Reduction in share capital

Following on from our article on the purchase of own shares we thought it would be also useful to provide information for when you consider a reduction in share capital.

In practice, this is a useful route when there is a takeover or change in shareholders and hence applicable for company acquisitions, Management Buy Outs (MBO) or Management Buy Ins (MBI). It can also be advantageous when you wish to exit as a shareholder but be mindful of the tax consequences of disposing or the cancellation of your shares. In most instances this will trigger an Income Tax charge but with planning this can trigger a Capital Gain instead.

There are many advantages to executing a “reduction of share capital’ and since 2006 a simpler process called the ‘solvency statement route’ was introduced. This procedure was introduced in the 2006 Companies Act to replace the court process which was expensive and time consuming and is now only used in limited circumstances.

Why would a private company reduce its share company?

As stated above, it is usually beneficial when there is a change of ownership. Instead of the existing shareholders funding the purchase of shares then the company can buy its own share back. This triggers a ‘reduction in share capital’

How can a private company reduce its share capital?

From 1 October 2008, it is possible to reduce the share capital of a private company limited by shares by either:

  • Passing a Special Resolution and apply to court for confirmation of the reduction (creditors of the company have certain statutory rights to object to the reduction of share capital during the court process); or
  • Passing a Special Resolution supported by a solvency statement made by all of its directors and deliver certain documents (listed below) to Companies House, without requiring a court process (the Solvency Statement Procedure).
  • A private company limited by shares can use the Solvency Statement Procedure unless its memorandum or articles of association prohibit a reduction of share capital (i.e. the express authority is not required).

    The Solvency statement to be made by each director of the company

    There is no right for a creditor to object to a reduction of capital supported by a solvency statement. However the solvency statement does protect the creditors of the company by requiring that all the directors give the solvency statement and take all the company’s liabilities into account (including prospective and contingent liabilities) when doing so. Therefore, if one or more of the directors is unable or unwilling to make the solvency statement, the company will not be able to use the Solvency Statement Procedure for its reduction of capital and will need to use the court approved procedure. Of course, objecting Directors can resign before the Solvency Statement is signed thus removing their requirement to consent.

    Timing is critical to using a Solvency Statement as it must be made not more than 15 days before the date on which the special resolution is passed.

    Before making the Solvency Statement, each director must very carefully consider the company’s financial position and the effect of the proposed reduction of share capital. Directors can decide to rely on an internal review of the company’s financial position or they can ask the auditors to prepare an independent assessment of its financial position. 

    However, the Directors should be aware that it is an offence if they make a Solvency Statement without reasonable grounds for the opinions expressed in it.  The maximum penalty for each director in default is imprisonment for a term not exceeding two years or an unlimited fine (or both).

    What you need to know:

    You can reduce share capital to a minimum of 1 issued share so long as the share capital reduction is pro rata across all members. However, you can reduce separate share classes so the procedure can be used to reduce a single shareholder’s allocation if that shareholder has a separate class of shares. If only one class of share exists and the requirement is to reduce one person’s shareholding then a reclassification of share capital will be required in advance of the reduction.

    A major benefit is that the reserve arising from a reduction of capital, share premium or capital redemption reserve is treated as a realised profit and can therefore be used to increase the P&L reserves especially where a company has accumulated realised losses or simply to allow for additional distributable reserves for dividends, to fund a purchase of own shares or to simply strengthen the balance sheet.