Over the past 15 months, many businesses have been adversely impacted by the economic disruption caused by COVID-19. While the Government has provided significant financial aid to the business sector, companies of all sizes have needed to review their debt burden to ease the economic distress caused by the pandemic. This has led to companies reorganising their debt via interest and capital payment holidays, debt equity swaps or debt forgiveness. Nonetheless, these measures can have unforeseen tax consequences. Therefore, it’s crucial to understand the situations which can result in a tax liability and how available exemptions can be accessed before making changes to debt terms or structures.
This article covers some of the more common issues that can arise and how they can be managed without unnecessary tax expense.
Releases between third parties
Generally, when a third-party lender releases the borrower from their debt for no consideration a tax liability can arise as a credit will be recognised in the borrowers accounts. If a taxable credit does arise there may be losses available to shelter the potential tax liability arising. However, this will use up a relief which may have been applied to group profits or against profits generated by the company in the future.
There are provisions that prevent such a credit from being taxable in a distressed borrower. Under the corporate rescue exemption, where it can be reasonably assumed that if the release hadn’t been entered into there would be a material risk of the borrower not being able to repay their debts within the following 12 months, the credit arising is not taxable. This doesn’t require the borrower to be in an insolvency procedure, but HMRC guidance does require the company to be in significant financial distress and so advice is recommended to establish whether this requirement is met. It’s possible to obtain advance clearance from HMRC that an exemption applies in certain circumstances when for example, there’s some doubt about an exemption applying
An alternative approach to debt forgiveness is a debt for equity swap, where the lender takes company shares in exchange for the debt it holds. A release in these circumstances is normally tax free provided a number of conditions are met.
Releases between connected parties
It’s important to point out that when the lender and borrower are connected debt forgiveness will not normally be taxable, although there are circumstances in which this exemption doesn’t apply.
For these purposes, a borrower is connected with a lender, if the lender ‘controls’ the borrower. Control is normally determined by the lender holding more than 50% of the share capital, together with voting rights in the borrower. This exemption will normally apply where, for example, a company has borrowed from its parent.
Under current circumstances debt modifications rather than an outright release are more common.
They can occur when the lender formally agrees to a reduction or postponement of interest payments and can also give rise to a tax liability. Whether such a liability arises will depend on the accounting treatment applied in respect of the modification. If the modification triggers a credit in the profit and loss account under general principles this will be taxable. By contrast, simply not enforcing the payment of interest when it falls due, shouldn’t in itself normally give rise to a tax charge. However, all circumstances causing such a suspension of payment should be investigated to confirm the tax treatment.
The accounting treatment for modifications can be complex under FRS 102 or IFRS 9 and, if a modification is classified as ‘substantial’ an accounting adjustment can occur which may be taxable.
If an accounting profit does arise under a modification, the corporate rescue exemption mentioned above can still apply without taxing the profit.
Normally a refinancing of debt at maturity shouldn’t result in adverse tax consequences. taxation. The borrower will simply be repaying existing debt with funds from a new finance provider and no profits or gains should be recorded in the company’s accounts. Where such refinancing takes place with an existing lender, care should be taken to ensure whether there’s been some form of release or modification of the original debt.
When a company is experiencing financial difficulties and is looking to reorganise its debt it’s essential to ensure the solution doesn’t result in an unforeseen tax charge. Addressing potential tax issues as early as possible in the process is key to ensuring the timely implementation of any reorganisation.