Lender-led debt restructurings: key points to be aware of
This note sets out a brief summary of some of the key UK tax points to be aware of, and pitfalls to avoid, when undertaking these debt restructurings.
Lenders may agree to a full or partial release of the debt to allow the borrower to remain solvent and continue trading, as well as increasing the chances of the borrower repaying any remaining debt. Typically, a release of debt by an unconnected lender will result in a taxable accounting profit for the borrower. Although a struggling borrower may often have sufficient brought-forward losses to shelter the tax charge, it may not be desirable to use up these valuable losses and the availability and use of such losses can often be complex.
In distressed debt situations, however, the “corporate rescue exemption” may be available to eliminate the tax liability without having to rely on the use of losses. In short, the exemption will apply where it is reasonable to assume that, without the debt release (and related arrangements), there would be a “material risk” that the borrower would be “unable to pay its debts” within the next 12 months.
Key points to note
- Unable to pay its debts: This means that, without the release (and related arrangements), within the next 12 months the borrower either would not be able to pay its debts as they fall due (i.e. would be cash-flow insolvent) or that the value of its assets would be less than its liabilities (i.e. would be balance sheet insolvent). However, it is not sufficient for there to be (i) temporary cash-flow issues or (ii) a snapshot of the balance sheet at a given point in time showing liabilities exceeding assets. What is instead required is for the directors to establish (and be able to evidence) that, looking at the borrower’s assets and making proper allowance for its prospective and contingent liabilities, the borrower cannot be reasonably expected to meet those liabilities.
- Related arrangements: A debt restructuring is often part of a wider set of negotiations and actions aimed at ensuring the company can continue to operate. HMRC acknowledges, therefore, that when considering whether it is reasonable to assume that without the debt waiver there would be a material risk that the company would be unable to pay its debts within the next 12 months, it is not necessary to consider the impact of the debt waiver in isolation but rather the wider restructuring steps may be taken into account too.
- Material risk: The “material risk” threshold is lower than the “no reasonable prospect” threshold required for the offence of wrongful trading under insolvency law, so relying on this exemption should not (of itself) mean that directors have breached company law obligations by continuing to trade.
- Evidence: It is crucially important for borrowers to retain evidence demonstrating that there was a material risk of insolvency within 12 months at the time of the debt waiver (e.g. correspondence on its financial position, evidence of likely breaches of financial covenants, management accounts, board minutes etc), which will be needed to support the “reasonable assumption” of the risk of insolvency in the event of a future HMRC enquiry.
Debt-for-equity swaps are often used by lenders to commercially release the underwater debt while giving them some potential equity-upside in the structure if the business recovers. Again, the release of the debt here will usually result in a taxable accounting profit for the borrower unless an exemption applies. While the “corporate rescue exemption” may apply to eliminate this liability, an additional tax exemption should also be available for debt-for-equity swaps where the debt is released in consideration for the issue of ordinary shares in the borrower.
Key points to note
- Ordinary shares: The shares issued in exchange for the release of the debt must be “ordinary shares” i.e. all shares other than fixed rate preference shares, which prevents lenders from just recreating the released debt in equity form.
- Ranking of shares: It is possible to benefit from the exemption even if the shares rank ahead of existing equity, provided a genuine fluctuating return is possible.
- Share value: The share issue has to be “in consideration for” the release (i.e. a gratuitous release cannot just be accompanied by an issue of shares to benefit from the exemption), but a wide disparity between the value of the shares issued and the face value of the debt released should not prevent the exemption from applying.
- Arrangements to divest: The exemption may not apply if there are arrangements in place for the lender to immediately sell the shares to a company connected with the borrower for nominal consideration (e.g. where the existing shareholders do not want to be diluted). However, a subsequent sale for market value due to changes in the lender’s commercial considerations should be acceptable.
A lender may agree to amend the terms of the debt to give the borrower more breathing room to recover, for instance by reducing interest rates or implementing an interest holiday. Agreeing to such contractual changes to the terms of the debt would seem to be straightforward, but there are important tax points to be aware of here.
Key points to note
- Substantial modification: If the amendments to the debt constitute a “substantial modification” for accounting purposes, a taxable profit may arise for the borrower. As with debt waivers, if an accounting profit does arise, the corporate rescue exemption may apply to eliminate the tax liability.
- Amendment vs rescission: It is also important to note that it is possible to make amendments to a debt that are so significant that they amount to an effective rescission of the old debt and the creation of a new debt. This is a case law test, the important factors being the intention of the parties and whether the changes go to "the root of the contract". If the changes are fundamental enough to represent a rescission of the existing debt, the amendments may also create a new testing point for transfer pricing purposes.
Transfer of debt to the borrower group
To facilitate a commercial release of the debt via a debt-for-equity swap, a lender will often transfer the debt to the topco entity in the borrower group in exchange for equity in topco. This will often be preferred to taking equity in the borrower itself to ensure that the lender’s equity interest is aligned with those of the existing shareholders, and also to avoid potentially "de-grouping" the borrower from the rest of its corporate group.
Key points to note
- Deemed release: Although there is no formal release of the debt here, because topco and the borrower are connected parties and the transfer will likely take place at an “undervalue” (i.e. the consideration paid by topco for the debt will be less than the debt’s carrying value), this triggers a "deemed release" of the debt resulting in a taxable credit for the borrower on the amount of the undervalue.
- Corporate rescue exemption: The corporate rescue exemption may again be available to eliminate the tax liability, but because the release is a “deemed” release (rather than a direct release), in addition to meeting the usual requirements for the exemption outlined above, topco must also actually release the debt within 60 days of acquiring it. The acquisition of the debt by topco must also be an “arm’s length transaction”.
- Debt-for-equity swap exemption: The debt-for-equity swap exemption may also apply here to a “deemed” release, again with additional conditions to those mentioned above. The key difference here being that the consideration given by topco for the acquisition of the debt must only consist of ordinary shares. Care must therefore be taken to ensure that in the context of the wider restructuring, any other benefits the lender may receive as part of the commercial negotiations are clearly de-linked from the transfer of the debt to topco.
- Anti-avoidance rule: There is also a targeted anti-avoidance rule that applies specifically to “deemed” releases, which can apply where there are arrangements in place with a main purpose of avoiding a deemed release occurring. HMRC confirms, however, that the use of either of the above-mentioned exceptions to the “deemed” release rules would not in itself be regarded as abusive. In the context of a genuine, commercially driven restructuring, therefore, HMRC should not seek to apply this anti-avoidance rule.
If a lender takes equity in the borrower group as part of a debt restructuring, it may impact the group’s interest deductibility position going forward.
Key points to note
- Corporate interest restriction rules: Under these rules, it is usually possible to elect that genuine third-party finance costs are not subject to the deductibility restrictions (under the group ratio rule or GRR). Following a debt-for-equity swap, if the lender has a 25% or greater equity stake, it will be a related party such that the GRR would no longer allow deductions for interest on that lender’s debt (but some deductions may still be possible under the alternative fixed ratio rule). Even if the lender has a less than 25% stake, there are widely drafted rules which could also deem the lender to be a related party if the lender is “acting together” with the group’s other shareholders (e.g. potentially by entering into a shareholders’ agreement). There are two exemptions which may assist here by preventing the lender from being treated as a related party under these rules.
- Grandfathering rule for corporate rescues: This may apply where the lender and borrower become connected as a result of a release of debt, and immediately prior to that release the conditions of the corporate rescue exemption are met. A lender and borrower will clearly become connected “as a result of a release of debt” on a direct debt-for-equity swap, but there is uncertainty as to whether the exemption would apply to the “deemed release” scenario discussed above; and
- Ordinary independent financing arrangements: This applies where the debt has been lent independently of the circumstances that give rise to the related party status between the borrower and the lender. HMRC’s interpretation of the exemption is narrow, and whilst a broader interpretation might be taken, it is sometimes difficult to be definitive about the availability of the exemption in a restructuring context.
- Anti-hybrids rules: If the lender and borrower are in the same “control group”, the anti-hybrids rules may apply to deny interest deductions for the group. The key test for a control group is whether the lender, together with those “acting together” with the lender, have more than a 50% equity interest in the borrower (directly or indirectly). The broad “acting together” rules may mean that a lender with a minority equity stake can be brought into the “control group” of the borrower, although it is worth noting the following.
- Acting together: HMRC has accepted that the “acting together” rules currently apply very widely and the government has published draft legislation in the Finance Bill 2021 to amend this definition (retrospectively from 1 January 2017) so that any investor holding a 5% or lower equity stake will be excluded from the acting together rules. If a lender, therefore, only takes a 5% or lower equity interest on a debt restructuring, the anti-hybrids rules should not affect the deductibility of interest on the lender’s debt.
- Equivalent rules: The imported mismatch rules can apply where there is a “mismatch” within the lender’s funding structure involving a non-UK jurisdiction which does not have “equivalent” anti-hybrids rules. There has been uncertainty as to whether the introduction of anti-hybrids legislation in other jurisdictions on its own is sufficient for there to be “equivalent” provisions that switch off the UK’s imported mismatch rules altogether, or if the rules in the other jurisdiction actually have to “apply” to restrict interest deductions to switch off the UK rules. The government has now published draft legislation in the Finance Bill 2021 which removes the test on whether the non-UK rules must “apply” in order to switch off the UK rules. This will be replaced with a test based on whether or not the non-UK jurisdiction has rules “equivalent” to the UK’s anti-hybrids regime as a whole. The Finance Bill’s explanatory notes make it clear that this now means there does not have to actually be a disallowance of the deduction in the non-UK jurisdiction in order for the UK rules to be disapplied.
A UK borrower paying interest to a non-UK lender will usually be relying on a double-tax treaty direction from HMRC that enables it to pay interest to the lender without withholding tax.
Key point to note
- Informing HMRC: HMRC gives directions on the basis of the original parties and original terms of the debt. If significant amendments are made to the debt (e.g. extensions, changes in the beneficial ownership of the income, changes in the lender/borrower relationship etc), HMRC will often need to be notified of the changes so they can either confirm no new direction is required or issue a new direction. Failure to do so could invalidate the previously issued direction, requiring the borrower to withhold tax on interest payments.