What is a demerger and how is it taxed?

Here is a comprehensive answer on what a demerger is and how it is taxed under UK law.

What is a Demerger?

A demerger is a series of transactions which have the effect and purpose of dividing the trading activities carried on by a single company or group of companies between two or more companies or groups of companies.

In broad terms, this may take place through making a distribution of the assets of a holding company to that company's shareholders.

Demergers relate to trading activities only and can involve all sizes and types of company. The provisions do not apply where a trading activity is to be sold or becomes owned by a person other than the existing members of the original company.

What the law says

The two types of demerger

1. Direct demergers (CTA10/S1076): A company (the "distributing company") makes a distribution to its members consisting of shares in a company (the "demerged company") which is a 75% subsidiary of the distributing company.

2. Indirect demergers (CTA10/S1077): A distributing company makes a distribution to one or more transferee companies consisting of either a trade or trades, or shares in one or more 75% subsidiaries, and shares are issued by the transferee company/companies to shareholders of the distributing company.

Capital Gains Treatment (TCGA 1992, s.192)

TCGA92/S192 has effect for facilitating transactions whereby trading activities carried on by a single company or group are divided so as to be carried on by two or more companies not belonging to the same group or by two or more independent groups.

Where a company makes a distribution which is exempt by virtue of CTA10/S1076:

• The distribution shall not be a capital distribution for the purposes of TCGA92/S122; and
• Sections 126–130 TCGA92 (share reorganisation provisions) shall apply as if the distributing company and the subsidiary whose shares are transferred were the same company and the distribution were a reorganisation of its share capital.

Furthermore, TCGA92/S179 (the degrouping charge) shall not apply in a case where a company ceases to be a member of a group by reason only of an exempt distribution — unless within 5 years of the exempt distribution a chargeable payment is made, in which case the degrouping charge can be reinstated.

Anti-avoidance: Chargeable Payments (CTA10/S1086)

Payments made within five years of an exempt distribution by any of the companies involved in the demerger (or companies connected with them) are treated as "chargeable payments" and are chargeable to Income Tax or Corporation Tax on income. The payer must deduct tax at the basic rate and account for it to HMRC.

Chargeable payments exclude distributions, exempt distributions, or payments made for genuine commercial reasons.

HMRC Guidance / Practice

Purpose of the regime

The tax system would normally inhibit the splitting up of businesses because such a split involves a distribution under CTA10/S1000. The demerger provisions in CTA10/Part 23/Chapter 5 aim to make it easier to divide and put into separate corporate ownership the trading activities of a company or group by removing the distribution charge in appropriate circumstances — making the distribution an "exempt distribution".

Income Tax treatment for shareholders

Where there is an exempt demerger, the distribution of shares (or issue of shares by a transferee company in an indirect demerger) is not a distribution for Corporation Tax purposes and is not dividend income of the shareholders. Therefore, there is no Income Tax liability of any kind in respect of the receipt of the shares.

Capital Gains treatment for shareholders

For the shareholder receiving the exempt distribution, the distribution will:

• Not be income; and
• Normally not give rise to a capital gains disposal — either because it is not a capital distribution and the share reorganisation rules (TCGA92/S126–130) apply, or because the demerger forms part of a reconstruction to which TCGA92/S136 applies.

No degrouping charge on loan relationships

Where a company leaves a group solely because of an exempt distribution, there is also no de-grouping charge under CTA09/Part 5/Chapter 4 on its loan relationships.

Clearance procedure

Companies may seek advance clearance under CTA10/S1091 that proposed transactions will constitute an exempt demerger. Even where clearance is given, the chargeable payments legislation at CTA10/S1086 can still apply if the demerger is subsequently exploited for avoidance purposes.

Summary Table