Holding companies and demergers
The Five-Year Rule After a Statutory Demerger, Explained
For five years after a statutory demerger, some payments to shareholders can be taxed as income. It is often mistaken for a ban on selling. It is not.
On this page8 sections
Key takeaways
- 1A statutory demerger under sections 1073 to 1099 of the Corporation Tax Act 2010 lets a trading company or group pass a trading subsidiary, or a trade, to its shareholders as an exempt distribution.
- 2Section 1086 provides that if a chargeable payment is made within five years after an exempt distribution, its amount or value is chargeable to income tax, or to corporation tax on income.
- 3The rule is aimed at value reaching shareholders outside the dividend rules without a genuine commercial reason.
A statutory demerger can separate two trading businesses without income tax or capital gains tax for the shareholders, provided the conditions are met. The relief has a tail, though. For five years after the demerger, certain payments by the companies to their shareholders can be taxed as income. People often take this to mean they cannot sell for five years. That is not what the rule says.
A quick reminder of the relief
A statutory demerger under sections 1073 to 1099 of the Corporation Tax Act 2010 lets a trading company or group pass a trading subsidiary, or a trade, to its shareholders as an exempt distribution. An exempt distribution is not a distribution for corporation tax purposes, so the shareholders pay no income tax on it, and the capital gains reliefs normally mean there is no disposal either. Because the relief is generous, the legislation includes rules to stop value leaking out of the companies tax-free soon afterwards. That is the chargeable payment regime.
What the rule says
Section 1086 provides that if a chargeable payment is made within five years after an exempt distribution, its amount or value is chargeable to income tax, or to corporation tax on income. Section 1087 stops the company deducting it.
Section 1088 defines a chargeable payment. It needs all four of these:
| Condition | In plain English |
|---|---|
| A | Paid by a company concerned in the exempt distribution, directly or indirectly, to a member of that company or of another company concerned |
| B | Made in connection with shares in one of those companies, or a transaction affecting those shares |
| C | Not made for genuine commercial reasons, or part of a tax avoidance scheme |
| D | Not a distribution or exempt distribution, and not made to a company in the same group |
"Payment" includes a transfer of money's worth, not only cash. Section 1089 adds a wider rule for unquoted companies, which can catch payments made under arrangements with the company or its main participators.
Section 1089 adds a wider rule for unquoted companies, which can catch payments made under arrangements with the company or its main participators.
What it means in practice
The rule is aimed at value reaching shareholders outside the dividend rules without a genuine commercial reason. Items that need checking include:
- a purchase of own shares that qualifies for capital treatment
- loans to shareholders, or releasing a shareholder's debt
- transfers of assets to shareholders at an undervalue
- payments to shareholders for their shares by a company connected with the demerged companies
Ordinary dividends are distributions, so they sit outside the rule and are taxed as dividends in the normal way. Payments with a genuine commercial reason and no tax avoidance purpose are also outside it.
Three simplified illustrations
These show how the rule works and are not advice on any case.
A retiring shareholder. Two years after a statutory demerger, one demerged company buys back the shares of a retiring director, and the buyback qualifies for capital treatment. As it is not a distribution, it could in principle be a chargeable payment. If it is made for genuine commercial reasons, such as the director's retirement, and is not part of a tax avoidance scheme, it is not chargeable. A section 1096 return may still be needed, and section 1092 clearance is worth considering beforehand.
A loan to a shareholder. A company concerned in the demerger lends a large sum to a shareholder on terms with no real expectation of repayment. That looks like value passing to a member in connection with their shares, and would need careful review against the conditions.
A normal dividend. A company pays its usual annual dividend. As a distribution it falls outside the chargeable payment rules and is taxed as a dividend.
The knock-on effect: degrouping
Usually, a company leaving a group because of an exempt distribution does not suffer a degrouping charge on assets it received from the group. Under section 192(4) TCGA 1992, however, that exemption falls away if a chargeable payment is made within five years. So a payment to a shareholder can bring back a corporation tax charge on assets moved before the demerger.
Reporting, even if nothing is chargeable
Section 1096 imposes two duties to report, each within 30 days:
- where a chargeable payment within the five years consists of a transfer of money's worth
- where a payment or transfer within the five years would be a chargeable payment, except that it was made for genuine commercial reasons and is not part of a tax avoidance scheme
So even a commercial payment may need a return explaining why it is not chargeable. This comes on top of the return due within 30 days of the exempt distribution itself.
Clearance for payments
Section 1092 lets a company ask HMRC in advance to confirm a proposed payment will not be a chargeable payment. HMRC must respond within 30 days of receiving the application, and may ask for further particulars first. For any significant payment to shareholders within the five years, this is often worth doing.
What about selling one of the companies?
This is where confusion arises. The chargeable payment rule concerns payments by the companies. A sale of shares by the shareholders to an unconnected buyer is a separate question.
The larger risk with a sale comes from the conditions for the exempt distribution itself. Section 1081 requires that the distribution is not part of a scheme or arrangement with a main purpose of, among other things, outsiders acquiring control of the distributing company or another company concerned, or a trade ceasing or being sold after the distribution. HMRC's guidance says the demerger provisions do not apply where the trading activity is to be sold or is to become owned by someone other than the existing members.
| Situation | Main risk |
|---|---|
| Sale arranged or planned when the demerger happens | The distribution may not be exempt at all, whenever the sale takes place |
| A genuinely unplanned later sale by shareholders to a third party | Not a chargeable payment in itself, but the whole arrangement should be reviewed |
| A company pays shareholders for their shares, or makes other payments, within five years | Possible chargeable payment, a return, and loss of the degrouping exemption |
If a sale is likely, a statutory demerger is often the wrong route, and a capital reduction demerger is usually more flexible, though it has its own anti-avoidance rules.
A five-year checklist
- Diary the end date of the five years from the exempt distribution.
- Review any payment, loan, asset transfer or buyback involving shareholders before it happens.
- Record the commercial reasons for each.
- Consider section 1092 clearance for significant payments.
- File any section 1096 return within 30 days.
- Remember the degrouping position for assets moved within the group before the demerger.
- Take advice before any talks with a buyer or investor.
Our specialist team prepares the advice, which is reviewed by a Chartered Tax Adviser. If you are planning a statutory demerger or have already completed one, book a call with our team. Our post on statutory demergers gives the background.
This article is general information, not advice. Tax rules change and their effect depends on your circumstances. Please speak to us before acting.
For more on how demergers work in practice, see our specialist demerger practice, Demerger Tax.
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