Navigating Capital Reduction in Business Sales: Avoiding Pitfalls
Brendan Ringrose, Partner has published an article entitled “Navigating Capital Reduction in Business Sales: Avoiding Pitfalls” in Accountancy Plus December Issue 2023
(https://digital.cpaireland.ie/issue/december-2023/ ).
In the world of takeovers and share sales, advisers face a common challenge. Buyers seek core assets and business from the target company but are keen to dispose of non-core assets beforehand. Pre-sale reorganisation becomes crucial to divest the non-core assets and pave the way for a successful transaction. Brendan Ringrose, Partner in Whitney Moore Law Firm, specialising in Corporate transactions, discusses the legal issues.
During takeovers or share sales of a target company, professional advisers often encounter a common challenge. The Buyer identifies the core assets and business of the target company but requires the disposal of non-core assets before proceeding with the transaction. This necessitates a pre-sale reorganisation to divest the non-core business and assets prior to the sale. For example, a company might operate a core software development business alongside non-core assets, like an office building used by the target. The Buyer insists on disposing of the office building before finalising the sale, typically achieved by transferring the non-core asset to either the target company’s shareholders or a company owned by them.
In this process, shareholders of the target company should consult taxation advisers to understand any potential liabilities, including capital gains tax and stamp duty. In some cases relief from these taxes may be claimed, subject to specific exceptions and conditions. However, there are legal questions to address such as whether the disposal constitutes a distribution. According to section 123(1) of the Companies Act, 2014 (as amended), a distribution is “every description of distribution of a company’s assets to members of the company, whether in cash or otherwise,” with certain exclusions like bonus shares or preference share redemptions. This is a description rather than a definition but in general, a distribution may arise where a company transfers an asset to a shareholder (or an entity controlled by a shareholder) for which it receives less than the market value of the asset. Nonetheless, deciding on the market value or relevant value for the asset can be uncertain, requiring consideration of Section 119 of the Companies Act, 2014.
Enter the concept of book value. Section 119 is applied to determine the amount of the distribution arising from a company’s transfer of a non-cash asset, contingent on the presence of distributable reserves and the company’s ability to make the distribution (if the amount of the distribution is calculated under section 119). In this context, if the value of the consideration for the transfer is equal to or higher than the asset’s book value, the distribution is deemed to be zero. Otherwise, the distribution amount is calculated as the amount by which the book value of the asset exceeds the consideration paid for the transfer.
The notion of distributable reserves plays a crucial role. As defined in Section 117 of the Act, distributable reserves are ” accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made.” However, a lack of sufficient distributable reserves can create challenges. If a distribution is made by a company in violation of the Act, and the member receiving the distribution is aware or hasreasonable grounds to believe so, they will be required to repay it to the company, under Section 122 of the Act.
One potential solution may lie within the financial statements. Certain financial reserves, identified as “company capital,” are specified in the Companies Act and cannot be distributed or considered distributable reserves. These reserves encompass amounts in the company’s share premium account, capital redemption reserve fund or capital conversion reserve fund.
To convert share premium into distributable reserves, companies can employ the summary approval procedure (SAP) in order to carry out a capital reduction under Section 84 of the Act. This involves a majority of the directors making a statutory declaration of solvency and obtaining a special resolution from shareholders no more than 12 months before the capital reduction commences. However, the risk involved in the SAP declaration should not be underestimated, since making a declaration of solvency without reasonable grounds can lead to unlimited personal liability of directors for the debts of the company.
Alternatively, if capital reduction using an SAP declaration poses unacceptable risks, the Act allows an application to be made to the High Court to seek an order to sanction the reduction. This would avoid the need for the directors to make the SAP declaration but does involve advertising a notice of the resolution in a newspaper. In addition this option would involve a more detailed legal procedure and be more costly, requiring a barrister and affidavits to be drawn up. It might take some months to obtain a court date and is subject to the discretion of the Court.
Once adequate distributable reserves are created, companies can proceed with transferring non-core assets to shareholders by means of a reorganisation. A reorganisation is where a company’s assets or undertaking or part thereof (i.e. the office lease in the above example) is transferred to a new company, with the consideration for such transfer being the allotment of shares in the new company to the shareholders of the transferring company. Section 91 refers to such transactions as a variation of company capital on reorganisation. For this to proceed, approval is required from the directors making the SAP declaration or by means of a shareholders’ special resolution that is confirmed by the High Court. Alternatively, the company must have distributable reserves at least equivalent to the value of the asset stated in its accounting records immediately before the transfer, deducting this amount from the reserves.
A noteworthy amendment in 2022 to section 91 simplifies transactions where the book value is lower than the market value. This allows for the transfer to proceed provided the company has distributable reserves equal to value stated in the “accounting records” which is thought to include the book value stated in the most recent management accounts rather than the audited accounts. If this applies it may not be necessary to make an SAP declaration or obtain a High Court order. However, prudent calculation by directors of the asset’s value in the accounting records and professional advice remains essential.
Lastly, section 91(5) provides that where such a transaction is implemented using an SAP declaration or a High Court order, there must be deducted from the company’s reserves and company capital such amount as the company shall, by ordinary resolution, resolve equivalent to the value stated in its accounting records immediately before the transfer of the asset.
In conclusion, pre-sale reorganisations may be required to maximise the value and attractiveness of the target business for potential buyers. If necessary adequate distributable reserves can be created by means of capital reduction, while the amendment to the Act in 2022 simplifies asset transfers in reorganisations. Financial due diligence and professional advice are crucial in navigating this complex landscape and avoiding potential pitfalls.