Companies may need to reduce their capital, for example to:
- repay excess cash to shareholders
- create distributable reserves to be able to pay dividends
- help with a demerger or spin out of a subsidiary
In this article we consider the following key issues:
- legal process
- accounting treatment
- tax treatment
(this article is a summary only, there’s alot of rules and regulations around this that would need to be carefully considered, as well as the specific circumstances affecting a company and the intentions behind the transaction)
1) Legal process
Under the Companies Act 2006 s.641 a private limited company can reduce its share capital without a court order or auditors statement, but it will need a special resolution supported by a solvency statement. A plc would usually need to get a court order and auditors statement.
Special resolution
The special resolution will require at least 75% of shareholders to agree to the capital reduction and they must be able to see the solvency statement at the general meeting, or if voting on a written resolution it should have been sent along with the proposed resolution (s.283 & 642).
Solvency statement
The solvency statement needs to be made by the directors of the company and it basically confirms that the company will be able to repay its current debts and also those falling due within the next 12 months.
To be able to make it, the directors would need to carefully review all of the company’s existing liabilities as well as contingent and prospective liabilities.
The solvency statement should not be taken lightly as its a criminal offence to issue it without having reasonable grounds. Directors should also consider if they have adequate insurance.
The solvency statement has to be made a maximum of 15 days before the date on which the special resolution is to be passed (s.642). So for example, if the directors make the solvency statement on 1 January 2023, holding a shareholders meeting on 31 January 2023 would be too late.
Filing at Companies House
The special resolution, solvency statement and also a statement of capital (form SH19) have to be registered at Companies House within 15 days of the resolution passing (s.644).
2) Accounting treatment
The share capital can be reduced in any way and s.641 mentions:
Share capital includes the nominal value of the shares issued, as well as share premium and capital redemption reserve. Revaluation and merger reserves are not usually included, but it may sometimes be possible to do other transactions/adjustments first to try and use these.
If share capital is directly reduced rather than share premium or capital redemption reserve then the shares would need to be cancelled at Companies House.
A key issue is that if excess capital is to be repaid using a reserve, then it can only repaid if there are sufficient distributable reserves. So if a company has accumulated losses then these need to be cleared first. But if the capital is reduced and there is a payment to shareholders at the same time, then accumulated losses don’t need ot be considered.
Paying dividends
If the purpose of the reduction of capital is to pay dividends in future then the share capital would be reduced and profit and loss reserves would be increased.
For example, a company has £500k share capital and £200k accumulated deficits and so cannot pay and dividends. It could reduce share capital by £300k to result in £100k profit and loss reserves which are distributable as dividends. The accounting entry would be:
Dr share capital £300k
Cr P&L reserves £300k
Surplus cash
Using the same example as above, rather than paying £100k dividends in future, the shares could be cancelled and the £300k cash could be repaid immediately, without having to create a reserve and pay dividends:
Dr share capital £300k
Cr cash £300k
Demerger/spin out
For example, a subsidiary is being spun out to raise investment on its own and the existing shareholders of the parent will be the new shareholders of the subsidiary (ie removing the parent company) and the subsidiary has a book value of £500k. A share capital reduction could be accounted for:
Dr share capital £500k
Cr Investment in subsidiary £500k
3) Tax treatment
Generally, if dividends are paid via a reserve to shareholders then they would be taxed as income. Generally, if share capital is directly repaid without a P&L reserve being created then its taxed as capital. If the amount repaid is the same as the original cost for the shareholders, then there is no capital gains tax.
The tax treatment can get REALLY complicated! So we’ve only put a short summary here which is very generalised as there are many possible scenarios.
See CTM15440 and CG57810 in HMRC’s manuals as a starting point.
Example
For example, as described in the accounting treatment section above, share capital is reduced and there is an immediate payment to the shareholders without a reserve being created.
The reduction does not form part of the company’s realised profits and so isn’t a distribution that has been subject to corporation tax.
The payment will normally be treated by HMRC as a repayment of share capital under TCGA92/S122 (unless its part of a demerger in which it case it may fall under TCGA92/S126 to S130 or S136)