In the second of a three-part article, Peter Rayney examines the practical uses of capital reductions.
Owner-managed companies frequently reduce their share capital to remove a profit and loss account ‘deficit’ (i.e. accumulated losses), to enable dividends to be paid.
A company will simply reduce its share capital with a corresponding credit being made to its profit and loss account. The reduction in share capital could be made via a cancellation of shares or a suitable sub-division of shares with a reduction of the nominal value attaching to each share. Importantly, a company can also reduce its share premium account and/or capital redemption reserve as though it were ‘share capital’ as part of this process (see CA 2006, ss 610(4) and 733(6),).
The amount transferred to the profit and loss account will then form part of the company’s distributable profits, as confirmed by the Companies (Reduction of Share Capital) Order 2008, SI 2008/1915.
Tax treatment of dividends arising from share capital reduction
HMRC considers that dividends/distributions paid out of profits created in this way will be treated as a ‘normal’ income distribution for tax purposes. The amount effectively loses its identity as ‘capital’ and hence cannot be treated as a repayment of share capital (CTA 2010, s 1000(1)A) - see also HMRC’s Company Taxation manual at CTM15440.
In any event, HMRC could also use the ‘transaction in securities’ legislation to treat the ‘distribution’ as subject to income tax at dividend tax rates. This is because the recipient shareholder(s) will generally retain their equity stake in the company and HMRC may consider that the repayment of share capital has been used to avoid income tax.
Capital gains analysis
Many advisers prefer the reduction to be implemented via a reduction in the nominal value of the shares, since this does not involve any disposal of shares (see below).
On the other hand, where the shares are actually cancelled, this triggers a disposal of shares under TCGA 1992, s 24(1). Since no payment is involved, the reduction of the share capital should fall within the capital gains share reorganisation rules in TCGA 1992, s 126. On this basis, the elimination of part of the shares does not, therefore, involve any disposal (TCGA 1992, s 127). The shareholder’s CGT base cost will simply be represented by fewer shares, i.e. the base cost of the retained shares will increase.
However, it might be argued that the there is a deemed disposal at market value on the basis that the shares have been disposed of other than by way of an arm’s length bargain (TCGA 1992, ss 17 and 128(3)). HMRC have never appeared to take this point, but clearly it is much safer to proceed via a reduction in the nominal value of the shares.
The example illustrates how the capital reduction procedures may be used to ‘create’ distributable profits for dividend payments.
Example - Using a capital reduction to create reserves
An extract from The Bishopsgate Emporium Ltd’s balance sheet at 31 October 2017 shows the following:
£
Share capital 10,000 Ordinary shares of £1 each 10,000
Share premium 200,000
Profit and loss account (80,000)
130,000
Mr Kite owns 100% of the company and is its sole director.
The company was affected by a substantial loss last year, but Mr Kite wishes to take a dividend of £80,000 this year and the company has no distributable reserves.
Acting on professional advice, the company reduces its share capital under the Companies Act 2006 procedure and creates £100,000 of reserves. A special resolution is therefore passed to eliminate £180,000 of its share premium account.
After the reduction, the shareholders’ funds shown in the balance sheet were made up as follows:
£
Share capital 10,000 Ordinary shares of £1 each 10,000
Share premium (£200,000 less £180,000) 20,000
Profit and loss account (£180,000 less accumulated
loss of £80,000) 100,000
130,000
In the above example, the company now has sufficient reserves to declare a dividend of £80,000. Since the reserves were created by a transfer to the company’s profit and loss account, the dividends would be subject to income tax in the normal way.
Practical Tip:
It is possible to create distributable profits to pay a dividend by reducing a company’s share premium account under the capital reduction procedure.
Capital Reduction Techniques For Owner-Managed Companies (Part 2)
