This helpsheet has been issued by ICAEW’s Technical Advisory Service to help ICAEW members to understand the company law and financial reporting implications of a share for share exchange.

Members may also wish to refer to the following related helpsheets:

• When can a subsidiary be excluded from consolidation under FRS 102?
• Is an audit required for a company?
• Groups and consolidated accounts under FRS 102

Eligible members with access to Bloomsbury Professional Online may also find the following published title of use:

• Group Accounts under UK GAAP

Check whether you have access to Bloomsbury Professional Online.

A share for share exchange is where one or more shareholders exchange shares they hold in one company for shares in another company. A common example of this is where a new holding company is put on top of an existing group. Shareholders give their shares in the old TopCo to NewCo in exchange for shares in NewCo.

In such situations, confusion often arises over the use of merger relief and merger accounting. Although both include the word ‘merger’ in their names, and both commonly arise in group reconstructions, this is really where the similarities end. Merger relief is a Companies Act relief from recording share premium. Merger accounting is a method of accounting for a business combination. Each can only be used where the relevant criteria are met.

When a company issues shares, the basic rule contained in section 610 of the Companies Act 2006 (CA06) is that those shares should be accounted for at the value of consideration received in exchange. Any excess over the nominal value of the shares issued is recorded in the share premium account.

Merger relief is a Companies Act relief from the creation of a share premium account on the issue of shares. Broadly, it applies where a company issues equity shares in consideration for the shares of another company (ie, a share for share exchange) where, as part of the arrangement, it secures at least a 90% equity holding in the other company. The specific criteria for merger relief are set out in section 612 of CA06. Where the criteria are met, the relief must be applied and therefore no share premium is recorded on the issue of the shares.

Merger relief only applies where group reconstruction relief does not apply. This is discussed in more detail below.

To the extent that the relief from recording share premium is available, section 615 of CA06 and FRS 102 paragraph A3.24 give the option to reduce the carrying value of the related investment by a corresponding amount. In effect, where the investment in the subsidiary is accounted for at cost less impairment, the cost may be recorded at either the nominal value or the fair value of the shares issued in exchange.

Nominal value

If recorded at nominal value, the accounting entries will be:

Dr Cost of investment in subsidiary Nominal value of shares issued

Cr Share capital Nominal value of shares issued

Fair value

If recorded at fair value, the accounting entries will be:

Dr Cost of investment in subsidiary Fair value

Cr Share capital Nominal value of shares issued

Cr Merger relief reserve Balance

There are no strict requirements with regard to the name of the reserve which is created; ‘merger relief reserve’, ‘merger reserve’ or indeed an ‘other reserve’ would all be acceptable, although it is sensible to name it a ‘merger relief reserve’ as it is then clear that it arose from merger relief.

Step Acquisitions

Where a company acquires a subsidiary in a series of transactions, merger relief is available on the transactions which takes the shareholding over 90%.

For instance, if Company A had 60% of Company B and now acquires a further 35%, the relief would apply to the transaction that took Company A’s holding over the 90% threshold.

Mixed Consideration

Where the issuing of shares is only part of the consideration paid for the equity of the acquired company, merger relief will still apply (assuming the other conditions are met), but it will only apply to the equity element of the consideration paid.

For example, Company A acquired 100% of the shares in Company B, paying £60k in cash, and issuing 1000 £1 shares with a value of £40k. Providing the criteria in s612 and s613 of CA06are met, merger relief would apply to the share issue.

By contrast, if the acquiring company were to issue shares in exchange for a mix of assets (ie shares in a company and another asset), merger relief would not apply.

This is because s612(1) talks in terms of the consideration for the issued shares being the issue, transfer or cancellation of shares in the other company., referring to “the consideration” not “any part of the consideration”, so the issuing company cannot receive anything other than shares in the acquired company as part of the transaction.

For example, Company C issues 1000 shares to the shareholders of Company D. As consideration for these shares, Company C receives 100% of the share capital of Company D and also receives £100k in cash. As Company C has received a mix of consideration for its shares, it appears that merger relief would not apply.

Group Reconstruction Relief 

Where a transaction is taking place between group companies, Group Reconstruction Relief may apply. Where this is the case, Merger Relief will not apply so it is important to first consider whether the conditions for Group Reconstruction Relief are met.

Group Reconstruction Relief is set out in s611 of Companies Act 2006 and rather than totally exempting the recording of share premium, it restricts the amount that is recorded.

The conditions are that:

• The issuing company is a wholly owned subsidiary;
• The shares are issued to the holding company or another wholly-owned subsidiary of the holding company; and
• The consideration received by the issuing company is the non-cash assets of a company within that group.

The application of Group Reconstruction Relief is not discussed further here.

Where a share for share exchange has occurred and the parent company is required to prepare consolidated accounts, the directors should consider whether the business combination is accounted for using:

• Merger accounting; or
• Acquisition accounting (the purchase method).

Merger accounting may (but does not have to) be applied if the criteria in FRS 102 paragraph 19.27 are met. If merger accounting is not applied to the business combination, then acquisition accounting must be used.

Merger accounting

Under merger accounting, the carrying values of the assets and liabilities of the parties to the combination are not adjusted to fair value on consolidation. Any difference between the consideration and the book value of the net assets acquired is shown as a movement on other reserves (usually in a ‘merger reserve’, although there are no strict requirements on what to call it). Guidance on the merger accounting method is included within FRS 102 paragraphs 19.29 to 19.32.

Whether or not merger relief has been applied in the parent accounts will impact the consolidation. There is no requirement to uplift the consideration to fair value under merger accounting.

If a share for share exchange was recorded at nominal value, the difference between the consideration and the nominal value of shares acquired will go to a merger reserve.

A merger reserve will also arise if a share for share exchange is recorded at fair value. It will likely be larger due to the consideration value , and we will already have a merger relief reserve in the parent’s accounts. While these are two separate reserves and should be tracked separately, there is no mandatory requirement to reflect them separately in the financial statements – they could be combined into a single merger reserve.

EXAMPLE
Person X owns 100% of Company A and Company B. Company A issues 50 shares with a nominal value of £1 to acquire 100% of the share capital of Company B. The fair value of these 50 shares is £25,000.

Merger accounting where share for share exchange recorded at nominal value:

Merger accounting where share for share exchange recorded at fair value:

 
* As discussed above, these two reserves could be presented together, giving a merger reserve of (50) as in the example where the shares were recorded at nominal value.

Acquisition accounting

Under acquisition accounting, a fair value exercise will need to be carried out. The requirements of FRS 102 paragraphs 19.6 to 19.24 will need to be adhered to. It is important to remember that when calculating goodwill, the cost of the business combination must be based on the fair value of the consideration given to acquire the subsidiary. This is the case even if merger relief applies and the directors have elected to record the investment at the nominal value of the shares issued in the parent’s own accounts.

This means if merger relief is used in the parent company accounts, our first consolidation adjustment will be to bring that consideration up to fair value. This will create an “other reserve in the consolidated accounts. There is no guidance on what to call this reserve, but it would seem inappropriate to call it share premium as the application of merger relief prohibits this, or to call it a merger relief reserve because it wasn’t created by the application of merger relief. Simply using the term “other” or “consolidation” reserve would be acceptable.

ICAEW members, affiliates, ICAEW students and staff in eligible firms with member firm access can discuss their specific situation with the Technical Advisory Service on +44 (0)1908 248 250 or via webchat.