Capital reduction demergers: the tax, step by step

A capital reduction demerger looks like a company law exercise. Resolutions are passed, a solvency statement is signed, a new company issues shares. But each step has a different tax consequence, and each consequence has its own conditions. The relief that works for the shareholders can fail on stamp duty. The step that is neutral for capital gains tax can create a corporation tax charge on degrouping.

This article takes a typical two-newco capital reduction demerger and goes through the tax at each stage. It focuses on tax, not on the Companies Act mechanics. For how the route compares with a liquidation demerger, see capital reduction or liquidation demerger?. For the 2026 anti-avoidance change, see Finance Act 2026: the new anti-avoidance test for reconstructions. For property, see moving property in a demerger: the SDLT traps.

The structure we are following

The steps below are a common pattern. Yours may differ, and the order matters.

1. Share exchange. The shareholders of the existing company (call it Trade Co) exchange their shares for shares in a new holding company, Holdco. Trade Co becomes a subsidiary.
2. Reclassification. Where different shareholders will end up with different businesses, Holdco's shares are reclassified into separate classes, one for each business.
3. Transfer to Newco 2. Holdco transfers one of its businesses, or a subsidiary holding it, to a second new company (Newco 2). Newco 2 issues its shares direct to Holdco's shareholders, not to Holdco.

After step 4, Holdco and Newco 2 each own part of what used to be one business. If the shareholders are staying together, they own both. In a partition, different shareholders own each.

Step 1: the share exchange (holdco insertion)

Shareholders: section 135 TCGA 1992. Where Holdco issues shares to the shareholders in exchange for their Trade Co shares, and Holdco holds or will hold more than 25% of Trade Co's ordinary share capital (or one of the other tests is met), the exchange is treated as a reorganisation of one company's share capital under sections 127 to 131. The new Holdco shares are treated as the same asset as the old Trade Co shares, with the same base cost and acquisition date. There is no disposal, so no capital gains tax.

Anti-avoidance: section 137, as rewritten. Since Finance Act 2026, section 137 applies where arrangements have a main purpose of reducing or avoiding capital gains tax or corporation tax. It applies to arrangements involving an issue of shares or debentures on or after 26 November 2025. HMRC's guidance says it does not apply where the advantage consists solely of deferral consistent with the purpose of the reorganisation rules. The question is whether anything extra has been added to the arrangements. Plans for later steps are part of those arrangements, so they need to be disclosed and explained.

Clearance: section 138. A section 138 application asks HMRC to confirm the exchange will be effected without arrangements to which section 137 applies. It must be made before the shares are issued, by the acquiring company or the target, with full disclosure. A clearance given on incomplete disclosure is void.

Stamp duty: section 77 FA 1986. Share transfers attract stamp duty at 0.5% of the consideration, unless a relief applies. Section 77 relief removes it on the instrument transferring the Trade Co shares to Holdco, broadly where:

• Holdco acquires the whole of Trade Co's issued share capital
• the only consideration is shares in Holdco issued to Trade Co's shareholders
• Holdco's share classes, and each shareholder's proportion of each class, mirror those in Trade Co (or as nearly as may be)
• the acquisition is for bona fide commercial reasons and not part of a scheme with a main purpose of avoiding tax
• there are no "disqualifying arrangements" under section 77A

That last test is the one to watch. Disqualifying arrangements are those where a purpose is that a particular person, or particular persons together, obtain control of Holdco. A person who held at least 25% of the target throughout the three years before the share issue is excluded. HMRC's stamp taxes manual says relief can be denied where arrangements give particular persons control and that exclusion is not met. If the plan is a partition where one shareholder will end up controlling a company, the interaction with section 77A needs to be looked at before the exchange, not after.

Relief under section 77 is not automatic. The stock transfer form must go to HMRC for adjudication with details of the relief claimed, and the same-day stamping service cannot be used. Section 76, the old reduced rate, was repealed in 2012. Don't rely on advice that refers to it.

Income tax. Inserting a holding company above the same shareholders does not itself pass value out. But it is a transaction in securities, and it can be the first step in arrangements that are looked at as a whole. We come back to this below.

Step 2: reclassifying the shares

Reclassify after the share exchange, not before. Reclassifying first can break the mirror-image condition for section 77 relief.

In a partition, the shareholders' shares are reorganised into separate classes, so that one class can be matched with one business. HMRC's own manual example of a partition uses this approach, with the original shares reorganised into A and B shares.

Tax points:

• Capital gains. A reorganisation of share capital is not a disposal. Under section 127 the new classes are treated as the same asset as the old shares, and the base cost is apportioned between the new classes.
• Stamp duty. If the classes are created in Holdco before the exchange and do not mirror those in Trade Co, section 77 can be lost. The sequencing of the share exchange and the reclassification needs to be planned with this in mind.
• Income tax. Altering the rights attached to securities is itself within the definition of a transaction in securities in section 684(2) ITA 2007. Rights that move value from one shareholder to another need a close look.

Where the shareholders are not splitting, a reclassification is often unnecessary. Everyone holds the same proportions in both companies.

Step 3: the capital reduction

Company law first. A private company can reduce its capital by special resolution backed by a directors' solvency statement. The statement must be made not more than 15 days before the resolution, and the reduction takes effect when the registrar registers the documents. The reserve arising is treated as a realised profit under the Companies (Reduction of Share Capital) Order 2008. Directors who sign a solvency statement without reasonable grounds commit an offence.

Why this is not an income distribution for shareholders. Section 1000(1) CTA 2010 defines a distribution, but excludes any amount representing a repayment of capital. A repayment of share capital is therefore not a distribution for corporation tax purposes. In many reductions nothing is paid to shareholders at all. The reduction simply turns share capital into a reserve that can support the transfer in step 4.

When it could be a distribution. The exclusion is not absolute:

• Bonus issues. Under section 1022 CTA 2010, where a company repays share capital and later issues share capital paid up other than by receipt of new consideration, the amount paid up can be treated as a distribution. A bonus issue after a reduction deserves careful thought.
• Value other than capital. If what shareholders receive is worth more than the capital that was repaid, or is paid out of profits rather than capital, the excess can be a distribution. The "repayment of capital" label does not decide it.
• Cash or other consideration. Cash, loan notes or other value alongside the new shares can change the analysis for the shareholders under section 136 and for the transactions in securities rules.

We do not recommend treating a capital reduction as a way to extract distributable value. Its job in a demerger is to create the reserves that support a restructuring, in a way that doesn't leave a taxable distribution behind.

Transactions in securities. Repayments of share capital have been within the transactions in securities rules since the Finance Act 2016. The definition of "transaction in securities" in section 684(2)(e) ITA 2007 expressly includes a repayment of share capital or share premium. So a capital reduction is a transaction in securities, and a section 701 clearance is advisable. That does not mean there is a charge. Section 684 applies only where:

• the person is a party to a transaction in securities
• the circumstances are within section 685, which involves close companies and the receipt of relevant consideration (broadly, value representing assets available for distribution) without paying income tax on it
• a main purpose is to obtain an income tax advantage
• an income tax advantage is obtained

Section 686 excludes a fundamental change of ownership, which a demerger between the same shareholders will not be. A section 701 clearance is the way to get HMRC's confirmation in advance. It sits separately from the capital gains clearances, which is why the combined application, discussed below, lists it separately.

For more on this topic see demerger income tax and distributions.

Step 4: the transfer to Newco 2

This is where most of the tax sits.

Shareholders: section 136. Newco 2 issues shares to Holdco's shareholders in proportion to their holdings, under a scheme of reconstruction. Section 136 treats the shareholders as exchanging their Holdco shares for the Newco 2 shares, with sections 127 to 131 applying as if both companies were one. There is no disposal, and the new shares are not an income distribution. A caution: HMRC could argue otherwise, under the transactions in securities rules or as a distribution, if cash or other value is extracted alongside the new shares. That is why clearance is essential, and why the application must describe every step and every payment. The base cost of the original shares is apportioned across the two holdings. For unquoted shares, that is done by reference to market values at the date of the later disposal (section 129).

For this to be a "scheme of reconstruction", Schedule 5AA TCGA 1992 requires, among other conditions, that the successor companies issue ordinary shares only to holders of ordinary shares in the original company, that entitlement is equal within each class, and that the business is carried on by the successor companies. HMRC accepts that a business can be divided and passed to companies issuing shares to different groups of shareholders.

The company: section 139. Holdco transfers a business, or shares in a trading subsidiary, to Newco 2. Under section 139, the transfer is on a no gain, no loss basis, provided Holdco receives nothing from Newco 2 other than the assumption of liabilities. There are conditions on residence and chargeable assets, and trading stock is excluded. HMRC's guidance notes that a controlling holding in a trading subsidiary can be treated as part of the parent's business, but that there may be a problem where the subsidiary only holds investments or property.

The new anti-avoidance test for section 139. Section 139(4A) to (4D), inserted by Finance Act 2026, applies where arrangements involving a transfer of business assets on or after 26 November 2025 have a main purpose of reducing or avoiding capital gains tax, corporation tax or income tax. The section 139(5) clearance now confirms that the reconstruction will be effected without such arrangements.

Two of HMRC's published examples are close to this route:

• A capital reduction demerger to separate a business that is then sold to an Employee Ownership Trust is not caught, because there are no additional arrangements to reduce the shareholders' capital gains tax.
• Restructuring so that a later share sale qualifies for the Substantial Shareholding Exemption is not caught where the conditions are met throughout the relevant period after the restructuring.

Stamp duty on the transfer. Section 75 FA 1986 gives relief on an acquisition under a reconstruction where non-redeemable shares are issued to all the target's shareholders, there are bona fide commercial reasons, and each shareholder holds the same proportions in both companies. Where holdings mirror exactly, section 75 relief is usually available, subject to its conditions and adjudication. In a partition the proportions do not mirror, so HMRC's manual says section 75 relief is not available on the transfer to Newco 2. Stamp duty at 0.5% can then arise on a transfer of shares at their value, so it has to be planned for. Where a business or property is transferred rather than shares, the analysis differs, and SDLT may be the larger concern.

Dividend in specie. HMRC's manual notes that a dividend declared directly in shares in specie normally has no chargeable consideration and no stamp duty, whereas a cash dividend satisfied by transferring shares can be chargeable. That is a different route from the one described here, but it shows how much form drives the answer.

Property: SDLT and the three-year trap

If Holdco's group owns property that moves, SDLT can easily be the biggest cost. In outline:

• Where the buyer is a company connected with the seller, SDLT is charged on at least market value (section 53 FA 2003), even if nothing is paid.
• Group relief (FA 2003 Sch 7) is available between companies in a 75% group. It is not available where, at the time of the transfer, there are arrangements for the buyer to leave the group. If the buyer leaves within three years while holding the property, the relief is withdrawn and a further return is due within 30 days.
• Reconstruction relief can give full relief, but needs mirror-image shareholdings, shares-only consideration and bona fide commercial reasons. A partition fails that test.
• Acquisition relief reduces SDLT to 0.5% of the consideration but requires the undertaking's main activity to be a trade that is not wholly or mainly dealing in land. A rental portfolio generally does not qualify.
• Both reconstruction and acquisition relief are withdrawn if control of the acquiring company changes within three years.

The trap is moving property out of the trading company as a preparatory step, using group relief, and then demerging. The demerger can be the very event that takes the buyer out of the group. See moving property in a demerger for the detail, including Wales and Scotland.

Corporation tax: degrouping, losses and intangibles

Capital gains degrouping (section 179 TCGA 1992). A company that leaves a group within six years of acquiring an asset from another group member, on the no gain, no loss basis in section 171, is treated as having sold and reacquired the asset at market value when it was acquired. The gain falls on the company leaving.

In an exempt statutory demerger, section 192(3) turns off section 179. A capital reduction demerger does not have that protection. HMRC's guidance on reconstructions says section 179 charges are possible. So the real position depends on the group's history. If a property moved into a subsidiary five years ago, that subsidiary leaving the group now can crystallise the gain. Section 179(2) can stop the charge where associated companies leave the group together, for example where both are 75% and effective 51% subsidiaries of the same company throughout, or one is such a subsidiary of the other.

Where the departing company is sold rather than demerged, section 179(3D) adds the degrouping gain to the share sale proceeds, which can let the Substantial Shareholding Exemption cover it. That is a point for a later sale, not for the demerger itself.

Intangible fixed assets. Section 780 CTA 2009 applies a similar charge where a company that received an intangible fixed asset from a group company leaves the group within six years, while still holding it. The asset is deemed realised and reacquired at market value. Section 782A removes the charge where the company leaves on a share disposal that qualifies for the Substantial Shareholding Exemption, which does not help in a demerger. A separate rule (section 818 CTA 2009) makes a transfer of intangibles in a reconstruction tax neutral, but it does not apply to transfers within a group, so any intangibles moved between group companies in the last six years should be reviewed before the demerger.

Group relief for losses. Group relief under CTA 2010 Part 5 needs the surrendering and claimant companies to be in the same group, meaning one is a 75% subsidiary of the other or both are 75% subsidiaries of a third. After the demerger, the companies are no longer in the same group, so losses can no longer be surrendered between them for periods after they separate. Group relief for carried-forward losses (section 188CB onwards) also needs the group condition to be met in the overlapping period. Check which company holds the losses before choosing which business moves.

After the demerger

Selling one of the companies: SSE. Under Schedule 7AC TCGA 1992, a company's gain on a disposal of shares can be exempt if it has held at least 10% for 12 months in the six years before sale and the investee has been a qualifying trading company throughout. Separating trading from investment activities can help, as HMRC's example in CG-APP20 accepts, but only if the conditions are met and no disqualifying arrangements exist.

Selling shares: BADR. An individual's gain on shares can qualify for Business Asset Disposal Relief at 18% from 6 April 2026, on up to £1m of lifetime gains, if the company is a trading company (or the holding company of a trading group), the individual is an officer or employee and holds at least 5% of the ordinary share capital and voting rights, throughout the two years to sale. Section 127 treats new shares as the same asset as the old ones, so the shareholders' earlier ownership usually counts towards the two-year period, and HMRC's manual (CG63975) looks back through a share exchange to the original company. But the new company must itself meet the trading company conditions, and the individual must meet the officer or employee and 5% tests in relation to it. Take advice before any sale within two years of the demerger. An election under section 169Q can treat a reorganisation as a disposal so BADR is claimed at that point, but it applies to all the shares in the reorganisation. See demerger and Business Asset Disposal Relief.

Inheritance tax: Business Relief. Shares are not relevant business property if the company's business consists wholly or mainly of dealing in securities, land or buildings, or holding investments (section 105(3) IHTA 1984). A holding company of trading subsidiaries is treated differently. After a demerger that puts property into its own company, the property company's shares may not qualify at all. The two-year ownership test is helped by section 107(4), which counts the period of ownership of earlier shares where shares are identified with them under the reorganisation rules. From 6 April 2026, 100% relief applies to the first £2.5m of combined qualifying agricultural and business property per person, and 50% above that. Any unused allowance can pass to a surviving spouse or civil partner. Separating assets can change which of them qualify, so the family's succession plan should be reviewed alongside the demerger.

Associated companies. The small profits rate limits (£50,000 and £250,000) are divided by one plus the number of associated companies (CTA 2010 s18D). A company is associated with another if one controls the other, or both are under the control of the same person or persons. If the same shareholders own Holdco and Newco 2 after the demerger, the two will usually be associated, and the limits are shared. An associated company that has not carried on a trade or business at any time in the accounting period is disregarded (section 18E).

VAT: transfer of a going concern

Moving a business from Holdco to Newco 2 may be a transfer of a going concern (TOGC). Under article 5 of the VAT (Special Provisions) Order 1995, a transfer of business assets is treated as neither a supply of goods nor of services where:

• the business, or a part capable of separate operation, is transferred as a going concern
• the assets will be used by the transferee to carry on the same kind of business
• if the transferor is a taxable person, the transferee is or becomes one because of the transfer
• for land that would otherwise be a standard-rated or option-to-tax supply, extra conditions apply, including an option to tax by the transferee and notification

If the conditions are missed, VAT can apply to the assets. A TOGC covers a transfer of a business. It does not cover a transfer of shares in a company, which is not a transfer of the business itself, so a simple hive-across of a business is the case in point. Check the VAT position, including any VAT group membership, before the transfer.

Clearances: what to apply for and when

Where the steps above are relied on, clearance is usually sought first. The applications that normally matter are:

Section 748 CTA 2010 is the company equivalent for transactions in securities. It is usually relevant only where a company, not an individual, is a shareholder.

One application. HMRC lets you make the statutory clearances in a single application to its Clearance and Counteraction Team, listing each provision applied for. It sets out the company details, a step-by-step description with diagrams, the shareholdings before and after, the consideration, the latest accounts and the reasons for the transaction.

Timing. HMRC has 30 days to respond to a complete application. It can ask for further particulars within 30 days, and then has 30 days from receiving them. For section 138, the applicant can ask HMRC to refer the matter to the tribunal if HMRC is not satisfied or does not decide within the 30 days. For section 701, there is no tribunal referral right. If further information is not provided within the time allowed, HMRC need not proceed.

What clearance does not cover. A section 138 clearance covers only section 137. Stamp duty and SDLT reliefs are not cleared this way. And a clearance given on incomplete disclosure is void, so the application has to describe all the steps and the plans for afterwards.

HMRC's non-statutory clearance service is not available where a statutory clearance exists. See what HMRC looks for in a demerger clearance and our page on HMRC demerger clearances.

An illustration (invented figures)

This is an invented example to show how the pieces fit. It is not a client case, and the figures are round and do not predict any real outcome.

Two shareholders each own 50% of Trade Co. It has a trading business worth £6m and a freehold warehouse worth £2m in a subsidiary, Prop Co. The warehouse was moved into Prop Co four years ago under group relief and was bought for £500,000 originally. The shareholders want to own the property separately, in a company where they continue to hold 50% each.

Steps: Holdco is inserted (section 135 exchange), Holdco reduces its capital, and Prop Co moves to Newco 2, which issues shares to both shareholders in their existing 50:50 proportions (a mirror-image demerger, so no reclassification is needed).

The point of the table is that the shareholder-level relief is not the main cost. A property that sits in a subsidiary because of an earlier restructuring, or a decision to move it again, is. The degrouping charge in this example would be avoided if the property had been in Prop Co for more than six years, or if the structure had left Prop Co in the group and moved Trade Co instead.

Common tax mistakes

• Relying on the capital gains reliefs and forgetting stamp duty. Section 77 and section 75 have mirror-image tests that shareholder-level reliefs do not.
• Moving property in first. Group relief on an earlier transfer can be withdrawn by the demerger. The preparatory move can also trigger degrouping.
• Assuming section 179 does not apply. The exemption is for exempt statutory distributions only.
• Treating the reduction as a way to pay out value. Value passing to shareholders outside the reliefs can be a distribution.
• Reclassifying before the share exchange. Classes that do not mirror can lose stamp duty relief.
• Not mentioning the plans after the demerger. A later sale is not necessarily a problem, but it has to be in the application. Clearance covers only what is disclosed.
• Missing the transactions in securities rules. A section 138 clearance does not cover income tax.
• Forgetting that the Companies Act and tax timetables run side by side. The solvency statement must be made within 15 days before the resolution, and tax clearance must come before the shares are issued.
• Ignoring VAT and associated companies. Both are easy to overlook until a return is due.
• Not checking Business Relief and BADR positions after the split. Property companies can lose the reliefs the group enjoyed.

Pulling it together

A capital reduction demerger can often be done without a tax charge on the shareholders or the companies. That depends on the conditions at each step, on the history of the group, and on what the shareholders plan to do next. The order of the steps matters. That is where we come in. We handle the whole process, from route and clearance to working with your lawyer and accountant on implementation.

To see how your own structure fits, try the demerger route finder or book a call.

Sources

• Taxation of Chargeable Gains Act 1992, sections 127 to 139, 171, 179, 192 and Schedules 5AA and 7AC (legislation.gov.uk)
• Finance Act 2026, sections 37 and 38 (legislation.gov.uk)
• HMRC Capital Gains Manual, CG-APP20, CG52723, CG52806, CG63975 (gov.uk)
• Corporation Tax Act 2010, sections 1000, 1022, 748 and 18D to 18F (legislation.gov.uk)
• Income Tax Act 2007, sections 684 to 686 and 701 (legislation.gov.uk)
• Finance Act 1986, sections 75, 77 and 77A; HMRC Stamp Taxes on Shares Manual (gov.uk)
• Finance Act 2003, section 53 and Schedule 7 (legislation.gov.uk)
• Corporation Tax Act 2009, sections 780 and 782A (legislation.gov.uk)
• Companies Act 2006, sections 641 to 644 and the Companies (Reduction of Share Capital) Order 2008 (legislation.gov.uk)
• HMRC, Apply for statutory clearance for a transaction (gov.uk)

This article is general information, not advice. Tax rules change and their effect depends on your circumstances. Please speak to us before acting.