London continues to be a leading market for leveraged finance transactions, with English law frequently governing finance documentation for both European and other international leverage finance transactions.
There is continued diversity both in terms of the range of financial instruments that fund the relevant transactions (including high-yield bonds, syndicated loans, unitranche or direct lending financings, second lien and payment-in-kind financings and preferred equity), as well as the sources of financing available to borrowers (including commercial and investment banks, institutional lenders and funds). In more recent times funds have, through unitranche and direct lending financings, gained increased market share in mid-market transactions.
Historically, parties tended to use industry forms reflecting well-established market practices to document the relevant facility agreement such as the Loan Market Association forms. However, more recently, favourable borrowing conditions, in part driven by competition from the US loan and bond markets, have led to the continued adoption of US 'covenant-lite' and bond market terms into European loans, particularly in sponsor-led transactions.
Regulatory and tax mattersi Regulatory matters
The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) are the financial regulators in the United Kingdom (UK). The PRA is part of the Bank of England and prudentially regulates and supervises banks, building societies, credit unions, insurers and major investment firms. The FCA is responsible for authorising firms and individuals who undertake any regulated financial services activities.
Cash loans to businesses are largely unregulated in the UK, unlike consumer lending or residential mortgages. Therefore, providing a secured or unsecured loan to, or subscribing for a secured or unsecured debt instrument issued by, an entity that is incorporated or tax-resident in the UK is not considered a regulated activity and does not require any kind of banking or similar licence or approval. It is important to note, however, that because much of this activity is carried out by businesses that are regulated for other purposes (banks, investment firms), there may be broader regulation impacting them that may impact the terms of any loan. Similarly, borrowers who are themselves regulated may have restrictions on the nature or scope of security they can offer as a result of financial regulation impacting their business. More complex forms of lending, such as arranging the issuance of, or transacting in, debt instruments that embed derivatives or underwriting a bond issuance would constitute regulated activities, requiring the financial institutions offering those services to comply with regulatory obligations.
The European Central Bank (ECB) published its guidance on leveraged transactions in May 2017. The guidance applies to all 'significant credit institutions supervised by the ECB' under Article 6(4) of the Single Supervisory Mechanism (SSM) Regulation. The UK, along with certain other European Union (EU) Member States, is not subject to the SSM Regulation; therefore, UK credit institutions do not fall within the scope of the guidance. Branches of UK credit institutions established within the SSM are, however, supervised by the ECB. The guidance is also not directly applicable to EU credit institutions that are not categorised as 'significant', or to non-bank institutions. The guidance came into force in November 2017 and is the EU equivalent to the US Interagency Guidance on Leveraged Lending.
The UK left the EU on 31 January 2020 (Brexit), and has now entered a transition period that is due to end on 31 December 2020. Finance providers in the UK previously relying on EU passporting rights to provide financial services in the EU by being a regulated entity in the UK will now have to analyse if they require any licences for financial transactions into the EU.
Borrowers and lenders are subject to the anti-money laundering and sanctions regimes in the UK and will also need to take into account anti-corruption legislation.ii Tax matters
Three areas of taxation are particularly significant in the context of leveraged finance transactions: (1) withholding tax on payments of interest to the lender; (2) the deductibility of interest for the borrower; and (3) tax issues on the enforcement of security.iii Withholding tax
Payments of yearly UK source interest are subject to UK withholding tax at the basic rate of 20 per cent. There are, however, a number of exceptions from the charge to withholding tax, with the following being the most commonly used exemptions:
- Exemption from withholding tax relating to the nature of the lender: Corporates and banks that are taxed in the UK may receive interest gross, given the income of such lenders is taxable in the UK in any event. Advances from building societies are also generally free of withholding tax on interest.
- Exemption relating to the nature of the security: The 'private placement' exemption entitles the holder of privately placed securities to interest free of withholding tax, provided the requirements are met, including the term of the security being less than 50 years and the security having a minimum value of £10 million. Additionally, the 'quoted Eurobond' exemption enables the holder of a security to receive interest free of withholding tax, provided the security is issued by a company and listed on a recognised stock exchange or admitted to trading on a multilateral trading facility.
- Exemption relating to double taxation treaties between the UK and other jurisdictions: The UK has entered into a number of treaties with other jurisdictions, which provide for a nil rate of withholding tax in the UK. Non-UK lenders tax resident in such jurisdictions are entitled to receive interest free of withholding tax. There is an administrative burden involved in relying on this exemption, given it must be claimed, and interest may only be paid free of withholding once a borrower has received an instruction from Her Majesty's Revenue and Customs (HMRC). Further, a claim under the normal certification process can take several months. The double taxation treaty passport scheme, however, grants certain lenders a 'passport' thereby streamlining the otherwise lengthy certification process.
The broad nature of the above exemptions gives significant flexibility, enabling UK borrowers to raise funds from different types of lenders, and different types of security. In particular, the quoted Eurobond exemption enables capital to be raised from offshore funds, which would usually not be capable of benefitting from double taxation treaties with the UK, as the UK will generally not provide for a nil rate of withholding tax in treaties with tax haven jurisdictions.
Additionally, it is important to consider the withholding tax position of any group company that on-lends external funds within its group and requires corresponding interest payments from its internal borrowers free of withholding tax. In this regard, Council Directive 2003/49/EC (the Interest and Royalties Directive) exempts interest and royalties from source state taxation (typically withholding tax) where the payer and payee are associated companies of different EU member states. In light of Brexit, however, the future of this Directive is uncertain. After the end of the transition period, absent any agreement to the contrary, neither the UK nor the EU will continue to be bound in so far as this Directive relates to the UK.iv Deductibility of interest
As a starting point, interest incurred by a UK corporate borrower is, under the loan relationship rules, deductible in calculating taxable profits. The loan relationships provisions, as a general rule, follow the accounts. This means that the amounts recognised in determining a company's profit or loss under generally accepted accounting practice will usually constitute credits and debits under the loan relationships rules. Interest on a loan is a debt service cost to the borrower, and this classification is the starting point for interest-related tax deductions. There are, however, rules that can restrict or prevent the deductibility of interest to be borne in mind, as interest deductibility is often a key commercial driver of debt financings. The below sets out three important examples, but there are other relevant restrictions beyond the scope of this chapter; for example, the unallowable purposes rule, the targeted anti-avoidance rule and rules re-characterising interest as a distribution.
- Corporate interest expense restriction rules limit the amount of interest expense large businesses can deduct when calculating their profits subject to corporation tax. Broadly, the rules place a cap to limit deductions to 30 per cent of a group's UK 'tax EBITDA', or alternatively a modified debt cap is imposed that ensures that a group's UK interest deductions cannot exceed the total net interest expense of the worldwide group. Net interest expenses under the de minimis allowance of £2 million will not be restricted by the rules.
- Where transfer pricing rules apply to a loan (particularly relevant in the context of related-party borrowing arrangements), they operate to deny the borrower a tax deduction for any part of the interest that exceeds an arm's length rate of interest. The terms, amount and availability of the debt will be readjusted (for tax purposes) to those of an arm's-length transaction.
- Corporate income loss restriction limits the amount of post-1 April 2017 profits against which carried-forward losses incurred in any period could be relieved to 50 per cent of profits over an annual allowance of £5 million. Since 1 April 2020, however, the relief provided by the £5 million annual allowance is shared between both carried-forward corporate income losses and carried-forward corporate capital losses.
Tax grouping enables UK group members to allocate gains and surrender losses as between members of the group on a current year basis. This enables deductible interest to be set off against the income generated by another group member, meaning borrowing need not be engaged in by an income-generating company within the group. Further, the group rules allow for assets to be transferred within the group on a 'no gain, no loss' basis. Where these assets are transferred outside of the group (for example, upon the enforcement of security by a lender), de-grouping charges may arise to tax any latent capital gains realised prior to the external transfer.