Reforming UK taxation of distributions code

HMRC have launched a consultation on a set of wide-ranging proposals to reform the taxation of distributions and repayments of capital from companies to their individual shareholders.  If implemented, the proposals would mark the most significant reform of the UK’s distributions rules since the introduction of corporation tax in 1965. 

The central theme of HMRC’s proposed changes is to apply consistent tax treatment to transfers of value to shareholders which HMRC consider to be “economically similar”, in particular by targeting situations where shareholders are seeking capital treatment over income treatment.  However, the proposals have significant implications for taxpayers undertaking corporate restructurings and reorganisations, and in particular demergers.

We understand that these proposals have been in the pipeline within HMRC for some time, and reflect areas where HMRC feel the rules should be tightened up (including to address points that are a regular source of disagreement between HMRC and taxpayers).

Capital to be “frozen” on the insertion of a new holding company

HMRC have identified a concern in relation to the use of a reduction of capital to return value to shareholders as a capital payment rather than an income distribution. Under the current rules, subject to the application of the transactions in securities (TIS) regime, capital treatment on the return of value to shareholders can be facilitated by inserting a new holding company on top of the existing group holding company: this is because the insertion of a new holding company can result in the shareholders holding “good” capital in the new holding company equal to the market value of the existing holding company’s shares. A subsequent return of value to shareholders by way of reduction of that “good” capital at the new holding company level can deliver capital treatment to shareholders as a result. 

Under the new proposals, the capital contributed by shareholders to the new holding company would be treated as “frozen”: i.e. capped at the level of “good” capital in the existing holding company.  The result would be that amounts returned to shareholders in excess of the “frozen” capital would be treated as a distribution rather than HMRC needing to rely on the TIS regime to counteract these sorts of transactions.  HMRC state that this change will harmonise the tax treatment of payments to shareholders that they regard as economically equivalent. 

The end of the road for capital reduction demergers?

HMRC have correctly identified that the proposed freezing rule would present a considerable challenge for demergers, which are often structured using this technology (i.e. the interposition of a new holding company followed by a capital reduction) in order to ensure that shareholders are not treated as receiving an income distribution when the demerger takes place. 

There is an alternative path available, but this involves reliance on the statutory demerger rules in Chapter 5 Part 23 Corporation Tax Act 2010.   Although the statutory demerger rules in principle provide relief from the demerger being treated as a distribution, they come with strict conditions (including a restriction on selling the demerged business) and onerous compliance obligations and can present an obstacle to making further returns of value to shareholders within five years following the demerger (the so-called “chargeable payments” regime).  HMRC acknowledge that the statutory route is “not currently well-used”.

HMRC’s proposals recognise that removing the capital reduction route would be a challenge for demergers and they therefore propose to liberalise the statutory route by removing some of the prescriptive requirements in the existing rules.  There is no mention of loosening or removing the chargeable payments regime, although we understand that HMRC are open to understanding whether these rules are currently perceived as a roadblock to statutory demerger transactions. HMRC are also considering removing the automatic right to appeal the denial by HMRC of a clearance application to the Tribunal, which could leave companies facing greater uncertainty as they embark on corporate restructurings and reorganisations.

We understand that the proposals are not intended to switch off the possibility of effecting a liquidation demerger as a third alternative route.

UK distribution treatment to be applied to dividends paid by a non-UK company

An important target of the consultation is the difference in treatment between returns of value to shareholders by UK and non-UK companies.  The existing distribution rules apply to treat various forms of transfer of value from UK resident companies as distributions (which are then generally treated as income in the hands of shareholders, save to the extent the distribution represents the return of “good” share capital). The same rules do not currently apply to transfers of value (such as share buybacks) made by non-UK companies, but it is proposed that many or all of those rules would be extended so that they do apply to non-UK companies in future. 

HMRC are also consulting on how best to draw the dividing line between dividends (which are treated as income distributions in their entirety) and other distributions (which are only treated as income to the extent they do not represent the return of “good” share capital) in the context of non-UK companies – noting that the company law governing these companies may be very different and have categories of distribution which are difficult to reconcile to UK legal concepts.  HMRC recognise that this can be an uncertain area and one that has led to significant disputes with taxpayers, e.g. Beard v HMRC [2025] EWCA Civ 385.

Changes to the loans to participators regime

For companies that are “close” (broadly, controlled by five or fewer participators or by directors who are participators), the loans to participators regime is a means by which returns of value to shareholders in the form of a loan can be subjected to a tax charge.  The charge is imposed at the level of the company making the loan or advance to its participator.  The charge is, in principle, temporary and repayable when the loan is repaid, but it is deliberately imposed at the upper dividend rate of 35.75% (rather than the corporation tax rate of 25%) to discourage the making of loans or advances to participators that are, in substance, disguised distributions.  In other words, in circumstances where a loan made by a company to a participator is left outstanding, the company is subject to a tax charge reflecting the charge which would have been incurred by the participator had the amount of the loan instead been paid as a dividend.

Significantly, HMRC are considering extending the loans to participators regime to loans advanced by non-UK resident companies.  However, HMRC recognise the practical difficulty of imposing tax charges on a non-UK resident company, and instead suggest that the charge would be borne by UK resident participators (subject to potential mitigants, e.g. HMRC are consulting on whether there should be a grace period for the loan to be repaid before the charge is imposed).

HMRC also acknowledge an overlap between the loans to participators rules and the distributions code, and in particular the potential difficulties that can arise in circumstances where a distribution is found to be unlawful and must be unwound.  The consultation notes that HMRC are exploring proposals to clarify the priority of the distributions rules and the loans to participators rules in this scenario. 

Stricter requirements for share buy-backs

The distributions code currently permits a share buy-back to be treated as a return of capital rather than an income distribution where a shareholder exits its investment for the benefit of the company’s trade.  HMRC propose that the “trade benefit test” be replaced with a more mechanical set of requirements with a view to better targeting the relief at genuine retirement situations, including that the departing shareholder must surrender their entire shareholding and any directorships upon the company’s purchase of its own shares. 

Transactions in Securities rules to be amended or replaced

The TIS rules have for many years been a means by which HMRC can recharacterize value accruing to shareholders from certain transactions as income rather than capital.  The consultation notes that HMRC plan to amend or replace the TIS rules with a “clearer and more principles based” anti-avoidance regime.  The revised TIS rules would be intended to serve as a “back stop” in circumstances where existing legislation is “sidestepped on mechanical grounds”.

What’s next?

The consultation is open until 14 September 2026.  HMRC have been quick to emphasise that the proposals do not seek to undermine or otherwise impact legitimate commercial restructurings and they will be actively engaging with stakeholders over the coming months.  No legislative timetable has been set for the implementation of these proposals.  Nevertheless, any groups contemplating corporate restructurings, or with individual shareholders (including management in a private equity context), will be keen to see how the detail of HMRC’s proposals develops, given the scope and ambition of the proposed changes.

If you would like to discuss any of the points raised in this blog post in further detail, please contact the authors or your usual Freshfields contact.