At a time when deal structure matters more than ever, are we about to lose an important source of optionality?

The government has unexpectedly proposed a major rewrite of the UK rules governing the taxation of distributions. The proposed reforms could affect almost every aspect of corporate restructuring, but few areas are likely to feel the impact more than demergers.

Under the current law, it is generally possible to separate one business into two without paying any tax whatsoever, provided there is no fundamental change of ownership and all trade and assets remain within a corporate wrapper. This makes sense as from a true economic perspective, nothing has really changed. Businesses demerge for many reasons, but one of the most common is to separate a business ahead of a sale, where selling the entire group may not be commercially desirable.

Why presale demergers matter

There is a statutory route to demerge which, in theory, should be the simplest way to achieve a demerger. The relevant business is distributed to shareholders without triggering a tax charge. In reality, though, this route is so hedged with conditions that it is often unusable. The main stumbling block is the condition that there be no onward sale. Statutory demergers are simply not allowed for pre-sale demergers.

This never used to matter that much as there were two other, equally serviceable, ways to demerge the 'three cornered' liquidation demerger and the capital reduction demerger. Both can be cumbersome, requiring multiple new entities and carefully sequenced steps to achieve, and both rely on a number of different reliefs all working together. Both, however, were very well understood in the market by tax advisors and corporate lawyers, were regularly blessed by HMRC through the clearance application process and, though sometimes costly and complex, relatively low risk.

The current demerger routes

The new proposals are expressly intended to prevent these routes being used in most cases. Most companies do not usually have the required amount of share capital to effect either of these types of demerger, and so part of the demerger process involves creating new share capital (often through share for share exchanges) in order to unlock the demerger opportunity.

Under the proposals, share capital would effectively be 'frozen' at the amount originally invested. The consultation makes clear that this is intended to close off traditional demerger routes, even if the detail as to how this freezing would take place is currently unclear.

How the proposed tax reforms would change the rules

The government's stated intention is to balance this with a relaxation of the rules around statutory demergers, in order to make this route the new default. While this would be a welcome step, the current proposal only relaxes the 'no onward sale' restriction for a five-year period rather than removing it altogether.

It may also be disapplied where all the trade is demerged, potentially allowing for the extraction of investment properties, but for many businesses it may still leave pre-sale statutory demergers out of reach.

Will statutory demergers fill the gap?

The rules are only at consultation stage at the moment and there is no indication of when they could be implemented or guarantee of what the final form of the regime would look like. But in its current form, pre-sale demergers look as though they will be impossible to implement in many cases. In a market where deal structure is increasingly important, reducing the availability of pre-sale demergers risks removing a valuable strategic option. The consequence may not be fewer transactions, but transactions pursued through structures that are less well aligned with the parties' commercial objectives.

What businesses should do now

If you are currently contemplating any pre-sale demerger, it would almost certainly make sense to implement this as soon as possible before any changes to the existing rules come into force. Even if there are no immediate plans to demerge, consideration could be given to maximising share capital now before the "freezing" rules come into place.

If the new rules apply in the way currently intimated, businesses would be well advised to consider if their structures require optimisation now and definitely well before even contemplating any sort of sale process.

Our corporate and tax teams have extensive experience advising on and implementing demerger structures. If you are considering a sale, separation or wider restructuring, speak to Tom Rank, Kate Featherstone, Amar Adatia or a member of the team for more information.