Breaking Up Is Hard To Do

Unscrambling a company throws up a variety of complications, warns DAVID YOUNG.

'I BELIEVE THAT there are cases where businesses are grouped together inefficiently under a single company umbrella. They could in practice be run more dynamically and effectively if they could be "demerged" … and allowed to pursue their own separate ways under independent management.'

These remarks are taken from Geoffrey Howe's Budget statement 1980. It is hard to fault the former Chancellor's logic as he introduced the demerger legislation, but he could not have anticipated just how inefficient grouping would become with the advent of taper relief. On the one hand, the sale of a business by a group will incur corporation tax, unless the disposal is of shares in a subsidiary which can benefit from the substantial shareholding exemption, but in any event there will be a further charge on extracting the profit into the hands of the shareholders. Compare this to the sale of shares in a trading company by individual shareholders with the benefit of the 75 per cent exemption from business asset taper relief.

Unfortunately, unscrambling a corporate structure is a great deal harder than incorporating in the first place but, nevertheless, there are many circumstances which would lead shareholders to consider splitting the businesses in a company or group, such as:

• One trade may be sufficiently successful to merit a flotation, but it may be held back by a less dynamic trade in the group.
• Finance requirements between trades may differ: one may attract venture capital but this may not be appropriate with a poorer trade in the group.
• One trade may be likely to be sold in the future, but another is to be retained or is unsuitable for sale.
• Shareholders may simply disagree over the future direction of the businesses with the result that each may wish to take a business and go his separate way.
• A business may have been passed to the children of the founder, but they cannot work together.
• A group may have significant investment assets, prejudicing the availability of business asset taper relief on the shares in the holding company. This would also adversely affect the substantial shareholding exemption, and after 6 April 2003 make it impossible to gift shares in the holding company. (From that date the definition of a trading company for section 165, Taxation of Chargeable Gains Act 1992 purposes will change to mirror the taper relief definition.)

This is not an exhaustive list. There are many more reasons for a group or even a company to be split. The common factor is the difficulty of achieving this without a penal tax charge.

This can be done by making use of the demerger provisions in sections 213 to 218, Taxes Act 1988 to split trading businesses apart. The requirements are onerous, however, and will not, inter alia, allow the demerger of an investment business. For that, we need to consider a reconstruction making use of a liquidation under section 110, Insolvency Act 1986.

In this article, I will introduce the concepts of each of these mechanisms to highlight when they can be useful. It is not intended to be a definitive guide.

Demergers

A demerger is the splitting off of a trade or subsidiary from a company or group by way of a distribution in specie. The legislation acts to make this distribution exempt.

There are three types of demerger envisaged in the Taxes Act 1988:

• A distribution directly to all or any of the members of a company of shares in a 75 per cent subsidiary.
• A distribution of the assets of a trade to one or more companies in exchange for an issue of shares by those companies to all or any of the members of the distributing company.
• A distribution of the shares in one or more 75 per cent subsidiaries to one or more companies in exchange for an issue of shares by those companies to all or any of the members of the distributing company.

It is not necessary for all the original shareholders to be involved in the new companies or in the demerged subsidiary afterwards. This effectively allows the mechanism to be used for two purposes. The first allows one trade to be carried on by one or more shareholders, and a second trade to be carried on by a different shareholder. For example, Mr A and Mr B may run a combined heating and air conditioning company. A demerger would allow Mr A to continue with the heating business while Mr B ends up with the air conditioning business.

Alternatively the shareholders can remain the same in what is known as an 'across the board' demerger. In that case, Mr A and Mr B would both continue in the businesses afterwards but, with the heating business owned separately from the air conditioning business, only in the same proportions as before.

Tax implications

The tax position on each of the types of demerger is as follows.

Type 1

• The distribution is exempt.
• No capital gains tax arises to the members.
• There is no stamp duty on the distribution in specie.
• The only charge is a capital gains tax charge on the distributing company based on the market value of the subsidiary. The existence of this exit charge meant, in the past, that this type of demerger was extremely rare. However, with the introduction of the substantial shareholding exemption, in many cases this gain will also now be exempt. For the first time, therefore, Type 1 demergers have become a more attractive option. It has the considerable advantage of placing the demerged subsidiary directly in the ownership of the members.

Type 2

• The distribution is exempt.
• No capital gains tax arises to the members.
• There is no exit charge in the distributing company, this is avoided by the operation of sections 136 and 139 Taxation of Chargeable Gains Act 1992.
• If the demerger is made across the board, any balancing charge on fixed assets can be avoided by making elections under sections 266 and 567, Capital Allowances Act 2001.
• Where, however, the demerger is made to certain members only, unless they are connected and the succession provisions in section 343, Taxes Act 1988 apply, there would be a balancing charge.
• The Revenue will normally accept that stock can be transferred at the lower of cost or realisable value.
• For stamp duty purposes, an across the board demerger is likely to be exempt under section 75, Finance Act 1986. Where the transfer is to certain members only, there will be a charge, but in most cases section 76, Finance Act 1986 will reduce this to 0.5 per cent.

Type 3

• The distribution is exempt.
• No capital gains tax arises to the members.
• As with a Type 2 demerger, there is no exit charge in the distributing company.
• Stamp duty will also be similar to a Type 2 demerger, i.e. generally exempt where it is across the board, but otherwise a charge at 0.5 per cent.

Value added tax

There should be no VAT on a Type 1 or Type 3 demerger, and under a Type 2 the transfer will normally be a transfer as a going concern. There are particular rules, however, for property on which there is an option to tax and for transfers of going concerns in partial exemption situations.

Revenue clearances

Clearance is needed under sections 215 and 707, Taxes Act 1988 in all types of demerger and in addition under sections 136 and 139, Taxation of Chargeable Gains Act 1992 in the case of Type 2 and 3 demergers.

Conditions to be met

There are a number of, sometimes onerous, conditions which limit the use of demergers, including:

• The companies must all be United Kingdom resident.
• Both distributing and demerged companies must be trading companies, or in the case of the parent company, a member of a trading group. 'Trading company' for this purpose means one whose business consists wholly or mainly of carrying on a trade.
• The demerged company must be a 75 per cent subsidiary.
• The distribution must be for the benefit of the trade.
• The distribution must not be made for the purposes of:
  • the avoidance of tax or stamp duty;
  • the acquisition by persons who are not members of control of the company;
  • the cessation of a trade or its sale;
  • the making of chargeable payments.

Chargeable payments are payments made, other than for bona fide commercial reasons, to the members within five years of the demerger.

The first essential feature of this long list of conditions is that demergers are appropriate only for trading companies. They do not assist with the splitting out of an investment company. In addition, the requirements relating to change of control and sale of a trade mean that a demerger cannot be made when there is a present intention to bring the trade to an end or to sell. It is not a means to implement a sale or to allow a company to be wound up. The Revenue will refuse clearance in these situations or will seek to withdraw it, if it subsequently becomes clear that there was an intention to sell.

The consequence is that if the demerger is being made to improve the taper relief position, it must be made well in advance of any disposal. Forward planning is therefore essential.

On the other hand, demergers allow part of a group to be split without impacting on the remaining businesses. In addition, the absence of the de-grouping charge allows for considerable flexibility in reorganising the group beforehand to transfer assets or create new subsidiaries. Unfortunately, this may not prevent a stamp duty charge if properties are moved into the demerged companies prior to the split.

Once the demerger has been made, however, the shareholders will have an increased opportunity to sell in the future in a way that maximises the taper relief and for those who wanted to go their own way, they can take their own business forward without having incurred a tax penalty.

Liquidations

The statutory demerger legislation does not help in every case, however, and there are, in particular, two common scenarios where a statutory demerger cannot provide the answer:

(a) where an investment business is to be split from a trading business; or

(b) where a business is to be separated so that it can be sold in the near future.

Both these situations often derive from taper relief issues. In the first case, the full amount of business asset relief may be prejudiced by the existence of a significant amount of investments in the company and, in the second case, where part of the company (or group) business is to be sold, the shareholders will want direct access to the business asset taper relief.

Where can we find an alternative reconstruction mechanism that works?

The answer lies in a liquidation under section 110, Insolvency Act 1986. This works by liquidating the original company (or the holding company in a group structure) and distributing the assets as a capital distribution on liquidation. The assets are not distributed to the shareholders directly, however, but transferred to new companies in exchange for an issue of shares to some or all of the original shareholders.

Investment/trade split

Take for example, the situation where A and B own a successful trading company where the profits have been used to invest in a portfolio of residential properties. The shares in the company will be non-business assets for taper relief purposes because of the existence of the property portfolio. This position can be rectified by taking the following steps:

• Two new companies are created.
• The original company is placed in members' voluntary liquidation and the assets distributed.
• The properties are transferred to one new company in exchange for an issue of shares in that company to A and B.
• The trading business is transferred to another new company, also in exchange for shares issued to A and B.
• Revenue clearances should be obtained under the share exchange provisions in sections 136 and 139, Taxation of Chargeable Gains Act 1992, and under the general anti-avoidance rules for transactions and securities in section 707, Taxes Act 1988.
• No capital gains tax arises on the transfer because of the application of the share exchange provisions.
• No stamp duty arises since the transfers are being made across the board, i.e., the shareholdings afterwards are a mirror image of the shareholdings before. Section 75, Finance Act 1986 will exempt the transactions.
• For VAT purposes, the transfers are going concerns, although if there is an option to tax on the properties, the new company would also need to make the election.
• The new shares stand in the shoes of the old shares and the taper relief period continues uninterrupted, but now the shares in the trading company will become business assets. An apportionment is required to take account of the previous non-business status, but the position will gradually improve from that day forward. For the investment company, the shares will continue to be non-business assets.
• The cost base in the old shares is transferred on an apportioned basis to the new companies and the assets are transferred at no gain/no loss.

It would also be possible to use the same mechanism for splitting the business between A and B so that, for example, A takes the investments and B the trade. The steps to implement this are broadly the same, although in that case the stamp duty exemption in section 75, Finance Act 1986 would not apply, since there is not a mirror image shareholding before and afterwards. However, the alternative relief in section 76 would be available to restrict the stamp duty to 0.5 per cent on the value of the assets transferred.

A and B have now achieved a separation of the investments from the trading business which means that business asset taper relief on the trading business is secured. It can ultimately be disposed of, allowing them to access the taper relief and also to retain the investment properties.

On a separate note, it also ensures that for inheritance tax purposes, business property relief will be available on the trading company, whereas this could also be prejudiced by the existence of investment assets on the original company's balance sheet.

Separating two trades

An even greater benefit is obtained in the scenario where A and B own a company that has two trading businesses, one of which they are seeking to sell and one of which they wish to retain. If nothing is done, the company would have to sell the assets of the trade, incurring a capital gain chargeable to tax at 19 per cent or 30 per cent as appropriate, and the shareholders will not be able to wind it up because of the existence of the other trade. Any extraction of the sale proceeds would have to be by way of income distribution, leading to further tax on the individual shareholders.

However, if the two trades are split by liquidating the company and following the steps above, it is open for A and B to sell the company containing the marketable trade and to benefit from the full 75 per cent taper relief exemption. They can retain the trade that they wish to keep in another company, which can also be sold or wound up in the future with the full taper relief exemption. In short, the tax on sale is limited to ten per cent of the gain, instead of something closer to 40 per cent or even 47.5 per cent if no action is taken.

The fact that a sale is contemplated would not prevent the reconstruction from proceeding effectively, as long as no formal arrangements are in place to sell at that time.

Groups

The liquidation route also works where there is a group position. The shares in subsidiary companies are simply transferred to a new company in exchange for an issue of shares in the same way as above.

However, one drawback of this form of reconstruction is that the de-grouping provisions in section 179, Taxation of Chargeable Gains Act 1992 are not disapplied as they are with a statutory demerger. This means that it is not possible to restructure a group by transferring assets prior to the liquidation, without incurring a gain. Care also needs to be taken where previous intra-group transfers have taken place in the last six years. Again, a gain could be triggered. This imposition of a gain under section 179 would eradicate the benefit of the reconstruction. The charge can however, sometimes be avoided by liquidating the existing subsidiaries and transferring all the assets to the holding company before splitting out to the new companies.

Other points

The provisions of the Insolvency Act require that the company be put into formal liquidation. Winding up under Extra-statutory Concession C16 is not appropriate for this type of reconstruction.

There is also a requirement that what is distributed is 'the whole or part of the company's business'. This can be a difficult issue. A trading business will always represent the whole or part of a business but, where investments are being distributed, there is a need for these also to represent a business. Business, in this context, requires a degree of activity and commercial organisation and there is some doubt that a single investment property would be sufficient to meet the definition.

Where the old and new companies are under common control and the succession provisions apply, the fixed assets can be transferred at written down value by making an election under section 266, Capital Allowances Act 2001 in the case of plant and machinery, or section 569 in the case of industrial buildings. This does require, however, that the predecessor and successor are connected. Where shareholders have split the company to go their separate ways, this may not always be the case.

Trading stock

Where the reconstruction involves a transfer of assets, either by way of a Type 2 demerger or a section 110 liquidation, trading stock will be transferred for consideration, i.e. the shares issued by the new company. The shares will reflect the value of the assets transferred. In theory, therefore, the stock should be transferred at market value and even where the old and new companies are connected, the election under section 100, Taxes Act 1988 may not be available to allow a transfer at cost. This could be particularly awkward where the stock involved is land and buildings.

There is, however, no consideration passing to the old company in return for the stock and, in practice, it is likely that the Revenue will accept a transfer at book value provided both companies agree and the same value is used for the opening stock figure.

Conclusion

Although a complex concept, the demerger provisions have become a very useful tool in the tax planner's armoury. Geoffrey Howe's comments remain true that there are times when companies are grouped together inefficiently, at least for tax purposes, and the benefits of obtaining full taper relief can be substantial.

There is a need, however, especially with statutory demergers to start the process well in advance of the time it is needed, and it is worth reviewing cases now to identify those where this kind of reconstruction would be beneficial.

David Young is a tax consultant at Berg Kaprow Lewis, and can be contacted on 020 8922 9104 or david.young@bergkaprowlewis.co.uk.

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