Positive effect on Distributable reserves
A reduction of share capital has a positive effect on the distributable reserves of a company. It creates a reserve which is treated as a realised profit for accounting purposes (unless, in the case of a reduction confirmed by the court, the court orders otherwise).
As a result, reductions of share capital are frequently undertaken by companies to:
- create distributable reserves;
- increase distribute reserves; or
- reduce accumulated losses.
Accumulated realised losses suffered by a company in previous trading periods can block the payment of dividends, even if the company is now trading profitably. A reduction of share capital can 'clear' these past losses so that dividends can be declared.
NOTE: As most readers will be aware, a company can only pay dividends out of distributable profits available for that purpose, being accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital.
To return Surplus Capital
A company may be sitting on cash that it has no immediate use for, perhaps as a result of a sale of assets, or where cash was raised on a share issue for a particular purpose and circumstances have changed so that the funds are no longer required (such an aborted acquisition).
In these circumstances, a reduction in capital can be used to return some or all of this cash to shareholders by repaying paid-up share capital.
To facilitate a share Buyback or Redemption
A company can redeem or purchase its own shares (buyback) out of distributable reserves or the proceeds of a fresh issue of shares. A private company also has the option of purchasing its own shares out of capital.
If the relevant company has insufficient distributable reserves to fund a buyback (and a fresh issue of shares or a purchase out of capital is not an option) then a reduction of capital can be undertaken in advance of the buyback to create the required reserves.