The five-year rule after a statutory demerger

A statutory demerger can separate two trading businesses without income tax or capital gains tax for the shareholders, where the conditions are met. But the relief comes with a tail. For five years after the demerger, certain payments by the companies to their shareholders can be taxed as income.

This is often misunderstood as a five-year ban on selling. It isn't. This article explains what the rule actually covers, how it interacts with a later sale, and how to stay on the right side of it.

Quick recap: the statutory demerger

A statutory demerger under sections 1073 to 1099 of the Corporation Tax Act 2010 lets a trading company or group distribute a trading subsidiary, or a trade, to its shareholders as an exempt distribution. An exempt distribution isn't a distribution for corporation tax purposes, so the shareholders don't pay income tax on it. Capital gains reliefs normally mean there is no disposal for them either. See statutory demergers.

Because the relief is generous, the legislation includes rules to stop value being taken out of the companies tax free soon afterwards. That is the chargeable payment regime.

What the five-year rule says

Section 1086 says that if a chargeable payment is made within five years after an exempt distribution, the amount or value of the payment is chargeable to income tax, or to corporation tax on income. Section 1087 says the company can't deduct it.

Section 1088 defines a chargeable payment. Broadly, it is a payment that meets all four of these conditions:

"Payment" includes a transfer of money's worth, not just cash. There is also a wider rule in section 1089 for unquoted companies, which can catch payments made under arrangements with the company or its main participators.

What this means in practice

The rule targets value reaching shareholders outside the dividend rules, without a genuine commercial reason. Examples that need checking include:

• a purchase of own shares that qualifies for capital treatment
• loans to shareholders, or the release of a shareholder's debt
• transfers of assets to shareholders at an undervalue
• payments to shareholders for their shares by a company connected with the demerged companies

Ordinary dividends are distributions, so they are outside the rule and taxed as dividends in the normal way. Payments with a genuine commercial reason and no tax avoidance purpose are also outside it.

Three illustrations

These are simplified examples to show how the rule is applied, not advice on any particular case.

A retiring shareholder. Two years after a statutory demerger, one of the demerged companies buys back the shares of a director who is retiring, and the buyback qualifies for capital treatment. Because it isn't a distribution, it could in principle be a chargeable payment. If it is made for genuine commercial reasons, such as the director's retirement, and isn't part of a tax avoidance scheme, it isn't chargeable. But a section 1096 return may still be required, and section 1092 clearance is worth considering first.

A loan to a shareholder. A company concerned in the demerger lends a substantial sum to a shareholder on terms with no realistic expectation of repayment. That looks like value passing to a member in connection with their shares, and would need careful review against the conditions.

A dividend. A company pays its normal annual dividend. As a distribution, it is outside the chargeable payment rules and is taxed as a dividend in the usual way.

The knock-on effect: degrouping

There is a second consequence. Normally, a company leaving a group because of an exempt distribution doesn't trigger a capital gains degrouping charge on assets it received intra-group. But under section 192(4) TCGA 1992, that exemption falls away if a chargeable payment is made within five years. So a payment to a shareholder can bring a corporation tax charge back into play on assets moved before the demerger.

Reporting, even when nothing is chargeable

Section 1096 includes two reporting duties, each within 30 days:

• where a chargeable payment within the five years consists of a transfer of money's worth
• where a payment or transfer within the five years would be a chargeable payment, except that it is made for genuine commercial reasons and isn't part of a tax avoidance scheme

So even a commercial payment may need a return explaining why it isn't chargeable. This is in addition to the return required within 30 days of the exempt distribution itself.

Clearance for payments

Section 1092 allows a company to ask HMRC in advance to confirm that a proposed payment won't be a chargeable payment. HMRC must respond within 30 days of receiving the application, and can ask for further particulars first. For any significant payment to shareholders within the five years, this is often worth doing.

What about selling one of the companies?

This is where the confusion usually arises. The chargeable payment rule is about payments by the companies concerned. A sale of shares by the shareholders to an unconnected buyer is a different question.

The bigger risk with a sale comes from the conditions for the exempt distribution itself. Section 1081 requires that the distribution is not part of a scheme or arrangement with a main purpose of, among other things:

• the acquisition of control of the distributing company, or of any other company concerned, by people other than the distributing company's members
• the cessation or sale of a trade after the distribution

HMRC's guidance says the demerger provisions don't apply where the trading activity is to be sold or becomes owned by someone other than the existing members.

So the position is broadly:

If a sale is likely, a statutory demerger is often the wrong route. A capital reduction demerger is usually more flexible, although it has its own anti-avoidance rules. See demerging before a sale.

A five-year checklist

For five years after a statutory demerger:

• Diary the five-year end date from the exempt distribution.
• Review any payment, loan, asset transfer or buyback involving shareholders before it happens.
• Record the commercial reasons for any such payment.
• Consider section 1092 clearance for significant payments.
• File any section 1096 return within 30 days.
• Remember the degrouping position for assets moved intra-group before the demerger.
• Take advice before any talks with a buyer or investor.

The rules depend on the facts, and the order and timing of later steps matters. We handle statutory demergers end to end, including clearance before and advice on payments after.

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