Peter Rayney offers some practical guidance on dealing with in-specie distributions.
For companies incorporated in England and Wales, a distribution in specie (or in kind) generally entails a company distributing an asset to its shareholders. It may also arise where a company declares a dividend of a specified cash sum, which is then satisfied by the transfer of the relevant asset to its shareholders.
In-specie distributions are often made in the context of corporate demergers and reconstructions, and their legal requirements must always be respected.
The Companies Act 2006 (CA 2006) deals with in-specie distributions in the same way as normal cash dividends. Consequently, the directors must be satisfied that the company has sufficient distributable profits to ‘frank’ the value of the in-specie distribution.
Measuring an in-specie distribution
Companies Act 2006, s 845 provides a statutory framework for measuring the in-specie distribution. Provided the company has adequate distributable reserves, the distribution is made at the carrying value of the (non-cash) asset in the balance sheet (not market value). The accounting entry will normally be: DR – Retained reserves; CR – Asset account (at carrying/book value).
A company can, therefore, make a legitimate distribution provided the distribution amount does not exceed its distributable profits. In other words, where an asset is transferred to an individual shareholder at less than its book value, the difference must be covered by its distributable reserves.
On the other hand, where an asset is not reflected in the accounts (for example, goodwill), the value of the distribution (under company law) is zero. For these purposes, it is sufficient that the company simply has positive reserves (of any amount).
Different rules apply for tax purposes where a distribution will arise on the recipient shareholders to the extent that the current market value of the asset exceeds any consideration paid by them (the tax consequences of in-specie distributions are covered in Part 2 of this article).
Illegal distributions
What happens if a company does not have sufficient distributable reserves to frank the ‘book value’ of the distribution? In such cases, the ruling in Aveling Barford Ltd v Perrion Ltd [1989] BCLC 626 comes into play. The more recent case of Progress Property Company Ltd v Moorgarth Group Ltd [2010] UKSC 55 also tells us that the legality of a distribution must be determined by its purpose and substance rather than its form.
Thus, it is important to look at all the surrounding facts – including the basis of the price for the transaction. Nevertheless, unless the relevant asset is transferred/sold for a market value consideration, it will frequently represent an unlawful return of capital (since it has not been made out of the company’s distributable profits).
Where shareholders have received an unlawful distribution knowingly – or they have reasonable grounds to believe it is illegal - CA 2006, s 847 requires them to return or repay the ‘unlawful amount’ back to the company. In the context of a private company controlled by its directors, it is unlikely that they will be able to rely on the defence that they were unaware of the unlawful nature of the distribution. This is why HMRC will invariably argue that the amount represents a ‘loan to a participator’, and hence a charge tax can arise under CTA 2010, s 455.
Practical tip
Before making an in-specie distribution, the directors must ensure that it is permitted by the company’s articles (in-specie distributions are permitted by article 34 of the current ‘Model Articles’ for private companies).
