16 February 2010

Reducing capital in the family business


Paul McGrath
Partner | UK

For those family businesses conducted through a limited company, company law imposes various restrictions on how value can be extracted by the owners. This article draws on the author’s experience of private companies using the new, relaxed regime for reductions of capital in order to return value to shareholders or restructure their businesses.

The Companies Act 2006 introduced a new method for private companies limited by shares to reduce their share capital. Historically, there has been a general prohibition on limited companies doing this, with only a few narrow exceptions permitted. The reasoning behind this ‘maintenance of capital’ rule is that, if the shareholders are to benefit from protection against the company’s creditors through limited liability, it is only fair that the creditors should know that the company’s publicly stated amount of capital will be maintained.
Before 1 October 2008, a private company could reduce its capital (that is, its stated amount of share capital and share premium) in one of three principal ways:


  • by applying to court for an order authorising the reduction;



  • by following the statutory procedure for the buy-back of its own shares out of capital; or



  • by re-registering as an ‘unlimited company’ (an unlimited company is, as the name suggests, a company whose shareholders do not benefit from limited liability and, as a consequence is not subject to the maintenance of capital rule). 



The new procedure (which is not available to public companies) is very simple. Essentially, the reduction must be authorised by the shareholders (by passing a special resolution) and supported by a declaration of solvency made by the directors. This is much quicker and cheaper than applying to court.
This article does not dwell on the procedural or tax aspects of the reduction but instead considers some practical examples of how this procedure is being used.

Paying dividends

As we (hopefully) come out of the recession, companies that have suffered losses may return to profitability. The owners may start to think about when they will be able to return some of these profits in the form of dividends. Dividends can only be paid out of the company’s distributable reserves (ie the accumulated, realised profits). Even though a company may have returned to profitability, an historic period of losses may have reduced the company’s distributable reserves such that they are insufficient to match the dividend proposed. There may even be a brought forward loss that will have to be reversed before any dividends can be paid.

If the company has a share premium account (ie the reserve created when shares are issued by the company for more than their nominal or par value), the new reduction in capital procedure can be used to convert this into a distributable reserve, enabling dividends to be paid. Even if there is no share premium available, a reduction in capital can help. If the company has, say, 10,000 issued £1 shares, each share could be converted into ten 10p shares. If nine out of every ten shares are then cancelled, there will still be 10,000 shares in issue, albeit that they will be 10p shares. The amount of the cancelled share capital can then be transferred to the company’s profit and loss account, boosting the distributable reserves by £9,000.

Demergers

One popular method of demerging a business is to make a tax exempt distribution (pursuant to s213 Income and Corporation Taxes Act 1988) of the business to a new company (‘newco’) set up by the owners of the existing company. While popular, exempt distributions are often frustrated by a lack of distributable reserves. A reduction of capital can be used to create distributable reserves as a preliminary step to a demerger distribution. Alternatively, the demerger could occur directly through the reduction in capital, some of the shares in the existing company being cancelled and, by agreement between the existing company, the newco and the shareholders, those shareholders being paid for their cancelled shares by the transfer of the demerging business to the newco and the issue by newco of further shares to the shareholders.

Share buy-backs 

Generally, a company may only fund a buy-back of its shares (or a redemption of redeemable shares) by using the proceeds of a fresh issue of shares or the company’s distributable reserves. As mentioned above, private companies have for a long time been able to repurchase their shares by using their share capital where there were insufficient distributable reserves. Although this has been widely used, the process is cumbersome. Not only does it require a special resolution and a statement of solvency, but the statement must be supported by an auditor’s report and the procedure must be advertised in the Gazette and a national newspaper and cannot be completed until 5 weeks after the resolution has been passed (to allow time for creditors to object).

Rather than following the statutory buy-back out of capital procedure, a company may instead reduce its share capital under the new reduction of capital procedure, transferring the amount of the reduction to its distributable reserves. The company is then free to use these newly created reserves to buy back its shares in the normal way. There will be no need to advertise the reduction or the buyback in the Gazette and a newspaper nor to wait 5 weeks before completing it.

A reduction in capital can also be used to avoid the application of another restriction in the Companies Act, namely that shares which are bought back by a company must be paid for in cash (this is the implication of s691 Companies Act 2006). By contrast, a reduction in share capital under the new procedure may be accomplished ‘in any way’ (s641(3) Companies Act 2006). If a company has a valuable non-cash asset and a shareholder wishes to exchange his shares for the asset, his shares could be reclassified as a new class of shares. This class of shares could then be cancelled under the reduction of capital procedure, the shareholder receiving the non-cash asset instead.

Paying-up unpaid amounts on shares

One of the consequences of the maintenance of capital rule is that when shares are newly issued, the shareholder must pay at least the nominal or par value for them (or, if he does not actually pay this amount, he will nevertheless be liable to pay it at some point in the future). This in turn means:


  • a company cannot issue ‘free’ shares, other than by way of a bonus issue to existing shareholders; and



  • once shares are issued, a liability to pay up any unpaid amount cannot be written off by the company.



Sometimes, shares may be issued mistakenly at the wrong price. For example, if a company believes that it owes £1,000 to someone, it might agree with that person to capitalise the loan by issuing 1,000 £1 shares. If, for whatever reason, the amount of the loan was only £800, the new shareholder will own 1,000 £1 shares but will only have paid up £800 on them. He will remain liable for £200 at some point in the future. The company cannot simply write off this amount.

A reduction of capital could be used here: if the company has a share premium account, this could be reduced and the amount of the reduction applied in paying up the unpaid amount on the shares.

Similarly, a reduction in capital could be used to effect the issue of free shares to an employee. The shares could first be issued as nil-paid shares and the reduction of capital could occur shortly afterwards to pay up the shares in full. The employment tax consequences of this should always be considered before embarking on any such exercise.

Winding-up

When a company’s life has run its course, there are two alternative ways to wind it up. The first is to appoint a liquidator to conduct a formal liquidation. Where a company’s affairs are relatively simple, it can be uneconomic to do this, so many companies follow the route of distributing their assets without appointing a liquidator, simply applying to the Registrar of Companies to have the company dissolved when it is no longer needed.

The problem with the striking-off route is that where assets are distributed in excess of the company’s distributable reserves, the excess is an unlawful dividend. The company has the legal right to recover these sums from the shareholders. Given that the shareholders control the company, one might be tempted to say, so what? The answer is that all rights of the company on its dissolution transfer to the Crown, so the shareholders may face legal action to repay these sums. The Crown, acting through the Treasury Solicitor, has long recognised that there is no public benefit served in insisting that all companies be wound up in a formal liquidation and so permits unlawful distributions of up to £4,000 made in the course of an informal winding-up to be retained by shareholders.

Where the value of the assets to be distributed exceeds the company’s distributable reserves by more than £4,000, the excess can still be recovered by the Crown. However, it is now open to the company to use the reduction in capital procedure either to increase its distributable reserves or simply to cancel its share capital. Assuming that the necessary declaration of solvency is properly made, the amount paid to the shareholders will not be an unlawful dividend and so cannot be claimed by the Crown.

Conclusion

The new reduction of capital procedure is a highly flexible and cheap solution to many problems faced by family owned companies when returning value to shareholders or restructuring the business. Although this article has not dealt with the tax consequences of reductions of capital, they should not be neglected. The taxation may depend upon the nature of the shareholder and the precise form taken by the reduction: professional advice should always be sought first.

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