Indirect demerger of a trade – part 1
Updated: Oct 30
Paul Davies, FCA, senior tax writer at Croner-i, considers the tax considerations when separating a company’s trading activities in a statutory demerger
Paul Davies, FCA Senior tax writer, Croner-i
This two-part article investigates how to achieve a tax efficient separation of a company’s trading activities by way of indirect demerger under the exempt distribution rules in Corporation Tax Act [CTA 2010], Pt. 23, Ch. 5.
Such demergers, alongside direct and indirect demergers of subsidiary companies, are commonly referred to as statutory demergers.
Under an indirect demerger, the trading activities which are going to be separated from the retained trading activities will be transferred by the original company to a standalone, newly-incorporated company [NewCo], in return for an issue of new ordinary shares by NewCo to the original shareholders of the original company.
A direct demerger, by contrast, would arise where the demerged activities were distributed by the original company directly to shareholders of the original company. A direct trade demerger does not, however, qualify for the same income tax reliefs as an indirect trade demerger and is therefore not considered any further.
The main tax challenge in any indirect trade demerger is to ensure that receipt of the newly issued NewCo shares by the original shareholders of the distributing company does not give rise to:
(1) an income tax charge for the original shareholders based on the value of the distribution;
(2) a chargeable gains part-disposal by the original shareholders of their original shareholdings in the distributing company; and
(3) a chargeable gains disposal by the distributing company in relation to any chargeable gains assets included within the assets of the trade distributed to NewCo.
The first part of this article will outline the conditions that must be satisfied in order that the shareholders of the distributing company can avoid the income tax charge. Part 2 will focus on the chargeable gains reliefs necessary to avoid the two chargeable gains disposals.
We will see that a statutory indirect trade demerger may be appropriate where trading activities presently carried on by the distributing company are capable of separation into two [or more] trades and where the intention is that each of the separated trades will be carried on by two (or more) companies under the common ownership of the original shareholders of the distributing company.
At times such a demerger is not appropriate where one or more of the demerged activities do not constitute trading activities, eg, property or other investment business, or in connection with:
(1) a proposed sale of one of the demerged trades;
(2) the cessation of one of the demerged trades;
(3) the acquisition of control of any of the parties to the demerger;
(4) uncommercial or tax avoidance motives; or
(5) the making of a chargeable payment.
It can be useful to distinguish between separation and partition demergers. The former arises where the demerged trade is distributed to NewCo in consideration for the issue by NewCo of new ordinary shares to the original shareholders of the distributing company in proportion to their original shareholdings.
The overall effect is that the original shareholders will hold shares in both the distributing company and NewCo in the same proportion as their original distributing company shareholdings.
A partition demerger is a variant of the demerger described above in which the new ordinary shares issued by NewCo are not issued in proportion to the original shareholdings.
For example, in the case of two original shareholders, A and B, each holding 50% of the distributing company, a partition demerger might involve the issue of new ordinary shares solely to shareholder B, together with the cancellation of B’s original shareholding in the distributing company.
The overall effect is that shareholder A would own 100% of the shares in the distributing company and that shareholder B would own 100% of the shares in NewCo.
Income tax relief
The exempt distribution rules provide income tax relief under CTA 2010, s1075. This provides that ‘an exempt distribution is not a distribution of a company for the purposes of the Corporation Tax Acts’.
As the income tax definition of distribution derives from the corporation tax definition, this means that an exempt distribution will not give rise to a distribution for income tax purposes.
A number of different types of distribution are capable of falling within the exempt distribution rules. In the context of our example, the relevant definition is in CTA 2010, s1077(1) which applies to a distribution consisting of both:
(1) the transfer by a company to one or more other companies (the transferee company or companies) … of … a trade or trades ; and
(2) the issue of shares by the transferee company or companies to all or any of the members of the company making the transfer.
To be an exempt distribution, the distribution must satisfy each of conditions A to D in CTA 2010, s1081 ; each of conditions G to K in CTA 2010, s1083; and (if the company making the transfer is a 75% subsidiary of another company) conditions L and M in CTA 2010, s1085. Looking at each of these requirements in turn:
This requires that each relevant company (here, the distributing company and Newco) is resident in the UK, or an EU member state, at the time of the distribution.
Condition B is that, at the time of the distribution, the distributing company must either be a trading company or a member of a trading group, ie, a company whose business (or a group the business of whose members taken together) consists wholly or mainly of carrying on a trade or trades.
Condition C is that the distribution must be made wholly or mainly for the purpose of benefiting some or all of the trading activities which before the distribution are carried on by a single company or group, and after the distribution will be carried on by two or more companies or groups.
Condition D is that the distribution must not form part of a scheme or arrangement the main purpose of which (or one of the main purposes of which) is:
(1) the avoidance of tax;
(2) the making of a chargeable payment;
(3) the making, in pursuance of a scheme or arrangements with a company, or with any of its main participators, of what would be a chargeable payment if that company were unquoted;
(4) the acquisition by any person or persons, other than the members of the distributing company, of control of:
• the distributing company (or other company in the same group);
• any other relevant company; or
• any company which belongs to the same group as the distributing company or any other relevant company;
(5) the cessation of a trade after the distribution; or
(6) the sale of a trade after the distribution.
A chargeable payment arises if:
(1) a payment (including the transfer of money’s worth or the assumption of a liability) is made by a company concerned in an exempt distribution (directly or indirectly) to a member of that company or any other company concerned in the exempt distribution;
(2) the payment is made in connection with shares in the company making the payment; in connection with shares in any other company concerned in the exempt distribution; or in connection with any transaction affecting the shares of those companies;
(3) the payment is not made for genuine commercial reasons, or forms part of a tax avoidance scheme; and
(4) the payment is not a distribution or an exempt distribution, and is not made to a company in the same group as the company making the payment.
A chargeable payment made within five years of an exempt distribution is chargeable to income tax or corporation tax.
Condition G is that, if a trade is transferred, the distributing company must either not retain any interest in that trade, or must retain only a minor interest in it.
Condition H is not relevant to distributions of a trade.
Condition I is that the only or main activity of NewCo (and any other transferee companies) after the distribution must be the carrying on of the trade.
Condition J is that the shares issued by the NewCo (and any other transferee company) must not be redeemable; must constitute the whole (or substantially the whole) of its issued ordinary share capital; and must confer the whole (or substantially the whole) of the voting rights in that company.
Condition K is that the distributing company must, after the distribution, be either a trading company or the holding company of a trading group.
Condition L, applicable only where the distributing company is a 75% subsidiary of another company, is that the group (or, if more than one, the largest group) to which the distributing company belongs at the time of the distribution must be a trading group.
Condition M, applicable only where the distributing company is a 75% subsidiary of another company, is that the original distribution must be followed by one or more further exempt distributions, and result in members of the holding company of the group (or, if more than one, the largest group) to which the distributing company belonged at the time of the original distribution becoming members of:
(1) NewCo (and any other transferee company) to which a trade was transferred by the distributing company; or
(2) a company (other than the holding company) of which the company or companies mentioned in (1) above are 75% subsidiaries.
This completes our look at the legislative conditions required for the distribution to be income tax exempt in the hands of the original shareholders under the exempt distribution rules.
It is important to understand that these provisions do not, as a general rule, provide chargeable gains relief to either the original shareholders in the distributing company, or to the distributing company itself. These issues, alongside other commercial and accounting issues, will be considered in Part 2.