often the only route to effect a split of a company (or group) in a tax efficient manner. Whereas the demerger legislation and the reconstruction legislation remain the most frequently used method in practice, a liquidation still remains the principal way of splitting a group where there are non-trading activities or insufficient distributable reserves to cover the dividend in specie.
There are effectively two methods available:
section 110, Insolvency Act 1986 (acceptance of shares etc. as consideration for sale of company property);
section 425 et seq, Companies Act 1985 (power of a company to compromise with creditors and members).
Section 110, Insolvency Act 1986
A section 110 scheme would normally proceed by way of a voluntary liquidation without court approval, with the liquidator, under instructions from Alex and Brian, transferring shares in David and Dwight to NewCo1 and NewCo2 in exchange for an issue of shares to them. See Figure 3. ManCo would then be wound up.
Figure 3



Such a transaction does not fall within sections 213 to 218, Taxes Act 1988 since there is no distribution and hence no exempt distribution. Section 209(1) confirms that any distribution made 'in respect of share capital in a winding up' will not be an income distribution (and hence section 213 will not apply). Therefore relief must be sought elsewhere; in this case by virtue of sections 136 and 139(1), Taxation of Chargeable Gains Act 1992.
Tax analysis
Individual shareholders
Shareholder reconstruction relief should be available under section 136, Taxation of Chargeable Gains Act 1992 (subject to the bona fide requirement of section 137(1)).
Distributing company (ManCo)
Company reconstruction relief from chargeable gains arising on the disposal of David & Dwight should be available under section 139(1), Taxation of Chargeable Gains Act 1992.
One final area of concern though is section 192, which offers the protection of no degrouping charges (arising under section 179).
A liquidation under section 110, Interpretation Act 1986 cannot take advantage of this section (as we have no exempt distribution) and hence, depending on the circumstances and values of the assets, a corporation tax charge could well arise, assessable on David and Dwight.
Section 425, Companies Act 1985
In the event of ManCo not having sufficient reserves to effect the demerger, application to the court under section 425 could be used to provide a solution. This is likely to be costly and will more than likely introduce additional time constraints into the picture.
The main distinction between the section 110 route and the section 425 route is that the former can be achieved by means of winding up ManCo, where section 427(3)(d), Companies Act 1985 specifically says that ManCo will not be liquidated.
Following on from this, section 209, Taxes Act 1988 confirms that a distribution by way of a reconstruction under section 425, Companies Act 1985 may be a Schedule F distribution. While there does appear to be some doubt as to whether there is a distribution (due to section 209(5) and (6), Taxes Act 1988 – distribution between resident companies), it has been said that, unless the transaction satisfies the demerger legislation (and hence exempts the distribution), the section 110, Insolvency Act 1986 route should be used as an alternative.
On the basis that section 425, Companies Act 1985 is applicable and the transaction proceeds, then the tax treatment will follow that of an indirect demerger, with Dwight and David each being transferred to a separate NewCo.
One final point to consider is the effect on Dwight and David ceasing to be members of the same group. While section 139, Taxation of Chargeable Gains Act 1992 offers protection against the charge to corporation tax on any chargeable gains, it will not prevent a degrouping charge arising.
Practical tax issues
Having covered the mechanisms by which the demergers are effected, it is useful to look at some of the practical issues that usually arise in a transaction.
Further consideration will need to be given to other non tax areas, for instance, trustee shareholders, impact on group creditors, impact on bank guarantees. However, these are beyond the remit of this article.
Statement of Practice 5/85
As mentioned earlier, the Government introduced legislation in 1980 that would facilitate 'the splitting up of a group... allowing businesses to pursue their own separate ways... under independent management'.
Bearing in mind that sections 136 and 139, Taxation of Chargeable Gains Act 1992 play a pivotal role in ensuring that much of the demerger legislation can operate practically (without a tax charge), it seems strange that in order for a scheme of reconstruction (in accordance with those sections) the Revenue considers that 'substantially the same' shareholders should own the business, in the same ratio, both before and after the transaction.
In the example, what would be the position if only Brian were to receive shares in Dwight (with Alex remaining as the sole shareholder of David)?
The Revenue has recognised this problem and bridged the gap with Statement of Practice 5/85 which extends the Revenue's statutory interpretation of reconstruction. Paragraph 3 confirms that where separate companies are established to take over individual parts of an undertaking and each company is owned by a separate group of shareholders, then the Revenue will treat this as amounting to a reconstruction for the purposes of capital gains tax (section 136) and corporation tax on capital gains (section 139) but not for stamp duty purposes.
From a practical point of view, retained reserves permitting, such a demerger could be effected by the reclassification of the share capital of ManCo (into A and B ordinary shares – the A shares deriving their value, etc. from David and the B shares from Dwight). A dividend in specie would then be declared in respect of the B share capital with Brian only benefiting.
Chargeable payments
The general proviso of the demerger legislation is that such a transaction should be effected for bona fide commercial reasons and does not form part of a scheme to avoid tax.
Following on from that, anti-avoidance legislation acts effectively to prevent a demerger being used to place cash from any of the companies involved in the demerger (or even companies connected with the companies involved in the demerger) into the hands of the shareholders direct in a non taxable form.
This is policed by the chargeable payment régime in accordance with section 214, Taxes Act 1988. Should any such payments be made within five years of the demerger the following will apply:
the payment will be taxable (as income) on the recipient shareholder under Schedule D, Case VI;
section 349, Taxes Act 1988 will apply (unless the payment is not a money payment) and the payer must deduct tax at the basic rate and account to the Inland Revenue under the CT61 régime – no deduction against corporation tax will be given for such payments.
The word payment has a wide meaning and is extended to cover the transfer of value satisfied in cash (excluding the payment by dividend), non cash or the assumption of liabilities. Readers should note though that a payment will not be treated as a chargeable payment if it is made for bona fide commercial reasons, constitutes a distribution or is made to another company in the same 75 per cent group.
Inland Revenue press release dated 29 June 1980 gives some guidance confirming that a buy back within five years of the demerger would be treated as a chargeable payment, though a sale would not.
Practitioners will therefore need to exercise care to ensure that no such payments are made. It would be wise for a company to take advantage of the existing clearance procedure and seek comfort from the Revenue that any proposed payments to shareholders will not be treated as chargeable.
Reconstruction or amalgamation
It was noted above that many of the tax reliefs permitting the division of companies (or groups) rely on there being a reconstruction or amalgamation. But what does the Revenue mean by this?
Rather unhelpfully, sections 136(2) and 139(9), Taxation of Chargeable Gains Act 1992 say that a scheme of reconstruction or amalgamation means a scheme for the reconstruction of any company or companies or the amalgamation of any two or more companies.
While formal guidelines have not been laid down by the courts, certain judgments have been given (predominantly in stamp duty cases) that are regarded as authoritative in the area. Perhaps the most appropriate is that of Mr Justice Buckley in South African Supply & Cold Storage Co Limited [1904].
In essence, the judgment requires there to be substantially the same identity of shareholders before and after the reconstruction. The Revenue interprets a reconstruction (in Statement of Practice 13/80) as having being effected if 90 per cent of the undertaking is the same before and after the transaction – the same being measured by such factors as turnover, profits and assets).
As touched on above, a strict interpretation of this definition would not allow us to split up a company by transferring different activities to different shareholders, were it not for Statement of Practice 5/85.
Value added tax
The transfer of Dwight to NewCo should constitute a transfer of a business as a going concern under Regulation 6 of VAT Order 1995 (Statutory Instrument 1995/2518). Care should also be taken, if appropriate, to deregister Dwight from the existing ManCo VAT group.
In summary
As practitioners will find, demergers are complex transactions and unfortunately in many cases the legislation is not tailormade to assist. However, with due thought and care it should be possible to find a way through the maze.
Martin Dawson is a tax director within Lathams tax planning team and can be contacted by e-mail on martin_dawson@lathamsgroup.co.uk.
 

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