A demerger is the process in which a function of a company is detached from the primary body, thus creating two or more entities with different functions. However, it is often the case that both the original company and the newly created entity are under the same group.

A business may choose to conduct a demerger for a variety of ends. In the case of a company with a range of services, one reason would be to create specialties for a particular product line or service. Through detachment of a key product line from the primary entity, it is possible for employees within this successor entity to develop specialization, rather than generalized skills.

Another common reason to adopt the demerger strategy is to avoid diseconomies of scale, often associated with larger businesses. By detaching a company from less profitable product lines, or from a division facing upcoming issues, this enables the primary company to enhance shareholder value and allocate a greater quantity of resources to more profitable areas. This also allows for the avoidance of legal liability in some cases.

A demerger can be carried out in numerous forms

  1. Dividend in specie, often through the avenue of exempt demerger. This is the process of the transfer of certain assets as dividends to shareholder, either directly or to a company owned by the shareholders.
  2. Reduction of capital. The original company will simultaneously reduce share capital and transfer assets to a company owned by shareholders.
  3. Liquidation under Insolvency Act 1986 S110. In this scenario, the initial company ceases to exist, with assets being transferred to two or more companies owned by the same shareholders.

A demerger, although having the potential to create economies of scale within an entity, can also produce tax liabilities. This is because, through the transfer of share capital and other assets from one entity to another, this may be considered a chargeable disposal liable to capital gains tax for the shareholders of the original entity.

A shareholder can avoid taxable liable on receipt of shares if a demerger is within the provisions of Part 23, Chapter 5, S1081 of the Corporation Tax Act 2010. That is: the companies involved reside within the UK; both the distributing company and the new company are trading; must benefit the trading activities of both companies; must not be carried out for solely tax purposes or produce a chargeable payment.

A direct demerger under these provisions will also qualify for rollover relief under the Taxation of Chargeable Gains Act 1992 S192. Otherwise, the demerger must fall under S136 of TCGA 1992 to avoid Capital gains tax.

For a company, a demerger may also give rise to a disposal by the original entity, given by the market value of the assets transferred. To avoid any chargeable gain, the shares transferred must either qualify for substantial shareholding exemption (SSE) or fall under the rollover relief provisions outlined in TCGA 1992 S139.

If you would like a clear picture on how this may affect you, please do not hesitate to get in touch. 

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