My corporate client has borrowed £10m from a bank, but it can no longer service the debt. It has been proposed to write off a significant part of this balance via a debt for equity swap. What are the pitfalls in trying to ensure that such a transaction can be undertaken on a tax free basis?
Assuming that the borrower uses an amortised cost basis of accounting for its loan relationships, CTA 2009 s 322(4) provides that no credit need be brought into account if the release of the debt is not a release of relevant rights and is:
‘Ordinary share capital’ takes its normal tax meaning from CTA 2010 s 1119 as any share capital aside from fixed rate preference shares, so this should not cause any difficulties.
However, what is meant by the phrase ‘in consideration for’? Here, HMRC sets out various issues within its Corporate Finance Manual. First, CFM33201 notes that the value of shares given in exchange for the waiver of the debt may typically be worth significantly less than the face value of the debt so waived. This does not impinge on the availability of s 322(4) relief. Indeed, such a debt restructuring will normally be undertaken by a company in financial difficulty and which therefore will, by definition, be worth little.
However, HMRC does take the view that arrangements for the bank to, say, transfer the consideration shares to a related party of the borrower can prejudice the availability of a tax free debt waiver. This is on the basis that the bank never has beneficial interest in the equity, so the shares cannot be said to be given by way of consideration. In case of doubt, it may be possible to seek a non-statutory clearance from HMRC.
Another important point to note is that the shares must be issued by the debtor company. Care must therefore be exercised where debt is owned across a group. In order to fall within this exemption, the debt should first be transferred up to the principal company.
Relief is also available where the debt is released in consideration of an ‘entitlement’ to such shares. Here, HMRC used to take the view that an option or warrant entitling it to subscribe to shares was not sufficient for these purposes. Fortunately, CFM33204 now makes it clear that such arrangements are sufficient for these purposes (provided that it is ‘likely’ that the option or warrant will be exercised).
That leaves us needing to consider what a release of ‘relevant rights’ is. The legislation links back to the anti-avoidance rule at CTA 2009 s 361, which deals with the acquisition of impaired debt by a connected company. Normally, in such circumstances, there is a deemed taxable credit in the borrowing company of an amount equal to the level of impairment of the debt. However, ss 361A, 361B and 361C turn off this charge in certain circumstances, including on the occasion of a genuine ‘corporate rescue’ (361A) or on the issue of replacement debt (361B).
Relevant rights are those acquired under the exemptions at ss 361A and 361B as above (but not s 361C, which deals with the acquisition of debt in exchange for the issue of equity by the connected company). If such acquired debt was subsequently waived, s 358(4) ensures that the normal exemption of a taxable credit on the waiver of a connected party debt does not apply. Similarly, such a charge cannot be avoided by instead using a debt to equity swap.
In addition, it should be noted that in the above analysis, we have not distinguished between the waiver of loan capital or accrued interest. Normal practice dictates that in the absence of any priority in the loan release documentation, the interest element will be deemed to be released first. In most cases, insofar as tax relief will have been claimed thereon on an accruals basis, this will make little difference. However, if the bank was resident in a tax haven and relief has been deferred under the late interest provisions in CTA 2009 Part 5 Chapter 8, it may be beneficial to specify that only loan capital is being waived.
Similarly, if payment of the interest would attract withholding tax, the funding bond rules at CTA 2009 s 413 must also be considered. These rather odd provisions can require part of the consideration shares to be paid over to HMRC, by way of settlement of the withholding tax deductible from the interest deemed to have been paid. This will be based on the market value of the consideration shares so issued.
Setting aside the above tax considerations, the ever increasing regulatory requirements placed on the banking sector may mean that they are unwilling to accept shares by way of consideration for a debt waiver. Section 322 does provide other alternatives, including the use of a company voluntary arrangement (CVA) or the tax-free restructuring of borrowings where the debtor is in insolvent administration or liquidation. A CVA requires the appointment of an insolvency practitioner and the notification of each and every creditor of the borrower. Such an approach may thus entail significant professional fees and may also attract unwarranted attention from otherwise unaffected creditors.
Fortunately, Finance Bill 2015 (Sch 1 Part 1 cl 16) proposes to extend s 322 to provide relief where a loan relationship is simply released in a case where it is likely the borrower will be ‘unable to pay its debts’ within the next 12 months. This provision is to retrospectively take effect from 1 January 2015, although until it is formally enacted (which we cautiously expect to happen before the general election), care should be exercised in seeking to rely on this new relief.
