Tax issues on debt restructure

Summary

The exact form of a debt restructure can have a significant tax impact. This means that the tax analysis should be addressed early on, as there may well be more and less tax efficient ways of achieving a broadly similar outcome for the borrower, while preserving relief for the lender on any element of commercial value loss.

Context of debt restructure

In current market conditions many groups are looking at restructuring their financing arrangements. Primarily the focus is on external debt, but in many cases there will be associated group debt which may need to be restructured too.

The most common types of debt restructure will be:

• For distressed or over-leveraged borrowers, debt for equity swaps;
• Partial debt waivers;
• Amendment of terms of existing borrowing; and
• In whole or part, new debt on different terms allowing repayment or buy back of existing debt.

The fact that interest rates are at historic lows means that, in addition to distressed or overleveraged borrowers, there are also borrowers whose market and covenant position is strong, either individually or by sector, who have an opportunity to refinance. This may be done to reduce borrowing costs or increase debt funding to create a war chest for acquisitions or a capital programme.

The primary questions here, of course, are commercial. However, an unexpected tax charge may affect the assumed economics of the arrangement, so it will be important to address the tax consequences at an early stage before finalising the mechanics. It will also be important to ensure that the way in which the transaction is implemented and documented is consistent with the tax assumptions.

Commercially, the key tax issue is that any credit to the income statement on release of debt is likely to be taxable unless either the debt is itself connected party debt or a specific relieving provision applies. Normally, from an accounting perspective, after initial recognition at fair value, a liability will be carried on an amortised cost basis, so that the borrower will not have reflected in its income statement any credits or debits reflecting changes in the fair value of its liability since the time of issue. Any discount or premium to amortised cost will therefore normally be recognised only when a transaction involving debt is effected. Occasionally, fair value treatment will have been adopted, and any credit or debit on implementing a transaction will largely reflect only the fair value movement since the last accounting date. There may also be an adjustment resulting from the difference between the accounts fair value methodology and the actual third party value, but this will generally be small.

Where the debt is not in the functional currency of the borrowing entity, or there is an associated hedging instrument (whether or not hedge treatment has been adopted from an accounting perspective), the treatment of the foreign exchange movement or the hedge will also need to be considered. The impact of changes to the hedging instrument will depend in part on whether the entity is following the accounts or applying the Disregard Regulations to give a synthesised treatment for the debt and associated hedging instrument. This will need careful consideration on the facts and has not been covered in the general summary below.

Where interest has been accrued but is unpaid or the debt has involved PIK notes (essentially provided for payment in bonds) which have not been issued, additional points will arise which have not been addressed below. With third party debt and regular coupon payments these amounts may be small (simply the accrual since the last interest payment date), but where interest has been deferred or rolled up, there may be more at stake.

Where there is distressed debt, it is sometimes assumed that any tax liability will be wiped out by available losses. It is true that more flexible loss relief rules since 2017 mean losses of different types are more likely to be available for offset, and group relief may be available for brought forward losses. However, it is desirable, if possible, to make sure losses are preserved to allow tax relief against profits as the company recovers. More fundamentally, after the group allowance of £5m has been exhausted, brought forward losses can only absorb 50% of taxable profits in a given accounting period. In a case where a debt restructure does create a tax liability, the amount of the charge is potentially on the full amount of the debt waived or restructured, so the amount at stake will be up to half of the excess over £5m. Losses from the current accounting period are not subject to restriction in this way so it may be possible to reduce that exposure.

Debt for equity swaps

Where senior lenders agree to accept equity for debt, but are unconnected to the borrower (broadly meaning that there is no controlling relationship), unless a specific exclusion applies, releasing debt could give rise to a tax charge. If the lender has an existing equity stake, the question of connection should be considered in more detail.

Key points to note are:

• An exchange of debt for ordinary shares should in most cases benefit from a specific exclusion, provided the documents are appropriately drafted. In some cases, there can be a tension between the requirement under this exclusion for ordinary shares and commercial expectations: however, the recent Upper Tier Tribunal decision in HMRC v Stephen Warshaw suggests, subject to possible further appeal, that some cumulative preference shares may in fact qualify as ordinary share capital for this purpose, giving greater commercial flexibility.
• The exclusion does not apply if in the relevant accounting period a fair value accounting basis is used. The policy reasons why the exemption should only apply to cases where there is an amortised cost basis used are debatable, particularly given the greater flexibility permitted by IFRS 9, but the accounting basis should be checked.
• Getting the documentation right is important. HMRC’s guidance makes clear that HMRC will not treat the exemption in a purposive way, so it is important that the conditions are clearly satisfied regardless of the broader commercial context.
• However, the exclusion will apply even if there is a discrepancy between the market value of the debt and shares issued. So, the exclusion is not prevented from applying because debt with a face value of, say £100, is exchanged for shares with a market value of, say £60: a significant discount will be common in the case of distressed debt. Care would be required however in any case involving manipulation of values. The basis of HMRC’s approach is that third party lenders will typically impose arm’s length terms, so in a context where the relationship is more complex (for example because lenders already have existing equity or there are other specific factors), or steps are being taken to shoehorn an arrangement into the exemption, the risks should be assessed with care.
• The interaction between the accounting treatment of the debt and company law requirements in respect of the share capital will need to be considered and will depend in part on whether the shares (perhaps because they need to rank equally with existing shares in issue) have a share premium or not.

Debt waivers

Where the debt is third party debt, the starting point is that any release creating a credit to the income statement will give rise to a tax liability.

There is a general exclusion for all debt releases where an amortised cost basis applies in the relevant accounting period and the release is as part of a statutory insolvency arrangement or involves a third party debt and the release is part of, broadly, an insolvent liquidation or administration or an equivalent process outside the UK.

Where the debt is troubled but there is no formal process in train, it may alternatively be possible to rely on an exception for cases in which it is reasonable to assume that, absent the release, there would be a material risk that the company would be unable to pay its debts within 12 months. This was intended to provide much greater flexibility than the exclusion for formal insolvency or administration processes, but in practice groups are often reluctant to rely on this because of the potential requirement to evidence that the conditions are satisfied. This can lead to concern about market signals and also to overlap with conditions for wrongful trading. In fact, improving the company’s position by debt restructuring without unnecessary tax charges may be one component of a strategy to ensure that the company can continue to trade, but often this particular provision is of less help than it was intended to be and groups prefer to rely on other exclusions.

In some cases it may in fact therefore be better to consider a debt for equity swap, even if the shares will have limited value. However, if the only purpose of the equity is to prevent a waiver tax charge and the shares lack economic value it would be expected that HMRC would challenge this under anti avoidance principles.

Attempts to step around the release rules by initially buying the debt into a related company, where it either drops out on consolidation or can be waived at a later stage (relying on the provisions which allow releases of debt by connected companies to be tax neutral) will now be caught by the anti debt buy in legislation. Broadly, this rule applies if the price paid is less than the amount which would have been the carrying value of the debt for the debtor company immediately before the acquisition. There are circumstances in which these provisions can still give a more beneficial result than the full waiver rules, but care is required and there is a targeted anti avoidance rule which will need to be considered by reference to the particular facts. There are exemptions from these rules (including the corporate rescue exemption and debt for equity exemption) but in general these will apply only to circumstances where the same treatment would have applied to a similar transaction being implemented direct by a third party lender.

So in most circumstances the only benefit of a purchase by a related company will be speed and simplicity with an external counterparty, which may give more scope for flexibility, as the detail of the ultimate restructure can be resolved after the buy in has been completed.

Amendment of terms, including 'substantial modification'

Simple forbearance in the form of not enforcing interest payments, for example, should not normally trigger a tax charge for the borrower.

However, formal debt variation may affect both the accounting and tax treatment and should be reviewed. Certain types of amendment to loan agreements could result in the original contract being deemed to be terminated or rescinded and replaced with a new one. The contractual position should be reviewed here, in conjunction with the expected accounting treatment and the analysis for the purposes of the relevant accounting standard. Arguably there may in any event be nothing to tax where there is no net credit to the income statement. However, the extent to which accounting entries can be disaggregated for the purposes of the loan relationship rules has always been a grey area, so there is normally a preference, depending on the amounts at stake and the nature of the amendments, for making sure that an exemption also applies.

After the Finance Act 2015 amendments to the loan relationship legislation, express provision was made to cover cases of debt-for-debt exchange in certain limited circumstances. So in certain cases, it will be possible to be entirely confident that a refinancing will not trigger a tax charge. However, the exemption created is very narrow and only applies in cases parallel to those covered by one of the waiver exceptions, in cases where it can be demonstrated that, absent the exchange, there is a material risk that the company will be unable pay its debts within 12 months.

In cases where this narrow test cannot be met or is seen to create reputational risk, there will be no generic exclusion. Here, repayment and new funding may be preferable, depending on key commercial factors, the nature of the amendment and associated accounting issues.

Repayment and new finance

Refinancing which simply replaces debt on maturity does not generally trigger significant tax charges because the maturing debt will be repaid with funds under a new facility. A debt restructure may be able to be effected on a similar basis where the loan principal corresponds to the amount under the original debt. Where debt is to be partially refinanced, it may be possible to ensure that only any part actually eliminated or written off gives a release. Particularly if the lender or syndicate remains the same throughout, the way in which the arrangements are effected legally is likely to be important for the tax analysis.

Lender and borrower mismatches

Where either debt is credit impaired the lender’s and borrower’s carrying costs will normally not match and the same may apply if the parties have adopted different accounting bases and due to credit changes or market factors the coupon no longer represents a coupon rate which is market rate for the borrower. A lender will normally only write down debt assets accounted for on an amortised cost basis under IFRS 9 for reasons of impairment. However, where debt is impaired for the lender, but the borrower is using an amortised cost basis, there will be nothing in borrower accounts to match the existing lender impairment.

Additionally, it is in practice more common for lenders than borrowers to choose the fair value model under IFRS 9. If a borrower is accounting for the debt on an amortised cost basis while the lender is fair valuing it, their accounts carrying values are likely to differ significantly.

In these cases, there may be commercial renegotiations as borrowers seek to strengthen their balance sheets, recognising that in some circumstances there may be no adverse impact on lender balance sheets where the amount settled reflects the lender’s carrying value rather than the full maturity value of the debt. In such cases, there may be a positive impact for a borrower’s income statement. If it makes an early repurchase of bonds, for example, which are trading at a value of 90 but with a face value of 100, there may well be an income statement credit of 10 (assuming an amortised cost basis of accounting and ignoring other wrinkles). However, unless one of the exemptions applies, this credit will normally be taxable. Previous strategies to allow a credit on a consolidated basis which was not taxable will in general now be caught by anti-avoidance rules. Perhaps surprisingly, the position may be different for owner managed businesses where debt is bought back by one or more individual stakeholders, although commercial factors here will be very important.

Address tax issues early

As is so often the case, early consideration of tax issues along with the overall commercial picture is most likely to prevent unnecessary tax costs, and ensure that the restructure can be implemented efficiently.