Demerging: how to split a business into two separate parts

So you’ve decided to split your business into separate parts, and you want those parts to be owned entirely independently of each other. This might be because parts of the business are developing in very different ways, or it may be because you have a buyer for one part, but not for the other. Whatever the reason, you may have thought that you could simply transfer out the business and assets that you want to separate; but now your accountant is telling you that that could have some horrible tax consequences and that you may need to use a more protracted process, like demerging, in order to minimise the tax exposure.

So what is a demerger?

It is a segregation of business activities initially held under common ownership, hopefully in a way that removes (or substantially reduces) any tax cost.

A demerger can either result in two separate businesses, each with the same shareholders holding same proportions in the new ownership structures (mirroring the pre-demerger ownership); or it can be a partition demerger, which is where the demerged business has only a few of the original shareholders.

A straightforward demerger can often by undertaken without a tax penalty; whilst a partition demerger will usually suffer some tax leakage when it comes to stamp duty (at 0.5%).

Why demerge?

The common reasons for wanting to demerge a business are:

• to separate different business sectors;
• to facilitate a sale or investment into only part of a business;
• to promote a material change in strategic focus;
• to divide a jointly owned group (which is often the solution for dividing family businesses where the inheriting parties disagree as to how the businesses should be developed);
• to return value to the shareholders; or
• to unlock the value of underlying businesses.

How to demerge

There are four main ways for demerging a business:

(i)                  by direct dividend demerger

(ii)                by indirect (or three cornered) demerger

(iii)               using a Section 110 Insolvency Act liquidation scheme demerger; or

(iv)               undertaking a capital reduction demerger

Each of the four types of demergers listed above enable the company to:

• split its business without a tax cost for the company (subject to the point about partition demergers and stamp duty mentioned above) enabling the businesses to develop independently of each other; and
• avoid a deemed distribution or disposal tax charge falling on the shareholders as a result of the restructuring.

It is often the case that options (i) and (ii) cannot be used, because to do so requires a company to have distributable reserves equal to the book value of the assets being demerged.

This leaves the Section 110 Insolvency Act demerger (which requires the appointment of a liquidator, and for that reason is often perceived by businesses to be a disadvantage) or a capital reduction demerger.

The focus of this article is the capital reduction demerger, because the last couple of years have seen a marked increase in the number of such demergers being undertaken. Their suddenly popularity is presumably as a consequence of the introduction of the corporate solvency procedure, which requires only a statement of solvency to be signed by all directors in order to undertake a capital reduction, as opposed to the historic requirement for court approval.

Capital reduction demergers

A capital reduction demerger involves a parent company (which may have been specifically inserted into a company structure for the purposes of doing the capital reduction demerger) resolving to reduce its share capital in order to return some capital to its shareholders. But instead of transferring cash to shareholders to satisfy the capital reduction, the company transfers shares that relate to the part of the business being demerged.

The reason for taking this slightly long-winded approach (or at least what may sound like a long-winded approach) is to prevent a taxable distribution arising for the shareholders. A capital reduction demerger prevents an income distribution by repaying the capital paid up on shareholders’ shares by way of capital reduction so that no distribution arises.

In very basic terms, a capital reduction demerger requires the following steps:

• a new company (“Newco”) is incorporated and placed on top of the company whose business is going to be split (although this may not always be necessary, it will depend on whether the existing company has sufficient share capital to accommodate the capital reduction);
• Newco incorporates a new subsidiary and the part of the business that is to be demerged is transferred from the company to the new subsidiary. This leaves a group with Newco at the top, and two separate subsidiaries beneath it;
• a further new company is incorporated (“Newco2”), so that when Newco reduces its share capital and goes to distribute the shares in the new subsidiary (carrying the demerged business), those new subsidiary shares can be transferred to Newco2. Newco2 in turn issues shares in itself to the shareholders of Newco.

Provided the shareholders receive Newco2 shares in accordance with the company reconstruction tax rules, they are not treated as having disposed of their shares in Newco. Rather, the Newco2 shares are treated as having been acquired at the same time and for the same cost as the Newco shares.

This means that any gain in the Newco shares is not taxed until the disposal of the Newco2 shares.

Practical considerations

There are some practicalities to consider before undertaking any sort of demerger; for example:

• Consider the impact on any pension schemes
• Consider the impact on any employee share option schemes; for example, does it trigger exercise?
• Can each of the demerged entities operate separately/independently of each other after the restructuring (is there going to need to be joint sharing of premises, IP sharing, or shared use of admin facilities such as HR and IT?)
• HMRC clearance can be obtained prior to undertaking the demerger to confirm that the proposed restructuring should benefit from reconstruction relief in respect of chargeable gains and that it will not fall foul of the transactions in securities anti-avoidance rules.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2023.