Finance Bill 2012: Debt buy-back legislation

On 27 February 2012 changes to the deemed release rules in the loan relationships part of CTA 2009 were introduced with considerable publicity and with retrospective effect. These now appear as clause 23 of the Finance Bill 2012.

The accounting approach

For accounting purposes it is an absolute principle that, if a debt is released by a creditor, that produces a debit in the balance sheet which has to be matched by a corresponding credit in the income statement. FRS 26 (IAS 39) provides:

‘39. An entity shall remove a financial liability (or a part of a financial liability) from the balance sheet when, and only when, it is extinguished, ie, when the obligation specified in the contract is discharged or cancelled or expires.

‘41. The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit and loss.’

For example, a company raises funds by issuing listed debt for 1,000. Its creditworthiness declines and the market value of the debt falls to 700. The company buys back the debt at a discount to its issue price. The accounting entries are:

Derecognition thus produces an accounting profit, be it only on paper. In a group situation it will be washed out in the consolidated accounts.

The tax approach

The tax analysis has never been taken as far as the accounting approach. This is for four reasons. First, a company should not profit from the risk of self-default. Second, tax systems generally accord a special treatment to intra-group debt, treating it as an equity investment (quasi-equity). Third, tax has to be paid with cash. Tax rules have to be aligned more closely with the cash position than the accounts position. Fourth, taxation is based on entity accounts so that paper profits in a group situation become real profits in tax terms.

Hence, the carrying value of debt for accounting and for tax purposes respectively fundamentally diverges.

The loan relationship rules

Every reader of Tax Journal knows that the loan relationship rules have one set of rules for loans where the creditor and debtor companies are unconnected, and another set of rules which apply where the creditor and debtor companies are connected. ‘Connection’ has since 2002 been defined in terms of voting control (CTA 2009 s 466). Where debtor and creditor are unconnected, and debt is written down, the creditor gets impairment relief and the debtor has to bring in a release credit. Where debtor and creditor are connected, and debt is written down, the creditor gets no impairment relief but the debtor does not have to bring in a release credit (CTA 2009 s 358).

How do these rules apply where either (a) an unconnected debtor and creditor become connected, or (b) connected creditors and debtors cease to be connected. Since 1996 there have been at least five attempts to answer this question.

Deemed releases

The concept of ‘deemed release’ was introduced by FA 2005. Until 8 November 2009, the law was set out in the original version of CTA 2009 ss 361, 362. These provisions applied in two cases:

• Section 361: Identity of creditor changes from one creditor to a different connected creditor, who has not previously been connected with the debtor. The original creditor sells debt at a discount to a new creditor who becomes connected with the debtor. At that point there is a deemed release by the new creditor of the discount at which the debt was acquired. The new creditor does not obtain an impairment loss. The debtor has to bring in a corresponding credit, which is chargeable to tax.
• Section 362: Identity of creditor remains the same but the creditor changes from being unconnected to connected. An unconnected creditor (C) holds or obtains a loan relationship at a discount. That creditor then becomes connected with the debtor. At that point there is a deemed release by the creditor of the amount of the impairment adjustment, if C’s accounts had been adjusted to take account of it immediately before connection was established. The creditor has no impairment loss. The debtor has to bring in a corresponding credit, which is chargeable to tax.

The legislation contained a broad-ranging exception for bona fide commercial transactions from the charge in case (1), and in relation to case (2) HMRC introduced a practice by which impairment provisions in the period in which the creditor became connected with the debtor were left out of account in calculating the deemed release in the debtor company.

The 2009 legislation

With effect from 9 November 2009 FA 2010 s 44 did away with the broad exception in CTA 2009 s 361 and replaced it with three narrow exceptions in ss 361A–361C, namely:

• corporate rescue exception (s 361A);
• debt-for-debt exception (s 361B); and
• equity-for-debt exception ( s 361C).

The first two exceptions were essentially a deferral. If the new debt was subsequently released, there would be a ‘release of relevant rights’ which would bring into tax the charge deferred at the time of the original acquisition (CTA 2009 s 322(4)).

‘Immediately after’

One gap in the legislation appeared to be left. The charge under s 361 (case (1)) was only applicable if:

• a company (D) was party to a loan relationship as debtor;
• another company (C) becomes party as creditor to that relationship; and
• immediately after it does so C and D are connected’ (s 361(1)(c)).

If therefore the acquired debt could be routed through an unconnected company, which subsequently became connected with the debtor, ss 361 and 362 would alike be circumvented.

My advice on this point was that debtor companies are driven between the Scylla of s 361 and the Charybdis of s 362. If the debtor escaped the whirlpool of s 361 he would end up on the rocks of s 362. The effect of the Ramsay principle on composite transactions should not be overlooked.

Other advisers were more sanguine. Some companies concluded that – to quote Bertie Wooster – they ‘had received absolute inside information straight from the horse’s mouth that all was hotsy-totsy’.

On that basis schemes were constructed under which:

• where listed debt was trading at a discount, the debtor put an unconnected company in funds to buy back the debt;
• the debt was acquired at a discount to its nominal value by Newco; and
• the debtor company then acquired Newco, which released the parent company debt.

The new legislation

Instead of submitting in the ordinary manner to the decision of the courts, the Budget introduces new rules back-dated to 1 December 2011.

The new legislation seeks to block such schemes with retrospective effect by a number of measures:

1. Section 361 (Case 1) is not as such changed. Instead it is given a special application for the period 1 December 2011 to 27 February 2012. If during that period there are arrangements whereby a company C acquires debt of D and then at a subsequent stage becomes directly or directly connected with D, then the deemed release provisions in CTA 2009, s 361(1) are regarded as triggered.
2. Section 362 (Case 2) is amended with effect from 1 April 2012 so that (i) there is no requirement for an impairment adjustment in C, and (ii) the amount of the deemed release is the excess of (a) the amount of the liability in D’s books, over (b) the creditor’s pre-connection carrying value(PCCV), being the cost of the acquisition of the asset.
3. Where companies become connected within case (2) on or after 27 February 2012 but before 1 April 2012 then different amendments to s 362 are made. The amount of the deemed release is the higher of two amounts, namely, (i) the impairment adjustment in C’s accounts and (ii) the excess of the PCCV in D’s accounts over the PCCV in C’s accounts.
4. In cases (1) and (2) where arrangements are entered into whose main purpose or one of whose main purposes is to reduce the amount of the deemed release in s 361 or s 362, that scheme is not effective. This is the new s 363A which applies to (i) any arrangements entered into before 27 February 2012 where the deemed release would have occurred on or after that date; and (ii) arrangements made on or after 27 February 2012.

Conclusions

First, the deemed release rules invent a transaction which does not take place (a deemed release) and tax it as if it did. This is not an anti-avoidance rule. It does not collect tax which might otherwise be avoided. It imposes tax which would not otherwise be due. It is the logical antithesis of an anti-avoidance rule. It is a tax creation rule.

Second, concerns have been expressed that the motives for the new legislation may have been political rather than technical. Constitutional norms may have been sacrificed. It was not for this that Thomas à Becket died on the steps of the altar of Canterbury Cathedral, or John Hampden refused to pay Ship Money.

Third, where companies are in distress, the prudent advice in the future must be: liquidate, don’t restructure.

Fourth, the underlying policy reason for the deemed release rules (other than simply to raise tax) remains veiled in obscurity. In the view of some, this is a solution seeking a problem.

David Southern, Barrister, Temple Tax Chambers