Two of the most common approaches, particularly where property or other investments are involved, are capital reduction demergers¹ and liquidation demergers¹, the former often being preferred because it is more straightforward to implement and avoids the stigma associated with liquidations.
A preliminary stage to most demergers is the insertion of a new holding by share for share exchange which would then be liquidated or reduce its share capital to facilitate the transfer (or retention) of assets between different shareholders. Historically this preliminary step could often be achieved without any tax cost, including stamp duty.
However, the unheralded introduction in 2016 of a disqualifying arrangements test at S77A FA 1986 reared an inadvertent challenge. The impact of this rule is to prevent stamp duty relief in respect of transactions where arrangements are in place for a person or persons to obtain control of the acquiring company. Where the outcome of a subsequent demerger is for different shareholders to take control of different groups of assets, stamp duty relief may not be available when the holding company is inserted, particularly in capital reduction demergers.
It¹s worth noting that in such transactions, a charge to stamp duty in respect of the demerged assets is often already unavoidable (particularly in light of other changes in Finance Bill 2019-20).
Since S77A was introduced, parting shareholders have therefore potentially been forced to accept duplicate and seemingly disproportionate tax transaction costs or, because of the way HMRC interprets the definition of a change of control differently in different types of demerger, to pursue the transaction by way of an alternative liquidation demerger which comes with greater complexity, cost and commercial risk. In worst cases, plans may need to be abandoned.
Hidden in the Finance Bill 2019-20 is a potential gem for those of us frequently advising on demergers: a relaxation to S77A so that the change of control clause essentially disregards situations where the person(s) obtaining control of the company have owned more than 25% for the past three years, subject to enactment next year.
It is clear from explanatory notes accompanying the change that this is drafted with capital reduction demergers in mind and is undoubtedly a positive step. In most cases, the demerger will not be a disqualifying arrangement, restoring flexibility to plan demergers without superfluous tax risks.
The above said, there do still appear to be some seemingly arbitrary deficiencies in the drafting and the relaxation will not always provide the protection expected. In some cases it will still not be possible to avoid duplicate stamp duty charges and, whilst these limited circumstances may be more acceptable collateral damage, it¹s unclear why any is necessary.
Family-run companies, as well as larger corporates, will often have minority shareholders: perhaps younger generations or employee or investor shareholders who will not independently own 25% of the shares.
Consider a recent experience where an investment company is owned by the second and third generations of two founding brothers, those two family units wanting to separate. This still may not be possible using a capital reduction demerger without potentially significant stamp duty exposures whereas the brothers themselves could have separated before they died and achieved a more efficient outcome, despite having arguably less of a commercial reason for doing so.
There is also a further hurdle in the requirement that the relevant shareholders must have held the requisite 25% for at least three years. There may have been changes in the shareholders or a prior reconstruction (circumstances do change after all) which mean that shares have not been held for the prior three years.
It is also not an uncommon structuring arrangement to insert multiple new holding companies before undertaking the demerger itself, for example where it¹s more desirable to transfer assets between companies by distributions in specie, potentially to manage SDLT charges if property is involved. In those cases, shareholders won¹t have held shares in those companies for three years such that the successive acquisitions benefit from the new relaxations.
These may feel like niche technical examples but every reconstruction is unique and there are always a range of factors and tax risks to balance. The commercial reality of most demergers is however that the financial value held by each shareholder is unchanged. No cash is created and any tax charges must be funded by other means. In extreme circumstances those tax charges can prove prohibitively high.
The proposed amendment goes part of the way to resolving the challenges inherent in the original drafting of S77A but it is still unclear why this was spilling over into demerger transactions in the first place. If the intention of this revision is to provide protection in legitimate commercial reorganisations (bearing in mind most of the relevant reliefs have commercial purpose tests anyway), it still seems inequitable that multiple stamp duty charges should arise even in obscure scenarios. More flexibility would be preferred.
It is our intention to comment on the consultation to encourage a more flexible and commercial set of changes but in the meantime S77A still has the potential to be a trap to be wary of.
Peter Mills is a corporate tax senior manager at accountancy firm, Menzies LLP.