Tax Talk: Corporate debt restructuring in COVID-19 times
The unforeseen tax consequences
Read time: 3 mins
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 partiesGenerally, 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 partiesIt’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.
Debt modificationsUnder 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.