Partitioning a property company free of tax
Introduction
One of your clients, Propco, is a successful property investment company. It is owned in equal shareholdings by a brother and sister who have a keen eye for property with high capital growth potential. This has paid off, as the company’s property portfolio has a total base cost of £500,000, but is currently worth £2 million.
The siblings are approaching retirement age, and the brother has made an offer to purchase half of the properties so that he can plan for his retirement.
However, they are concerned about the corporation tax (CT) and stamp duty land tax (SDLT) liabilities arising on a straight sale, and the funding for the purchase which will need a large amount of bank finance.
Basic planning
Recall that for tax purposes, the chargeable gain in these circumstances will be calculated by reference to the actual market value of the property, and not the price actually paid.
A very basic form of planning would be to review the underlying gains on each property, and transfer the ones with the lowest increases in value since they were purchased. However, there is a much better option that you could consider.
Demerging
A demerger could be a tax-efficient alternative to a sale. This involves the splitting of two or more businesses from within a single company, into one or more new companies. It can also be used to separate two or more companies from within a group of companies.
A demerger can either retain the same shareholders for both the old and new companies or, in the case of a partition demerger, split the shareholders so that only some of the original shareholders retain the old company and some own the new company.
Broadly speaking, there are three types of demerger:
- statutory demerger
- liquidation demerger; and
- capital reduction demerger.
In all cases, the essence is that the business or company being split is transferred from the company to the shareholders (directly or indirectly) using the company’s own income or capital resources.
Pro advice. As a demerger uses a company’s own resources to transfer the business being separated, there is no need for your client to obtain bank finance to fund the purchase. A demerger therefore solves your client’s secondary problem of funding the purchase.
Which demerger?
Propco can’t use a statutory demerger, as these are only available to trading companies. Propco’s business activities consist of residential lettings, i.e. exploitation of land, and it is therefore classed as an investment company. It would need to use either the liquidation or capital reduction route.
A liquidation demerger would involve Propco being placed into a members’ voluntary liquidation, with the respective properties being distributed to two new companies that are owned separately by the siblings. The new companies would issue shares to the siblings in return.
This is a viable option, but it carries the negative perception of liquidation (even though it is a solvent liquidation). It also means that a liquidator’s fee will be incurred, and there is a possibility that SDLT will be payable.
Capital reduction
A capital reduction demerger involves the return to the shareholders of original share capital. In your client’s case, rather than returning cash to the siblings, properties would be transferred to them of equal value to the share capital being reduced.
Pro advice 1. It is imperative that Propco has sufficient share capital equal to the value of the properties being demerged for this to work.
Pro advice 2. If Propco does not have sufficient share capital to cover the transfer of the properties, for example because the company was incorporated with only £100 of share capital, it can create the required share capital by inserting a holding company above it using a share-for-share exchange.
Example. Propco has properties valued at £2 million with half of them to be transferred to the brother. Propco will therefore need to have share capital of at least £1 million to cover the £1 million of properties leaving the company.
On the assumption that the value of Propco is equal to the value of the properties it owns, i.e. £2 million, company law will allow the new holding company to issue shares to the siblings up to a value of £2 million, in exchange for the shares it receives in Propco.
Your client’s new holding company will then have share capital of £2 million available to reduce and cancel as part of the demerger.
Pro advice. Getting an accurate and up to date valuation of the properties will be crucial, so ensure the transaction takes place as soon as is feasible after a valuation to protect against price fluctuations.
Step by step
Carrying out a capital reduction demerger for Propco would involve four steps.
Step 1. Insert a holding company (Holdco) above Propco via a share for share exchange, issuing shares in Holdco to the siblings equal to the value of Propco. This forms a group of two companies.
Step 2. Transfer the properties that are going to the brother from Propco to Holdco. This is an transfer between two companies in the same group, so it does not trigger any CT or SDLT charge.
Pro advice. If Propco has sufficient distributable reserves, the transfer should be paid as a dividend in specie rather than as a loan. This will ensure there is no risk of a claw back of SDLT group relief as a distribution in specie is exempt from SDLT.
Step 3. Reorganise the shares in Holdco into A and B shares, with the brother owning the A shares, and the sister owning the B shares.
Pro advice. The rights attaching to the A shares should be amended so that they only carry entitlement to the properties within the holding company, i.e. the properties that are going to the brother. The rights attaching to the B shares should be amended so that they only carry entitlement to the shares in Propco, which will now only own the properties going to the sister.
Step 4. Undertake a reduction of share capital in the holding company in respect of the B shares. As the B shares only carry entitlement to the shares in Propco, it is the shares in Propco that are returned to the sister in exchange for her B shares being reduced.
Pro advice. In order to avoid any tax implications on the reduction of share capital, the shares in Propco should not be transferred directly to the sister, but rather to a new company (Newco) owned solely by her, who will then issue shares to her in return.
End result
The result of these steps is that the brother is the sole owner of Holdco, which owns half of the properties, and the sister is the sole owner of Newco. Newco in turn owns Propco, which owns the remaining half of the properties.
Stamp duty
The only tax charge that arises is stamp duty at 0.5% on the transfer of shares from Propco to Newco. As the shares are valued at £1 million, the charge would be £5,000, which is far lower than the CT and SDLT that would arise on a straight sale.
There is a planning technique known as swamping which could significantly reduce this charge, and we will look at it in detail in a separate article.
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