There are a number of different methods for demerging assets from a corporate entity. One particular method – the capital reduction demerger – has become increasingly popular in recent years.
Why consider a capital reduction demerger?
It is common for a business, over time, to accumulate a variety of assets – such as properties, intellectual property, investments or cash reserves. Not all of these assets may be required for the normal trading of the business so business owners in this situation may want to consider separating, or demerging, these assets from the business.
There are a number of potential benefits to this:
- to protect the assets in the event of a claim against the trading company (i.e. if the assets have been demerged out of the trading company, a trading creditor will not usually be able to pursue them);
- as the first step towards extracting value for the shareholders (either through dividends or a sale of a corporate entity)
- for estate planning and business succession purposes.
The capital reduction demerger process can be complicated, but is set out step by step below as a case study.
Case study
Mr and Mrs Smith each own 50% of their company, TradeCo. In addition to a profitable trading business, TradeCo also owns a valuable share portfolio. Mr and Mrs Smith would like to extract the share portfolio in order to protect it against any claims brought against TradeCo and to increase their options for passing the value of the share portfolio to their children, without affecting the trading business. The value of TradeCo is 90% attributable to the trading business and 10% attributable to the share portfolio.
Step 1 – Introduction of a Holding Company
Mr and Mrs Smith will set up a new company, HoldCo#1, which will acquire all of the shares in TradeCo from Mr and Mrs Smith in exchange for the issue of shares in itself. At the end of Step 1, Mr and Mrs Smith each own 50% of HoldCo#1 and HoldCo#1 owns TradeCo. TradeCo continues to own the trading business and the share portfolio.
Step 2 – First Transfer of Demerging Assets
TradeCo will declare a dividend in favour of HoldCo#1 of the share portfolio. At the end of Step 2, TradeCo continues to own the trading business but the share portfolio is now owned by HoldCo#1.
Step 3 – Second Transfer of Demerging Assets
HoldCo#1 will create a second subsidiary, InvestCo, and transfer the share portfolio to InvestCo as payment for a subscription of shares in the capital of InvestCo. At the end of Step 3, HoldCo#1 owns two subsidiary companies, being TradeCo (which continues to own the trading business) and InvestCo (which now owns the share portfolio). Mr and Mrs Smith continue to each own 50% of HoldCo#1.
Step 4 – Division of Share Capital
The share capital of HoldCo#1 will be split into two classes:
- A shares, which represent HoldCo#1’s ownership of TradeCo; and
- B shares, which represent HoldCo#1’s ownership of InvestCo.
Assuming there are 100 shares in the capital of HoldCo#1 and the values attributable to the trading business and share portfolio remain 90% and 10% respectively, then the 100 shares will become 90 A shares (45 owned by Mr Smith and 45 owned by Mrs Smith) and 10 B shares (5 owned by Mr Smith and 5 by Mrs Smith).
Step 5 – Capital Reduction Demerger
Mr and Mrs Smith create a further new company, HoldCo#2. The demerger can now be completed by the following steps occurring simultaneously:
- HoldCo#2 acquires InvestCo from HoldCo#1;
- Rather than pay HoldCo#1 for InvestCo, HoldCo#2 instead issues shares to Mr and Mrs Smith such that they each own 50% of HoldCo#2;
- HoldCo#1 cancels the B shares (which, following Step 4 above, represent HoldCo#1’s ownership of InvestCo) by way of a capital reduction, which is a statutory process requiring the directors of HoldCo#1 to confirm that HoldCo#1 is solvent and will remain so for at least 12 months; and
- Mr and Mrs Smith effectively “lose” their shares in HoldCo#1 but gain them back in HoldCo#2.
At the end of this Step 5, Mr and Mrs Smith own 50% each of HoldCo#1, which owns TradeCo. Mr and Mrs Smith also own 50% each of HoldCo#2, which owns InvestCo. The two groups of companies are now completely separate from each other, but remain owned by the same shareholders.
Further factors to consider
The above is, perhaps surprisingly, a simplification of the process – there are numerous other factors to be considered depending on the specific circumstances of the business in question. Examples include:
- tax clearances – before commencing the process, it is necessary to get the advance permission of HMRC;
- the valuation of the assets to be retained and demerged – this is critical to ensuring that the demerger takes effect as intended (i.e. the proportions of shares split into the classes in Step 4 above must accurately reflect the proportionate values of the assets involved);
- the solvency of the business – the directors must be confident that there is no risk of the company being or becoming insolvent, as they will be personally liable and the consequences can be severe;
- the nature of the assets to be demerged – this can have an impact on how the assets are moved between the various companies and the timescales involved; and
- whether the trading business will be affected by the demerger – the process involves a change of control of the trading entity (i.e. when it is acquired by HoldCo#1), which can trigger termination or other adverse clauses in trading contracts with customers and suppliers.
The Progeny Law and Tax team has extensive experience of planning and implementing capital reduction demergers. For more details, please get in touch, or see the Progeny Club Legal subscription offering for details.
