A reduction of capital is a capital re-organisation that has the effect of allowing the return to shareholders of capital would otherwise not be distributable. A reduction of capital is used to increase distributable reserves to make dividend payments possible, or to make a large return of capital more efficient.
There are a number of possible mechanisms, including:
- a share buy back,
- the conversion of share capital and non-distributable reserves into debt capital
- the conversion of non-distributable reserves into distributable reserves.
One common scenario where a reduction of capital is useful is a company that has large accumulated losses but has returned to profitability and wishes to pay dividends. If large losses have been made in the past, it may take many years before balance sheet retained earnings turns positive again. However, if a business has genuinely returned to profitability and is likely to remain solvent, there is no real reason why it should not be able to pay some of those profits to shareholders.
The solution is to convert non-distributable reserves into distributable reserves.
Another common scenario is a company that simply no longer needs as much capital as it did — for example, because it has arranged a sale and leaseback that has taken a lot of assets off its balance sheet, or because it has sold a business.
One easy solution would be the conversion of non-distributable reserves to distributable, followed by the payment of a special dividend, This, however, would mean that many shareholders would be unable to avoid paying income tax on the special dividend. One alternative (that has been used by large UK listed companies), is to convert share capital into debt. Existing shares are cancelled and replaced with new shares (fewer, or with a lower par value) and bonds, the latter typically redeemable at the option of the holder. This allows shareholders to take the return of capital as a capital gain, and time it to their advantage.
Mechanisms such as this vary with the shareholder base (i.e. what sort of tax effects the majority of shareholders want). They will also evolve over time as tax rules change.
Share buy-backs are often not a real reduction in capital at all. Most companies that buy-back shares tend to buy small quantities every year, so their economic effect is to return current profits to shareholders in a way that appears (again) )as a capital gain.