A capital redemption reserve fund is a type of reserve fund that exists both on a company's financial statements and as a part of the company's internal accounts. U.S. Security and Exchange Commission regulations legally mandate a capital redemption for certain transactions as a hedge against incurred capital reduction. Until a company liquidates, the company cannot distribute funds from the capital redemption reserve to shareholders, or use the proceeds from the fund for any purpose.
A capital redemption reserve is an established fund that holds money in reserve to protect a company from the loss of capital. A company protects itself from such a loss by essentially setting aside the same amount of capital required for the specific transaction. Further, by maintaining the capital redemption reserve, the company can set aside adequate funding to pay creditors in the event the company runs into fiscal problems. Additionally, a company can use the capital redemption reserve for specific purposes with court approval.
When the Reserve is Utilized
According to "Principles of Finance," the most common situation that requires a company to create a capital redemption reserve is when a company redeems its shares. Per SEC regulations, any time a company buys back its own shares with capital or with new shares, the company must put the same amount of money into a reserve fund called a capital redemption reserve. The fund, therefore, offsets the reduction of the company's equity as a result of the share buyback. Further, a company must set aside the same amount of capital in a capital redemption reserve fund when the company purchases the shares with company profits.
Purpose of a Capital Redemption Reserve
The capital redemption reserve fund holds a reserve that the company may use, if necessary, to meet its continuing obligation to creditors. Thus, the reserve functions as a protector of the company's equity. The fund itself is not distributable. This means the company cannot use the funds to pay dividends to shareholders, or for any purpose beyond that of maintaining company equity or for issuing bonus shares. Ultimately, the capital redemption reserve protects a company's creditors.
When the Reserve Does Not Apply
The legal requirement to establish a capital redemption reserve when a company buys back its own shares does not apply in all cases. When private companies whose shares are not bought and sold by the general public buyback shares, these companies do not have to establish capital redemption reserve funds. Additionally, a public company can sometimes obtain a court order that allows the company to buyback shares without establishing a capital redemption reserve fund.