The purchase of distressed companies throws up different issues from standard corporate acquisitions. Care needs to be taken to ensure that the consideration structure offers the protection that the buyer wishes and any debt restructuring of the target’s debt does not cause unexpected tax charges to arise. Making a loan to target for it to pay off its debt is the most popular route but debt purchasing, share subscriptions or gifts may also be considered.
The purchase of distressed companies throws up different issues from standard corporate acquisitions. Eloise Walker and Mark Ingram set out the tax issues.
Over the past few years it has been increasingly common for purchasers to acquire distressed companies. These acquisitions can present a whole host of additional tax and commercial issues compared with a normal acquisition of a company. These issues are not often immediately apparent and can cause some headaches for the tax managers involved.
Let’s look at a common situation for distressed companies. Mr A from Company X wants to purchase Company Y. Company Y has hit financial difficulties and is on the cusp of insolvency but is not yet insolvent. The shareholders of Company Y are only willing to sell the shares in Company Y and as such Company X is only willing to pay £1 for Company Y. So far so good, but Mr A has also agreed that Company X will provide £20m worth of funding into Company Y to repay some of its current debt.
The parties have agreed that warranties and indemnities are to be given by the sellers. It seems that the consideration for Company Y is £1, but on discussing the matter further with Mr A it becomes apparent that Company X considers the economic value of the deal to be £20m (after all, Company X is putting £20m into Company Y as part of the deal).
An initial commercial point that needs raising is what will the limit of liability for any warranty or indemnity claims be. Normally you would expect to see the limit of liability based on the consideration payable for Company Y. Under our
Under our example, Company X has only paid £1 and any payment by the sellers under the warranties and indemnities exceeding £1 will not fall within the scope of Extra Statutory Concession D33. This payment will not be an adjustment to the consideration and is likely to be taxable in Company X’s hands.
There are some practical ways around this issue, namely, either:
The relative merits of each of these methods
Options to restructure the debt
Using our example above, Company X has agreed to provide £20m worth of funding to Company Y so that Company Y can repay its debt, but Mr A wants to know how Company X might achieve this. There are a number of options that Company Y’s shareholders might want to consider. Essentially the main options to fund Company Y are:
Company X could also fund the repayment of the debt in other ways (eg, by subscription for preference shares in Company Y), but consideration of these would take up a whole new article so we shall limit ourselves to the most popular scenarios.
Each of these options raises their own issues and will need to be reviewed in the context of the wider transaction. Tax issues aside, one overriding concern is whether Company Y is technically insolvent. The directors and Company X should review the
When considering these options with Company X it will need to be borne in mind what Company X expects as a return (if any) for the refinancing and what exit plan Company X has for Company Y.
Figure 2 sets out a summary of the issues that arise in respect of each of these options, discussed further below.
Purchase of Company Y’s debt
Company X could agree with the lenders of Company Y to purchase the debt from these creditors. Commercially, this may have the benefit that Company X is able to buy the debt at a discount from Company Y’s creditors.
From the perspective of Company X it will have acquired a money debt and will fall within the loan relationship rules in CTA 2009 Part 5 – Company X will own the whole share capital of Company Y and will be ‘connected’ for the purposes of the loan relationship rules under CTA 2009 s 466.
If Company X acquires debt at less than its face value from a third party and becomes connected with Company Y, Company X will be deemed to release some of its rights under the loan relationship rules in accordance with CTA 2009 s 361. This will trigger a taxable receipt in the target which is broadly equal to the discount. It will therefore be important for Company X that it falls within one of the exceptions to CTA 2009 s 361. The most likely exception to apply (if any) is the corporate rescue exemption under CTA 2009 s 361A. The conditions require careful consideration and cannot always be satisfied; also, with this exemption, the timing when Company X acquires the debt is important. Company X must acquire the debt within one year prior to its acquisition of the shares in Company Y or 60 days after. Usually everything will be arranged to happen on the same day, but if Mr A wants to proceed with the company purchase before the debt purchase is agreed, you will want to advise Mr A of this risk.
Although Company X acquires the debt, this does not necessarily help the financial position of Company Y. In particular, Company Y will still be as indebted as it was before Company X acquired it. Following the acquisition of the debt, Mr A suggests that he would like to improve the debt position of Company Y and has suggested that Company X waive the debt owed to it by Company Y.
Any adjustments to the new debt issued by Company Y to Company X will be subject to the connected parties rules under the loan relationship regime such that if there is any release of debt by Company X under CTA 2009 s 354, no tax deductible can be claimed by Company X.
Company X and Company Y will also need to consider the transfer pricing and thin capitalisation rules under TIOPA 2010 Part 4 as Company X will wholly own Company Y when there is the new loan from Company X. As such there will be restrictions on deductions if the transaction is not on arm’s-length terms, although if Company X and Company Y are both UK taxable companies there should usually be no effective increase in tax (as Company X’s income should be correspondingly reduced).
Additionally even if TIOPA 2010 Part 4 did not apply, there are special catch-all provisions within the loan relationship rules which Company X and Company Y would need to consider if the new loan is not at arm’s-length. Under CTA 2009 s 444 credits and debits of Company X and Company Y may be restricted to those of ‘knowledgeable and willing parties dealing at arm’s length’. This will not apply where TIOPA Part 4 applies or where debt is acquired from a non-connected party at less than market value.
It is important that any intra-group loan satisfies the conditions of being a loan relationship. This has become increasingly important following the case of MJP Media Services Ltd v HMRC [2011] STC 2290. As such a loan to Company Y should be properly documented, especially where no monies move through Company Y’s accounts because Company X (as is usual in practice) makes payment directly to existing lenders on its behalf.
Additionally, a normal commercial loan to Company Y is not subject to stamp duty and the only stampable consideration (if documented properly) should be the £1 consideration paid. This is the most trouble-free way to fund a target acquisition and therefore the most popular route.
Company X could consider gifting cash to Company Y to repay its debts. This option is unlikely to be very tax efficient for either Company X or Company Y. For Company X it is unlikely that it will get a tax deduction for any gift and it should not increase its base cost in Company Y under TCGA s 38 (assuming substantial shareholding exemption is not applicable).
For Company Y it is likely that the gift should be
Company X could decide that it will subscribe for new shares in Company Y once it has acquired Company Y. This will mean that Company Y will have additional share capital and funds to be able to repay its loans. As described in the loan to Company Y section, this repayment of debt should follow the accounting treatment.
The subscription for new shares will form part of Company Y’s share capital and therefore it will be difficult for Company X to be repaid this sum in future without undergoing some form of capital reduction. Company Y will also need distributable reserves in order to make distributions going forwards and these will be from post-corporation tax profits.
For Company X it will have acquired new shares and there is a point in TCGA 1992 s 17(2) to watch out for here around the number of shares issued. Under s 17(2), the base cost of the new shares will be the lower of: (i) the value given for the shares (the cash subscribed in this case) and (ii) the market value of the new shares. An example is the easiest way to explain the problem. Let’s say Company Y wasn't distressed and has 1.5 million ordinary shares already in issue (current market value £3m), and Company X subscribes for three million new shares for £3m. Company X's base cost in the new shares should be £3m, because that is lower than the market value of 3 million (new shares issued) divided by 4.5 million (total shares) multiplied by £6m (value of the issuer) ie, £4m. Now let's assume Company Y is distressed and its current market value is nil. The base cost is then the lower market value which is 3m (new shares issued) divided by 4.5m (total shares) multiplied by £3m (value of the issuer) ie, only £2m. If Company X will have the benefit of the substantial shareholding exemption on a later disposal of Company Y, this may not matter, but if there is any doubt about that it may be important to bear the potential effects of TCGA 1992 s 17(2) in mind.
Eloise Walker, Partner, Pinsent Masons
Mark Ingram, Solicitor, Pinsent Masons
The purchase of distressed companies throws up different issues from standard corporate acquisitions. Care needs to be taken to ensure that the consideration structure offers the protection that the buyer wishes and any debt restructuring of the target’s debt does not cause unexpected tax charges to arise. Making a loan to target for it to pay off its debt is the most popular route but debt purchasing, share subscriptions or gifts may also be considered.
The purchase of distressed companies throws up different issues from standard corporate acquisitions. Eloise Walker and Mark Ingram set out the tax issues.
Over the past few years it has been increasingly common for purchasers to acquire distressed companies. These acquisitions can present a whole host of additional tax and commercial issues compared with a normal acquisition of a company. These issues are not often immediately apparent and can cause some headaches for the tax managers involved.
Let’s look at a common situation for distressed companies. Mr A from Company X wants to purchase Company Y. Company Y has hit financial difficulties and is on the cusp of insolvency but is not yet insolvent. The shareholders of Company Y are only willing to sell the shares in Company Y and as such Company X is only willing to pay £1 for Company Y. So far so good, but Mr A has also agreed that Company X will provide £20m worth of funding into Company Y to repay some of its current debt.
The parties have agreed that warranties and indemnities are to be given by the sellers. It seems that the consideration for Company Y is £1, but on discussing the matter further with Mr A it becomes apparent that Company X considers the economic value of the deal to be £20m (after all, Company X is putting £20m into Company Y as part of the deal).
An initial commercial point that needs raising is what will the limit of liability for any warranty or indemnity claims be. Normally you would expect to see the limit of liability based on the consideration payable for Company Y. Under our
Under our example, Company X has only paid £1 and any payment by the sellers under the warranties and indemnities exceeding £1 will not fall within the scope of Extra Statutory Concession D33. This payment will not be an adjustment to the consideration and is likely to be taxable in Company X’s hands.
There are some practical ways around this issue, namely, either:
The relative merits of each of these methods
Options to restructure the debt
Using our example above, Company X has agreed to provide £20m worth of funding to Company Y so that Company Y can repay its debt, but Mr A wants to know how Company X might achieve this. There are a number of options that Company Y’s shareholders might want to consider. Essentially the main options to fund Company Y are:
Company X could also fund the repayment of the debt in other ways (eg, by subscription for preference shares in Company Y), but consideration of these would take up a whole new article so we shall limit ourselves to the most popular scenarios.
Each of these options raises their own issues and will need to be reviewed in the context of the wider transaction. Tax issues aside, one overriding concern is whether Company Y is technically insolvent. The directors and Company X should review the
When considering these options with Company X it will need to be borne in mind what Company X expects as a return (if any) for the refinancing and what exit plan Company X has for Company Y.
Figure 2 sets out a summary of the issues that arise in respect of each of these options, discussed further below.
Purchase of Company Y’s debt
Company X could agree with the lenders of Company Y to purchase the debt from these creditors. Commercially, this may have the benefit that Company X is able to buy the debt at a discount from Company Y’s creditors.
From the perspective of Company X it will have acquired a money debt and will fall within the loan relationship rules in CTA 2009 Part 5 – Company X will own the whole share capital of Company Y and will be ‘connected’ for the purposes of the loan relationship rules under CTA 2009 s 466.
If Company X acquires debt at less than its face value from a third party and becomes connected with Company Y, Company X will be deemed to release some of its rights under the loan relationship rules in accordance with CTA 2009 s 361. This will trigger a taxable receipt in the target which is broadly equal to the discount. It will therefore be important for Company X that it falls within one of the exceptions to CTA 2009 s 361. The most likely exception to apply (if any) is the corporate rescue exemption under CTA 2009 s 361A. The conditions require careful consideration and cannot always be satisfied; also, with this exemption, the timing when Company X acquires the debt is important. Company X must acquire the debt within one year prior to its acquisition of the shares in Company Y or 60 days after. Usually everything will be arranged to happen on the same day, but if Mr A wants to proceed with the company purchase before the debt purchase is agreed, you will want to advise Mr A of this risk.
Although Company X acquires the debt, this does not necessarily help the financial position of Company Y. In particular, Company Y will still be as indebted as it was before Company X acquired it. Following the acquisition of the debt, Mr A suggests that he would like to improve the debt position of Company Y and has suggested that Company X waive the debt owed to it by Company Y.
Any adjustments to the new debt issued by Company Y to Company X will be subject to the connected parties rules under the loan relationship regime such that if there is any release of debt by Company X under CTA 2009 s 354, no tax deductible can be claimed by Company X.
Company X and Company Y will also need to consider the transfer pricing and thin capitalisation rules under TIOPA 2010 Part 4 as Company X will wholly own Company Y when there is the new loan from Company X. As such there will be restrictions on deductions if the transaction is not on arm’s-length terms, although if Company X and Company Y are both UK taxable companies there should usually be no effective increase in tax (as Company X’s income should be correspondingly reduced).
Additionally even if TIOPA 2010 Part 4 did not apply, there are special catch-all provisions within the loan relationship rules which Company X and Company Y would need to consider if the new loan is not at arm’s-length. Under CTA 2009 s 444 credits and debits of Company X and Company Y may be restricted to those of ‘knowledgeable and willing parties dealing at arm’s length’. This will not apply where TIOPA Part 4 applies or where debt is acquired from a non-connected party at less than market value.
It is important that any intra-group loan satisfies the conditions of being a loan relationship. This has become increasingly important following the case of MJP Media Services Ltd v HMRC [2011] STC 2290. As such a loan to Company Y should be properly documented, especially where no monies move through Company Y’s accounts because Company X (as is usual in practice) makes payment directly to existing lenders on its behalf.
Additionally, a normal commercial loan to Company Y is not subject to stamp duty and the only stampable consideration (if documented properly) should be the £1 consideration paid. This is the most trouble-free way to fund a target acquisition and therefore the most popular route.
Company X could consider gifting cash to Company Y to repay its debts. This option is unlikely to be very tax efficient for either Company X or Company Y. For Company X it is unlikely that it will get a tax deduction for any gift and it should not increase its base cost in Company Y under TCGA s 38 (assuming substantial shareholding exemption is not applicable).
For Company Y it is likely that the gift should be
Company X could decide that it will subscribe for new shares in Company Y once it has acquired Company Y. This will mean that Company Y will have additional share capital and funds to be able to repay its loans. As described in the loan to Company Y section, this repayment of debt should follow the accounting treatment.
The subscription for new shares will form part of Company Y’s share capital and therefore it will be difficult for Company X to be repaid this sum in future without undergoing some form of capital reduction. Company Y will also need distributable reserves in order to make distributions going forwards and these will be from post-corporation tax profits.
For Company X it will have acquired new shares and there is a point in TCGA 1992 s 17(2) to watch out for here around the number of shares issued. Under s 17(2), the base cost of the new shares will be the lower of: (i) the value given for the shares (the cash subscribed in this case) and (ii) the market value of the new shares. An example is the easiest way to explain the problem. Let’s say Company Y wasn't distressed and has 1.5 million ordinary shares already in issue (current market value £3m), and Company X subscribes for three million new shares for £3m. Company X's base cost in the new shares should be £3m, because that is lower than the market value of 3 million (new shares issued) divided by 4.5 million (total shares) multiplied by £6m (value of the issuer) ie, £4m. Now let's assume Company Y is distressed and its current market value is nil. The base cost is then the lower market value which is 3m (new shares issued) divided by 4.5m (total shares) multiplied by £3m (value of the issuer) ie, only £2m. If Company X will have the benefit of the substantial shareholding exemption on a later disposal of Company Y, this may not matter, but if there is any doubt about that it may be important to bear the potential effects of TCGA 1992 s 17(2) in mind.
Eloise Walker, Partner, Pinsent Masons
Mark Ingram, Solicitor, Pinsent Masons
