For both borrowers and lenders, the UK tax regime for their financial transactions is broadly a case of applying old rules to new situations for which the rules were not intended. The themes of macro-economic structural change and the struggle for tax policy to cope with it are illustrated by the current tax treatment of, and HMRC’s proposed approach to, contingent convertible bonds. While the government is right to consult thoroughly on changes to existing legislation, the pace of change is still in many cases unnervingly slow and there are still too many situations where tax rules are driving the commercial deal.
Access to finance for companies, especially SMEs, in the current financial world is accepted as being severely limited.
On, seemingly, a weekly basis, the press report that our biggest banks are failing to meet their targets for lending to businesses under the so-called Project Merlin.
Yet, at the same time, large companies enjoy access, at extremely low rates of interest, to a range of lenders.
These lenders are keen for exposure to what are considered, in many cases, to be safer credits than banks themselves, or even, in this age of sovereign defaults, than national governments.
Meanwhile, new regulatory obligations themselves drive the issue of new instruments, such as CoCos (contingent convertible bonds), by financial institutions.
Tax rules drafted in, and designed for, the debt-laden past must now apply to a financial world far from the contemplation of their draftsmen.
In this article we examine how those arguably outdated tax rules impact on the new financial landscape.
Tax policy
The government’s stated approach to corporate tax reform, as set out in HM Treasury’s consultative document Corporate Tax Reform: delivering a more competitive system issued in November 2010, includes some welcome principles.
In particular, in the face of the accelerating pace of technological development, the government’s stated principle that ‘the tax system needs to keep pace with these developments and not stifle adaptation or create perverse incentives for business’ is particularly pertinent.
Similarly important are the aims that ‘the tax system should be fair across corporate tax payers without distorting commercial decisions’ and that ‘in bringing forward reforms, the government will seek to avoid complexity where it can’.
One may have some sympathy with the implicit acceptance in that last principle that tax legislation will by necessity often be complex.
However, the new policy of consulting extensively on draft legislation prior to its implementation is, undoubtedly, leading to a reduction in patent errors in legislation, which themselves lead to additional amendments and unnecessary complexity.
Nevertheless, the pace of change is still in many cases unnervingly slow. The tax treatment of foreign profits, for example, continues to change, and the continual drip-feeding of new legislation adds to the impression that the government is simply reacting defensively and under pressure from mobile multi-national corporates rather than having a decided view on the changes it wishes to make.
We are in danger of finding that the new industries and the banks that finance them will have shifted their operations out of the UK (not just to traditional ‘offshore’ jurisdictions but, of more concern, to the financial centres of Europe and Asia) before the government engages with them to convince them to stay.
New capital instruments
The themes of macro-economic structural change and the struggle for tax policy to cope with it are illustrated by the current tax treatment of, and HMRC’s proposed approach to, CoCos.
These instruments, which have been talked about for some years now, are increasingly being seen as an interesting new asset class in their own right, with the possibility of specialist funds being set up to invest into them.
CoCos, of course, can take a number of different forms. They will typically be fixed income securities which convert to equity if a pre-set measure of financial strength is breached.
As such, they combine elements of debt and equity. However, they are not easily definable and can fall to be classified at varying levels in a financial institution’s capital structure.
Equally, of course, we have not yet seen the full range of CoCos issued into the market and, as Basel III comes into force, we will doubtless see variations on a theme as banks seek to prepare themselves for the changes required.
The UK tax rules which govern the tax treatment of these instruments, however, have been on the statute book for generations.
A key concern for any CoCo is the extent to which interest payable on the CoCo is deductible: the conversion or write-down feature of the CoCo can often lead to the conclusion that distribution treatment applies, unless the securities into which conversion may be made are listed on a recognised stock exchange; or the fact that the return depends on the results of the company’s business can do likewise.
In some instances, careful structuring of an arrangement can achieve the same economic result as a ‘traditional’ CoCo (if such a thing can be said to exist) yet produce an entirely different result as regards distribution treatment.
A different, yet perhaps even more anomalous, result of the use of a CoCo is the likely application of stamp duty reserve tax on trading, as a result of the loan capital exemption not being available.
While it is possible in many cases to structure out of an SDRT charge, the requirement to make the notes bearer instruments or the like is an increasingly bizarre requirement in an international context and adds costs and complexity, of particular concern to smaller deals.
In light of these and similar concerns, the issue by HMRC of their discussion paper The tax treatment of regulatory capital instruments is a welcome development.
That paper, highlighting as it does the many tax and accounting concerns over new instruments designed to respond to the challenges of Basel III, is an indication both of the government’s willingness to consult on changes needed to facilitate a new and rapidly developing area, but also the extent of the measures that will be needed to deliver a (benign) tax result for institutions which use these instruments which is reasonably comparable to the tax result prevailing in other jurisdictions.
Compromised loans
Since the onset of the banking crisis, the tax ghost at the proverbial feast has been the extent of unsupportable and unrefinanceable debt, lent particularly (though not exclusively) in the real estate sector, which has continued unrecognised for accounting purposes by lenders.
As banks begin to grapple with the huge volumes of compromised assets on their balance sheets, new structures and financial players are emerging.
With the (largely) continued closure of the securitisation markets, debt funds, particularly real estate debt funds, are emerging as serious players.
The business models vary: the desire of historical lenders with large exposures to offload their loan books, albeit, at a (sometimes substantial) discount, where agreement on pricing can be achieved, creates opportunities for those willing to adopt a relatively passive holding policy, while the loan-to-own model suits those who wish to exercise more active control and force borrowers into insolvency.
These funds are generally much more mobile than the banking institutions they replace as lenders and so are able to be based outside the UK, with consequential tax benefits.
Withholding tax and reliance on tax treaties for relief is of great importance for these funds. The new Double Taxation Treaty Passport Scheme introduced by HMRC last autumn, which eases the process for lenders in obtaining treaty relief from withholding tax on interest paid by UK borrowers, is a welcome improvement on the previous system.
However, the fact that it only applies for loans entered into from September 2010 is a frustration; it could so easily apply in respect of transfers of old loans too.
A less welcome concern for lenders is the continuing uncertainty over how the Indofood decision ([2006] STC 1195) is to be interpreted.
HMRC’s published view, that the interpretation in tax treaties of the term ‘beneficial ownership’ in light of its ‘international fiscal meaning’ will generally only be necessary in cases of ‘treaty abuse’, is not particularly comforting; this is another example of application of legislation by reference to a subjective and non-specific view of how the world should operate. It continues to be a hindrance to investment into UK debt securities.
For debt fund investors, the quest continues for an effective vehicle through which to invest into UK debt while ensuring that tax is payable only on profits enjoyed by investors by reference to their own tax treatment.
Offshore vehicles, as we have seen, have UK withholding tax to worry about (not to mention local tax issues, such as the introduction of transfer pricing requirements in Luxembourg). Transparent onshore vehicles, like the limited partnership, suffer from the same problem.
A UK limited company is generally subject to all the restrictions on deductions for financing costs, while the regime for securitisation companies, upon which latterly the securitisation market in the UK relied so heavily, is as yet broadly untested as regards its application to the more active management requirements of debt fund investors, as compared to the traditionally passive securitisation deals done a few years ago.
There is certainly room in the market for a vehicle, based along REIT lines, which would allow investors to enter this market and so assist the unwinding process of excessive real estate-related debt in the UK.
Borrower concerns
If things are tough for lenders, pity the borrowers. As bank lending remains tough to source, corporates are being forced towards the high yield bond market, and mezzanine debt is filling the vacuum left as traditional senior debt levels decline.
From a tax perspective too, those UK corporate borrowers who are looking to achieve a restructuring of their debt without recourse to an insolvency process are faced with the prospect of tax charges on loan waivers (other than debt for equity swaps) and increased risks that financing costs will be denied under the transfer pricing rules.
These rules are supplemented by the rules (tightened in November 2009) which impose charges on the purchase of impaired debt issued by a connected company (other than in certain closely defined circumstances).
The aim of these rules appears to be to ensure that solvent companies do not manipulate the tax rules to achieve a tax-free reduction in their borrowings.
However, while those companies which are formally in an insolvency process, such as administration, can use a range of transactions to clean up their capital structure without triggering a tax charge, by comparison a company which is in the same financial position, but with creditors and shareholders who can agree amicably on a route forward and who do not wish to incur the costs of appointing administrators, is placed at a disadvantage.
HMRC also appear to be prone to taking an unnecessarily tough line on the application of the exception for debt-equity swaps. In order to benefit from the exception, a release of debt must be ‘in consideration for’ ordinary shares or an entitlement to ordinary shares.
HMRC say very properly in their guidance in their Corporate Finance Manual (at CFM33202) that:
‘a bank or other lender may accept shares in exchange for releasing debt because they hope that the shares will increase in value, allowing them to recoup all or part of their loss on the debt (or even make a profit). If the release gave rise to an additional tax charge on the debtor company, it would depress the value of the shares and, in effect, inflict a further financial loss on the lender. The purpose of CTA 2009 s 322(4) is to facilitate such debt/equity swaps by allowing them to proceed on a tax-neutral basis.’
What HMRC do not appear to realise fully is that, almost invariably in the current market, the fact that the bank is agreeing to release part of the debt only arises because the borrower is, as a technical matter, in default on its loan, and, as such, generally in a position where its shares are valueless.
HMRC appear to require that the bank should receive shares of real value as part of the deal, which is, of course, virtually impossible to show in these scenarios.
Even where their debt remains in place, borrowers continue to face a range of restrictions on the deductibility of interest costs.
As finance becomes harder to source, more structured deals with a closer affiliation to an equity position may become necessary.
In these cases, the transfer pricing rules may apply especially if financers can be considered to be working together with shareholders to finance the company (as would indeed generally be the case especially in the current economic position).
Debt carrying high interest rates to reflect increased levels of risk may also face challenges on deductibility, on the grounds that the consideration given by the borrower represents more than a reasonable commercial return for the use of that principal.
Such securities may also carry the risk of degrouping the issuer from its parent company for tax purposes, thereby triggering corporation tax degrouping charges or clawbacks of SDLT group relief.
Furthermore, moves to limit further the deductibility of finance costs under rules such as the worldwide debt cap impose, through their sheer complexity apart from anything else, further hindrances to doing effective business even in a wholly UK context.
There is good news, however, in the REIT market. Budget proposals include relaxations of the existing regime to make financings more flexible, in particular to deal with a difficult market.
Industry representations have recently been submitted and there is hope that the regime will be revised, enabling equity finance to be more attractive as a new source of capital for those in the real estate investment sector.
Conclusion
For both borrowers and lenders, the UK tax regime for their financial transactions is broadly a case of applying old rules to new situations for which the rules were not intended.
It would be wrong to replace the old rules with a completely new regime; and the government is right to consult thoroughly on changes to existing legislation, not least because in the current environment circumstances legislated for today may not apply tomorrow.
However, there are still too many situations where tax rules are driving the commercial deal, such as where companies are using insolvency procedures, with all they entail, for jobs and creditors, because of the tax advantages that they provide or where the UK rules require a different financing structure to be applied in the UK from one which would be available in, say, Hong Kong.
The government could do worse in its quest to revive the British economy than to demonstrate more of a zeal to solve these issues (welcome though the discussion paper on CoCos and proposals on REITs may be).
Cathryn Vanderspar, Corporate Tax Partner, Berwin Leighton Paisner
Charles Goddard, Corporate Tax Partner, Berwin Leighton Paisner
