In law, the share capital of a company (the capital injected into the company by the shareholders in return for their shares) belongs to the company, and not its shareholders. The reason for this rule is so that the company has a cushion of capital out of which it can pay debts to third parties. This gives comfort to creditors like suppliers that the company is solvent.
One aspect of this rule is that the company must maintain a certain level of share capital, and not reduce it unless it follows a special procedure. It used to be the case that a company would have to go to court to reduce its capital, but now this rule only applies to PLCs – private limited companies can reduce their share capital by issuing a directors’ solvency statement and following a set procedure. In this guide, we explore why you might want to reduce share capital, and how to go about it.
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What is capital reduction?
When a company reduces its capital, it does so by cancelling shares. After the share capital has been reduced, the number of shares in the company will reduce by the amount of the reduction in capital.
It can do this in a number of different ways:
- If it has spare cash available (i.e. not tied up in assets) it can simply repay the capital to the shareholders and cancel the shares.
- It can reduce the nominal value of shares in issue.
- It can waive or reduce any liability that’s due on unpaid shares.
Why reduce share capital?
There are several reasons why you might want to reduce your company’s share capital:
To enable you to pay a dividend to shareholders
If your company has accumulated losses, you may not be able to pay dividends as these losses affect your balance sheet. You may find yourself with accumulated losses if you’ve had a poor spell of trading, if the value of the company’s assets has dropped, or if a project such as an acquisition has been unsuccessful for example.
The net effect of a capital reduction if you have accumulated losses is to effectively wipe out those losses and put the company back into profit. This means that the directors will be able to declare a dividend.
To pay cash back to shareholders
If your company is sitting on cash it doesn’t need for its day-to-day operations, for example, if it has raised funds for a project that won’t go ahead as planned, it can return this cash to shareholders and reduce its capital.
To redeem its shares
A company might want to buyback its shares (for example if a shareholder wants to retire) but it won’t be able to do this unless it has distributable reserves or issues new shares. If you neither have distributable reserves or want to issue more shares, you can reduce capital instead and cancel the shares in return for a payment in cash.
To transfer assets to shareholders
Rather than pay cash, a company can transfer non cash assets, such as property, to shareholders and cancel an equivalent value of shares.
As part of a group reorganisation such as a demerger
Sometimes as part of a merger or an acquisition, or a demerger where a company splits out its trading activities into different companies, a capital reduction will be used as part of the transaction.
Rules for reducing share capital
There are two ways in which a limited company can reduce share capital, by way of a court order or by issuing a solvency statement in which the directors declare that the company can pay its debts.
A public company may only reduce its capital with court approval.
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What is the procedure for reduction of share capital?
For both private and public companies, you will achieve a capital reduction by passing a special resolution of the eligible members of the company. A private unlimited company can reduce its share capital if the Articles of Association allow it to, and there is at least one non-redeemable share in issue after the procedure.
The directors’ solvency statement procedure
If you are planning for the directors to sign a solvency statement, they will need to fully understand the consequences of the capital reduction on the company, and be sure that the company is solvent, bearing in mind any liabilities that may need to be paid in the next year. The net effect of this is that the directors will need to have sight of the management accounts and financial statements showing its net assets, cash flow statements and projections.
As a practical matter, directors should ask an auditor or accountant to help them prepare the statement and keep a record of their decision and the reasons they believe the company is solvent. They should also show that they have carried out a risk assessment with respect to the company’s trading future and considered any other factors relevant to the company’s commercial activities.
The solvency statement will need to be made available to the members who will vote on the special resolution.
The solvency statement procedure is as follows:
- The directors resolve to propose a share capital reduction.
- The directors sign the solvency statement.
- The members pass the special resolution.
- The solvency statement, a compliance statement, the special resolution, and a statement of capital is filed at Companies House within 15 days of the passing of the special resolution.
If the directors intend to wind up the company within a year, then they will confirm in the solvency statement that the company will be able to pay its debts within twelve months of the date that the winding up procedure commences, or in other cases, that the company will be able to pay its debts as they fall due within the year following the date of the statement.
If the company is a PLC, then the reduction of capital procedure is similar, but the special resolution to reduce the capital must be approved by the court. A private limited company can also choose to have the reduction court-approved rather than following the solvency statement procedure route. You may decide to follow the court-approved route if you think one or more directors may not be willing to sign the solvency statement, or if creditors might object, or the company won’t be left with one non-redeemable share.
The court approval route
The first step in the court approval procedure is for the shareholders to pass a special resolution to reduce the company’s capital. After this, the company will apply to the Companies Court to reduce its capital, having first agreed a timetable with the court. The claim form will contain details of the company’s capital, its Articles, its financial affairs and the proposed capital reduction, and be supported by a witness statement from the company’s chair.
The company will also have to show that the shareholders have agreed to the reduction, having received proper notice explaining the implications.
At an initial hearing, the Registrar will consider the application in open court, and if it agrees that the claim will proceed, it will list it for a final hearing.
The court will usually agree to a capital reduction if it’s happy that the company’s creditors agree, or if the company will take steps to protect them, and it’s satisfied that the shareholders have been properly informed, and the proper procedure followed.
Third parties
A final thing to note if you are thinking of reducing capital is to make sure, if you have different classes of shares, that the reduction in capital won’t conflict with the rights of the shareholders of the various classes, for example, that preferred shareholders will be paid first.
You should also check to see that the terms of any bank loans or shareholders’ agreements don’t require the prior consent of parties to those agreements in a share capital reduction scenario.
Reducing share capital in demergers
Where a business wants to split out its business activities into different companies, it may choose to demerge them. In a capital reduction demerger, the parent company in a group of companies reduces its capital and transfers the shares of the subsidiary that it wishes to demerge to a new company, whose shares are then issued to the shareholders of the parent company.
What is capital reduction and reconstruction?
A reduction of capital may be used in the context of a scheme of arrangement whereby a corporate group is reorganised. In this process, the target company’s shares are cancelled by way of a reduction in capital. The resulting reserve is capitalised and paid up shares issued to a new holding company in exchange for the issues of shares by that holding company to the target’s shareholders.
Because the target company’s share capital is reduced to zero, the capital reduction will need to be court approved, as the solvency statement procedure is not appropriate.
Capital reduction and dividends
Companies are only permitted to pay dividends out of retained earnings. A company may be trading profitably yet have accumulated losses that prevent payment of a dividend. A reduction of capital can be used to reduce those losses or create a distributable reserve sufficient to permit the payment of a dividend.
Capital reduction vs share buyback
In contrast to capital reductions, share buybacks are most commonly used to enable a shareholder to exit a company, where the existing shareholders are unable or unwilling to fund the purchase of the departing shareholder’s shares. They are also used to return cash to shareholders, to change the respective shareholdings of individual shareholders and in connection with employee incentive schemes.
Tax implications
If you are planning to reduce capital, then you should take expert tax advice as this is a complex area. It’s probable that any reduction in capital won’t be treated as taxable income but may be viewed as a disposal for capital gains. Where the nominal value of shares or unpaid amount on shares are reduced, this would not constitute a disposal. But if shares are cancelled, then the situation is slightly different, as deemed or actual proceeds could arise and be subject to tax.
