It is a fundamental principle of company law that the share capital of a company belongs to a company, not its shareholders. The share capital must remain intact to satisfy (if only in part) the company's debts, should the company become insolvent. Companies may not therefore make distributions to their shareholders unless they have sufficient distributable profits to do so. This is called the capital maintenance rule.
If a company transfers assets to its shareholders, it must ensure that the above rule is not breached. If the assets are sold at market value, the sale will be a genuine commercial transaction. However, if the assets are sold at undervalue, this will be a distribution of capital to the shareholders, which is unlawful if the company does not have sufficient distributable profits to cover the value of the assets being transferred. It is therefore advisable that if group companies wish to transfer assets between themselves that the transferring company has sufficient distributable profits and that this is noted in the directors' board meeting, and also in a shareholders' resolution.
Recent case appealed to the Supreme Court
In the case of Progress Property Company Ltd v Moorgarth Group Ltd  UKSC 55, the entire issued share capital of a subsidiary company was transferred between two companies within the same group. The sale price was less than market value and it was alleged that this was an unlawful distribution. However, it was undisputed that the directors genuinely believed that the sale price was the fair market value and that there was no intention to commit fraud. The case was appealed to the Supreme Court which held that:
- A sale of assets between group companies should be treated in the same way as the transfer of assets by a company to its shareholders. If the value of the sale is not covered by distributable profits, there is an unlawful distribution of share capital.
- However, if there was a genuine belief on the part of the director who orchestrated the sale, that the transaction took place at market value, it will be treated as a genuine commercial sale, rather than an unlawful distribution.
- If a transaction is found to have been a genuine commercial sale, it will stand even if it appears, with hindsight, to be a bad bargain.