Guidance published by HMRC in its Corporate Finance Manual has recently been updated to reflect a change in practice regarding the corporation tax treatment of debt for equity swaps.
Debt for equity swaps are commonly used in corporate restructuring, particularly when a company is in financial difficulty. They may also be encountered in the termination of joint venture arrangements where, prior to the sale of shares in the joint venture company by one co-venturer to the other, the parties wish to convert any loans made to the company into shares.
Generally speaking, where a debt owed by a UK resident company to an unconnected creditor (50/50 joint venturers will typically not be connected with the joint venture company) is released, a charge to corporation tax may arise in the borrower company. The loan relationship tax rules require a credit to be brought into account for tax purposes that is equal to the amount of credit recognised in the company's accounts.
An exception exists, however, where the debt is released "in consideration of" an issue of ordinary shares in the borrower company. In HMRC's recently expressed view, the release of a debt will not be considered to have been made in consideration of shares if the lender company has no interest in being a shareholder of the borrower company and is releasing the debt gratuitously, with the shares being issued merely to obtain a tax advantage for the borrower company. Where there are contractual or other arrangements in place under which the shares issued to the lender company when the debt is released are sold immediately after their issue, HMRC's view (which differs from what most practitioners hitherto have understood the law to be) is that the exception does not apply because the consideration that the lender company receives for releasing the debt is not the issue of the shares but the consideration paid on the subsequent sale of the shares.
Although it is considered that HMRC's revised guidance goes beyond the requirements of the legislation in a number of respects, there remains a risk that a court might agree that, applying a purposive interpretation of the legislation, HMRC's additional criteria should be read into the debt for equity exception. Where possible, therefore, transactions should be structured so that they are able to fall within the new guidance. Alternative ways of structuring the transaction to achieve the same effect may also be available.
If it is not possible to structure the transaction in such a way, a clearance should be sought from HMRC in respect of the proposed transaction and the argument made as to why the legislation should be applied in accordance with the way the legislation is written rather than in accordance with HMRC's revised guidance.