Is it the end of the road for capital reduction demergers?

This article aims to provide some context to one component of the series of changes to the tax treatment of corporate distributions that HMRC has proposed in its consultation document of 23 June, titled ‘Modernising the taxation of distributions and repayments of capital from companies’.

This component, which will have very far-reaching consequences for corporate demergers, is the measure targeting distributions of profits to shareholders.

The tax planning being targeted

For many years, it has been a poorly-kept secret amongst tax practitioners that there is a simple way to distribute profits of a company to individual shareholders that avoids the high income tax rates on dividends and income distributions, and enables them to pay CGT on the distribution instead.

The statutory position is that any sums a company distributes to its shareholders on a capital reduction or share buyback, in excess of the original subscription price for the shares (ie the paid-up share capital – nominal capital and any share premium), are taxed as an income distribution.

If this is done by way of a share buyback, there is a statutory exemption from the distribution being subject to income tax. However, the requirements for this exemption are onerous and rarely satisfied unless the shareholder is completely ceasing involvement with the business.

For a reduction of capital, there is also the statutory exemption for ‘indirect distributions’. Here too, the requirements are rarely satisfied.

However, the legislation which sets out the rules for the income tax computation on buybacks and reductions of capital allows that any ‘new consideration’ which has, in the past, been given by the shareholder, counts as part of the paid-up share capital which reduces the shareholder’s gain that is subject to income tax.

The legislation recognises that the shareholder might be giving up other shares in exchange for receiving new shares. There are detailed rules stopping shareholders giving up an interest in some existing shares, receiving new shares, and treating the market value of the earlier shareholding as ‘new consideration’ for the new shareholding.

However, these rules only apply where the shares relinquished and the new shares issued are in the same company. Where an individual subscribing for shares in a company gives, as consideration, shares in another company (as on a share-for-share exchange), the shareholder can treat the market value of the shares given up in the share-for-share exchange as paid-up share capital (ie new consideration) on the new shares in the holding company.

If the shareholder then sells the new shares back to the holding company, or if there is a reduction of capital in those new shares, the shareholder will only be liable for income tax on the excess that they receive from the company above the market value of the old shares at the date of the share-for-share exchange.

The shareholder will still be liable for capital gains tax (CGT) on the whole increase in value from the subscription price for the old shares. But, if the buyback occurs soon after the share-for-share exchange, before the new shares have appreciated in value, there will be no income tax liability at all.

The shareholder will have been gifted a tax-free ‘step-up in the income tax base cost’ of their shares, merely by doing a share-for-share exchange before doing the buyback.

The ‘transactions in securities’ (TiS) rules have always been relevant here. These are broad rules that enable HMRC to attack transactions that deliver an ‘income tax advantage’ if it considers that obtaining the advantage was one of the main purposes of doing the transaction. This advantage is typically turning distributable income into capital. So, it has always been necessary to disclose the forthcoming share buyback when seeking TiS clearance for the share-for-share exchange. Historically, HMRC has generally given that clearance.

Cases where this tax planning has been used have come before the courts. The judgments in the First-tier Tax tribunal cases of Wroe in 2022 and Hunt in 2025 are not explicit on the taxpayers’ reasons for doing a share-for-share exchange but, to anyone aware of this tax planning, it is perfectly obvious what the taxpayers were up to. The irony is that HMRC used the TiS rules to successfully attack the tax planning in these cases whereas, had the tax advisors simply disclosed all the steps of the tax planning, HMRC would probably have given clearance for it.

Wider application of this tax planning

This piece of tax planning, which many would say, with some justification, allows one to avoid tax in a way that cannot have been the intention of the legislators, has much wider application than is often realised.

The ‘step-up in the income tax base cost’ is actually what makes capital reduction demergers workable in tax terms. Step 1 of a capital reduction demerger is generally the insertion of a holding company on top of the existing company whose business is being demerged. And it is this share-for-share exchange, rather than any magic in the demerger itself, which enables shareholders to receive shares in the new company that acquires the demerged business without having to pay income tax on the market value of those new shares.

Proposed counteractive measure

The consultation document makes clear that HMRC is perfectly aware of this type of tax planning (though it does not explain why HMRC has facilitated it by giving TiS clearance for so many years).

To counteract it, the government proposes to introduce legislation that will ‘freeze the income tax base cost’ (ie the amount treated as the paid-up capital in shares) at the amount originally subscribed. Where shares are exchanged for shares in a new holding company, the original subscription price will be carried over into the holding company shares for the purposes of determining the income tax base cost, just as already happens for the purposes of determining the CGT base cost.

The document invites interested parties to suggest undesirable outcomes that the counteractive measure will have on legitimate demergers. However, it then goes on to make clear that HMRC is aware of the negative impact this will have on capital reduction demergers – namely that individual shareholders will be subject to income tax on their share of the value of the demerged business. So, merely pointing out that this change will kill off capital reduction demergers is unlikely to change the government’s thinking.

Rather than proposing some derogation from the new measure for legitimate corporate demergers, HMRC appears to consider that the era of capital reduction demergers will have run its course and, in its place, shareholders and their advisors should make more use of ‘statutory demerger’ relief. As stated above, this is currently a very seldom-used route to avoid an income tax liability for individual shareholders, with onerous requirements on the company and the shareholders, in particular around changes of control of the company within five years of the demerger.

The government’s proposal is that the requirements for statutory demerger relief will be significantly relaxed and that statutory demergers will replace capital reduction demergers as the standard route by which businesses in a single company will be demerged into separate companies.

Additionally, for share buybacks, the government is also proposing significant changes to the statutory exemption from income tax on buybacks.

Ultimately, this means that the counteractive measure freezing the income tax base cost will, if enacted, have very significant effects on the ways corporate and tax lawyers do demergers and buybacks. The TiS rules will also become less significant since HMRC will have no reason to consider whether obtaining the tax saving on a demerger or buyback is a main purpose of the transaction if the tax saving is not available in the first place.

The consultation will close in mid-September, after which the government will publish its proposals for what legislative changes to make, in relation to this and the other proposals in the consultation document. In reality, it is hard to imagine the government not going ahead with this particular measure.