In the second of three short articles to be published over the coming weeks on the topic of Summer Updates for VCT Fund Managers, Roger Blears examines some particular considerations on how best to reorganise existing UK portfolio companies so that groups with multiple businesses can demerge assets for sale to overseas buyers.

The UK market was already a competitive arena for finding the next best investment. And US PE and other global investors are now here and willing to pay a premium for companies they regard as undervalued.

All fund managers now compete globally.

How best to reorganise existing UK portfolio companies so that groups with multiple businesses can demerge assets for sale to overseas buyers?

There are a number of different ways for a company or group to demerge assets, and the most appropriate in any particular case is likely to depend upon the interaction of a number of factors, including commercial and tax considerations.

Here are our notes on possible optimum reorganisation structures to demerge subsidiary businesses for sale to US or other overseas investors, taking particular account of impacts on VCT investors.

Perhaps the portfolio group comprises a UK Topco and two wholly owned subsidiaries Sub-1 and Sub- 2. The Topco’s shares are held by a VCT, the management team and a handful of investors. The VCT also holds preference shares and loan notes.

The Topco receives an offer for Sub-1 from a third-party buyer (the “Buyer”) which is for a mixture of cash and shares in the Buyer. The management team consider that it would be more tax efficient for the Buyer to acquire the entire share capital of Topco rather than acquiring [the entire share capital of Sub- 1 from Topco. However, all existing Topco shareholders also wish to maintain their interest in Sub- 2, with their ongoing interest in Sub- 2 mirroring the current ownership of Topco.

To achieve this, the following steps may be taken.

The ordinary share capital of Topco is redenominated as to two classes of shares, with one class being wholly and exclusively entitled to the shares in Sub-1 (“Sub- 1 shares”) and the other class being wholly and exclusively entitled to the shares in Sub- 2 (“Sub- 2 Shares”).

Topco then cancels its share premium account in order to create sufficient distributable reserves in Topco with which to cover a distribution in specie of its shareholding in Sub- 2 to a new company (“Newco”). Topco then distributes its shareholding in Sub- 2 to Newco in consideration, wholly, for the issue of new Newco shares and loan notes to the Topco shareholders in due proportion to their Topco holdings of shares and, as applicable, loan notes.

Following that transfer and the registration in the books of Newco of the newly issued shares, the Topco shareholders can then consent either to a secondary share cancellation of the share capital represented by the Sub- 2 Shares in Topco or, alternatively, there being no assets remaining to which they are entitled, to their being re-denominated as Sub-1 shares.

Topco, then holding only the issued share capital of Sub – 1, is subsequently sold to the Buyer after completion of the reorganisation.

The aggregate value of a VCT investor’s qualifying holding will, of course, be reduced when the shares and loan notes it holds in Topco are disposed of to the Buyer.

The effect of the reorganisation as regards a VCT investor’s residual qualifying holding is that its new shares and new loan notes issued by Newco will continue to be a qualifying holding, but only for a period of three years from the date they are issued in the case of shares, and five years from the date they are issued in the case of the loan notes, subject in each case to certain provisos.

This continued qualification arises because of the deeming provisions in The Venture Capital Trust (Exchange of Shares and Securities) Regulations 2002 and the SI 2018/109 Venture Capital Trust (Exchange of Shares and Securities) (Amendment) Regulations 2018 (SI 2018/109) (“Exchange Regulations”).

It is important however that the reorganisation leading to new investments in Newco is a distinct and separate transaction, in time, to the sale to the Buyer of a VCT’s shares and loan notes in Topco. This is because the VCT investor does not then need to consider the impact of “c” in the formula in Regulation 7(2) of the complex Exchange Regulations and is able to proceed on the basis that the VCT value of its new shares and loan notes in Newco will simply be a pro rata share of their original acquisition cost rather than a newly arrived at market value.

The aim of the valuation provisions in the Exchange Regulations is to ensure that for the purposes of the ‘15% holding condition’, the ‘80% qualifying holdings condition’, and the ‘70% eligible shares condition’, the aggregate value of the original holding and the new holding remains unchanged, save to the extent that the VCT receives a cash consideration pursuant to the reorganisation.

The formula used to deal with this is as follows.

				Nmv
Nv	=	Ov	x	——–
				Nmv + C

Where

Nv = the aggregate value of the new shares and new securities issued by Newco

Ov = the aggregate value of the old shares and loan notes issued by Topco when last valued for the purposes of 278 (1)-(3) ITA 2007

Nmv= the aggregate market value of the new shares and new securities issued by Newco immediately after [the reorganisation period]

C = the aggregate market value, immediately after [the reorganisation period] of (1) any monetary amount, any monetary right and any other consideration (excluding the new shares) received by the VCTs in consideration for their old shares and loan note investments

From this formula it can be seen that if there is no cash consideration paid out to the VCT pursuant to the reorganisation, the aggregated valuation of its old and new holdings will remain the same on the basis that where C=0 then

				Nmv
Nv	=	Ov	x	——–
				Nmv + C

becomes

Nv	=	Ov	x	1

Where, on the other hand, a VCT receives some monetary consideration under the reorganisation, the continuing value of its qualifying holding will be reduced rateably by the fraction of the old value divided by the new value plus the cash consideration. This would require a market value to be calculated for Nmv.

A theoretical and sometimes real problem with the Exchange Regulations is that they were enacted in 2002 and these deeming provisions refer to Schedule 28B of the Income & Corporation Taxes Act 1988, which has since been repealed.

Although the Exchange Regulations were amended in 2018, the amendments were only partial, and since 2002 there have been many other amendments to the qualifying conditions which must be satisfied by a VCT qualifying company and which now appear in chapter 4 of Part 6 of ITA 2007.

An alternative approach to the reorganisation described above would be for the capital reduction to proceed by way of a transfer by Topco to Newco of Topco’s holding in Sub-1.

Newco with its subsidiary Sub-1 would then be sold to the third-party buyer.

The advantage to the VCT in this alternative demerger approach is that the VCT’s retained holding of the Sub-2 Shares in Topco would continue to be a qualifying holding on an indefinite basis (until disposal) rather than only for the periods of three and five years in respect of the shares and securities it acquires in Newco, which is a consequence of the first reorganisation structure described above.

The alternative structures proposed for the demerger reorganisation are also intended to secure tax neutrality for the management and non VCT investor shareholders, so that neither an income tax liability nor a liability to tax on chargeable gains is generated in respect of any step taken to implement the demerger. This includes relying upon the availability of certain statutory tax reliefs, and the related statutory tax clearances should be obtained.

The expectation is also that any profit realised on the ultimate sale of Topco (or Newco, as the case may be) should be subject to tax on chargeable gains, such that, if the shareholdings of the management shareholders qualify, business asset disposal relief would be available to them. However, in order to obtain certainty in this respect, statutory clearance in relation to the application of certain anti-avoidance provisions should also be obtained.

Contact:

Roger Blears | Senior Partner | RW Blears LLP
70 Colombo Street, South Bank, London, SE1 8PB
T +44 (0)208 159 2501 | M +44 (0)7896 151376
E [email protected] | W https://www.blears.com