HMRC proposes ending Capital Reduction Demergers: What businesses need to know

As businesses grow, their structures often become more complex. Expansion, acquisitions and investment can create opportunities, but they can also make it harder to manage the business or prepare part of it for sale. Restructuring can provide greater flexibility, but with HMRC proposing significant changes to the rules around capital reduction demergers, business owners may need to act sooner rather than later.

Businesses grow organically; they recruit people, enter new markets, design and create new products, and to do this, they often raise funding to tackle a growing thirst for investment. One consequence of success is that your business structure can become unwieldy and costly to manage, and it may not provide the flexibility if someone offers to buy part of it from you.

For example, imagine you start a veterinary business in Bristol with a single practice. Thanks to a strong reputation and loyal clients, the business grows steadily until you own five practices across the city. Fuelled by this success, you expand further, opening practices in Exeter and Bath before acquiring another in Birmingham. You now have a thriving business operating across four major UK cities.

However, while the Birmingham acquisition is profitable, it’s simply too far away to manage effectively, so you decide to sell it. When you speak to your adviser, you’re told that although a sale is possible, the profits would remain locked within the company. After years of hard work and investment, you had hoped to extract some of the value you’ve created personally, rather than leaving the proceeds trapped within the business.

To do this, you are told that you can reorganise the group that you have grown so that the bit you want to sell is owned by you personally without triggering any taxes and that when you sell, you will get the money personally and pay capital gains tax on those profits. This makes a lot of sense to you, as this is exactly the outcome had you simply owned the Birmingham practices in your own name and not within the wider group.

So, the question is, how?

Currently there are three main ways of doing this that, subject to the mechanical conditions being met and, critically, HMRC granting clearance that they agree that the transaction is not being carried out to avoid tax, allow you to restructure without triggering income tax, capital gains tax or corporation tax:

• A capital reduction demerger;

• An exempt demerger; and

• A liquidation demerger.

By far and a way the most common methodology we see in practice is the first one, a capital reduction demerger. This article does not cover how this is done. But in principle, it works by splitting out part of it to the same shareholders so that it is held independently without triggering a tax charge.

So, what’s the problem?

From time to time, HMRC releases consultations whereby they outline changes to existing legislation or whole new policies to the public and request feedback through a list of questions.

A couple of weeks ago they did just this, and you can find a link to it right here.

Within its pages, HMRC announce that they want to remove the ability for groups to carry out a capital reduction demerger. In its place, they intend to alter an existing process known as an ‘exempt demerger ’, by making its conditions more flexible.

On the face of it, this all sounded rather good. Whilst a capital reduction is a well-trodden path, it is reasonably complicated and takes both time and cost to execute. An exempt demerger is perhaps simpler on the face of it and therefore potentially more attractive – all that you are really doing is declaring a distribution to the shareholders of the shares in the company that you want to demerge. If you can do this without triggering a tax charge, then it would be preferable to do this thanhave tofollow a more complicated process to get the same end result.

However, the proposals announced by HMRC contain a nasty; if the shareholder sells their stake in the business within 5 years of the exempt demerger taking place, the disposal proceeds would automatically be subject to income tax and not capital gains tax. This is not strictly true; there are always carve-outs, but as a capital reduction is often done to spin out a company that the owner wishes to sell in the not too distant future, this condition may prevent them from doing so.

Importantly, HMRC seem to want to leave the ‘liquidation demerger’ route in place (often referred to as a section 110 demerger after the insolvency provisions that it relies upon). However, these are expensive to operate and necessitate the liquidation of an entity that some clients steer away from.

Why does this matter?

Any reorganisation takes time. And it would appear that we may be running out of it if you want to reorganise your business using a capital reduction demerger. Whilst we have no idea if HMRC proposals will come to light or when they may do so, we strongly suggest that if you are thinking about doing something like this, that you begin that process now.

Need advice

If you’re planning a business reorganisation or think the proposed changes to capital reduction demergers could affect you, our tax specialists are here to help. Contact the team to discuss your options and ensure you’re well prepared for any future changes.