Covid-19 and Debt Restructuring

One of the inevitable consequences of the economic downturn resulting from the Covid-19 crisis is that many companies will need to take steps to restructure debts. This Tax Bite very briefly highlights some of the most important tax points to be aware of on common debt restructuring actions, and some consequences companies may not have thought of.

• General rule – debt waivers are taxable – where the lender and borrower are not connected for tax purposes, if a debt is released or waived the general rule is that the borrower is taxed on the amount written off (assuming there are insufficient losses to offset that amount). The upside though is that the lender should get a deduction for the amount written off (assuming a UK corporate taxpayer). Where the borrower is in financial difficulty and the waiver is aimed at securing its viability, there is a “corporate rescue exemption” in the legislation, which if available switches off the tax charge (but still leaves the deduction available for the lender). Advisers are, however, often uncomfortable concluding that the corporate rescue exemption will be available, as it involves a hypothetical, subjective assessment of whether the company would go into insolvency. In the Covid-19 crisis however, that assessment may be clearer.

• Debt for equity swaps – not least due to the uncertainty that can hang over the availability of the corporate rescue exemption, debt for equity swaps have been popular from a tax perspective as there is a more straightforward exemption from the waiver / release tax charge in the legislation when the loan is released in consideration for an issue of ordinary share capital in the borrower (whilst still maintaining a deduction for an unconnected lender). The value of the shares issued does not necessarily have to match the loan written off, nor is there a set amount of time the shares must be held. However this exemption too has its limits, for example HM Revenue & Customs will not accept that the exemption is available if the lender has no real interest in being a shareholder and arrangements are made for the shares to be transferred to another party very shortly after issue.

• Subscription and repayment - If neither of the above exemptions is available then the lender could subscribe cash for new (possibly deferred) shares and that cash is then used to repay the debt. Ideally the cash would physically move and it should be the case that there is no tax charge for the borrower (as it is a repayment not a release), but the downside is that the lender will not benefit from a tax deduction. The commercial and other legal consequences of this route would also need to be considered.

• The risk of change of control – particularly in debt for equity swaps, it is possible that the lender could end up with a controlling stake in the borrower. The tax implications of a change of control of a borrower, particularly if there is a corporate group structure, can be very complex. Some of the potential implications (which are very much fact-dependent) include de-grouping charges, the inability to make use of carried forward losses, and additional restrictions of claiming deductions for interest payments.

• Deemed release rules – there are two sets of rules under which companies are deemed to have had a debt released resulting in a tax charge. They cover (a) where a debt is impaired (i.e. worth less than its face value) and the lender becomes connected with the borrower, and (b) where an impaired debt is acquired by a lender that is already connected with the borrower. Broadly, the rules are aimed at preventing exploitation of the general rule that debt waivers between connected companies do not trigger a tax charge for the borrower. These rules are complex and often overlooked. There is a corporate rescue exemption, as with the general debt waiver rules, but subject to the same concerns over whether the exemption can be relied on.

• Implications for EMI / EIS – if the debtor company has issued EMI options and/or has EIS investors, then if the result of a debt restructuring transaction is that the company comes under the control of another corporate, this will be a disqualifying event for EMI options (whenever it happens) and will result in loss of EIS reliefs (if it happens within three years of the issue of the shares, or if later within three years of the qualifying trade commencing). If the company is in severe financial distress, any EMI options could be “underwater” anyway but the company could not grant any further EMI options whilst under corporate control, whereas for EIS investors even if the investment had not performed well they would not want to see their income tax relief on investment clawed back.

Posted on 27/05/2020 in Tax News, Debt Restructuring, Tax and Covid-19


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