Reduction of Capital: What Is It and When Might You Use One?
A reduction of capital sounds like something a company would only consider if it was in financial difficulty. In reality, it can be a useful restructuring tool for healthy private companies too.
It can be used to create distributable reserves, deal with historic losses, return surplus capital to shareholders, help facilitate a shareholder exit or form part of a wider reorganisation.
So what exactly is a reduction of capital - and when might it be useful?
What does “reducing capital” actually mean?
When shareholders invest in a company and receive shares, part of that investment forms the company's share capital.
There are rules around what a company can do with that capital. In particular, a company cannot simply treat share capital in the same way as ordinary profits and pay it out to shareholders whenever it chooses.
A reduction of capital is a formal process that allows a company to reduce some or all of its share capital and, depending on the circumstances, create reserves that can be used more flexibly.
For private companies, this can often be done using a solvency statement procedure, without going to court.
The directors make a formal statement about the company's ability to pay its debts, the shareholders approve the reduction by special resolution and the relevant documents are filed at Companies House.
Why would a company want to reduce capital?
1. Creating distributable reserves
This is one of the most common practical uses.A company may be profitable and have plenty of cash in the bank but still be unable to pay a dividend because it does not have sufficient distributable reserves.
That can happen because of the way the company was originally funded or because of historic accounting losses.
A reduction of capital may, in appropriate circumstances, convert amounts tied up in share capital into distributable reserves.
That can give the company greater flexibility over what it does with those funds in the future, including the potential payment of dividends where the relevant requirements are met.
The important point is that having cash and being legally able to distribute it are not necessarily the same thing.
2. Dealing with historic losses
A company's balance sheet can sometimes carry losses from years ago, even though the underlying business is now performing well. Those accumulated losses may restrict the company's ability to pay dividends.
A reduction of capital can potentially be used to eliminate or reduce those historic losses, effectively helping to tidy up the balance sheet and create a clearer position going forward.
This does not mean making the losses disappear commercially. It is a restructuring of the company's capital and reserves.
For a business that has moved on from a difficult period, however, it can be a useful way of making sure its balance sheet better reflects where the company is today.
3. Returning surplus capital to shareholders
Sometimes a company simply has more capital than it needs. Perhaps a large investment was made into the business for a project that did not proceed, or the company has sold an asset and no longer requires the same level of funding.
A reduction of capital can potentially provide a mechanism for returning surplus capital to shareholders. Again, this is not simply a case of transferring money out of the company.
The company must follow the correct legal process, and the directors need to consider carefully whether the company will remain able to meet its debts.
Tax advice will also be important in determining how any payment to shareholders is treated.
4. Helping a shareholder exit
A reduction of capital can also form part of the solution where a shareholder wants to leave a company. For example, the company may want to buy back that shareholder's shares.
A company purchasing its own shares is subject to specific rules, including rules about how the purchase can be funded.In some circumstances, a reduction of capital can be used as part of the wider restructuring to create the reserves or capital structure needed to facilitate the exit.
The exact route will depend on the circumstances, but the wider point is that capital reductions can be useful when ownership of a business is changing, not just when money is being returned.
5. As part of a wider reorganisation
A capital reduction does not always happen on its own. It can be one step in a wider corporate reorganisation. For example, it can be used as part of a demerger, where businesses within a group are being separated.
It may also be used when simplifying a company's share capital or reorganising a group ahead of a wider transaction.
That is why the commercial objective matters. The question should not be:
“Can we do a reduction of capital?”
It should be:
“What are we trying to achieve, and is a reduction of capital the right way to help us get there?”
What is the solvency statement?
For many private companies, one of the key parts of the process is the directors' solvency statement. This is not simply another document for the file.
The directors are making a formal statement about the company's financial position and its ability to pay its debts. That means they need to understand the company's current and expected financial position before signing it.
Up-to-date management accounts, forecasts and information about existing and potential liabilities may all be relevant.
Directors should therefore take the solvency statement seriously and make sure they have appropriate financial information and advice before proceeding.
Is a reduction of capital right for your business?
A reduction of capital is not something every company will need.
But it may be worth considering where:
The company has cash but insufficient distributable reserves;
Historic losses are restricting its ability to pay dividends;
The company has more capital than it now needs;
Capital is to be returned to shareholders;
A shareholder exit or share buyback is being considered; or
A reduction is needed as part of a wider restructuring or demerger.
As with any restructuring, the starting point should be the outcome you are trying to achieve. A reduction of capital is a tool – not the objective itself.
How Daly McCormick can help
At Daly McCormick, we advise companies, directors and shareholders on reductions of capital and wider corporate reorganisations, working alongside accountants and tax advisers where appropriate.
Whether you are looking to create distributable reserves, deal with historic losses, return capital, facilitate a shareholder exit or carry out a wider restructuring. We can help you identify what you want to achieve - and the right legal steps to get there.
Your business. Our legal expertise.
Dungannon, Belfast, Omagh
02887441840
Disclaimer: The information provided here does not, and is not intended to, constitute legal advice. Instead, the information and content available are for general informational purposes only.
