The Financial Secretary to the Secretary announced yesterday (14th October 2009) to Parliament a change in the rules on how companies are taxed when they or connected parties buy back their debt at a discount. The change is expected to be introduced by the Finance Bill 2010, but applies to debt buy backs taking place on or after 14th October. To read the text of the announcement please click here
In essence the change abolishes a relatively wide exemption from an anti-avoidance rule introduced in 2005, which allowed companies to structure the buy back of debt on a tax free basis. At the time of writing the full details of the legislation effecting the change are not available. It is however clear that while a certain exemption will be available in the context of companies in financial difficulties, the change will have a significant impact on structuring debt buy back transactions in the UK, both in the case of companies in financial difficulties, and more generally. Importantly, the change does not seem to affect the legislation which exempts certain debt waivers from the charge to tax, and in appropriate circumstances it should therefore continue to be possible to structure debt buy backs on a tax neutral basis.
The previous position
As a general rule the difference between the amount paid by a company to redeem or buy back its own debt, and the amount originally borrowed by the company, gives rise to an accounting profit in the hands of the company. Under the UK loan relationship rules such profit is charged to tax.
As an anti-avoidance measure the relevant tax rules extend the same treatment to situations where a company connected with the borrower acquires the debt at a discount. For instance and in broad terms, if a subsidiary of the borrower acquires the borrower's debt at less than the amount borrowed, the legislation deems there to be a waiver of the debt to the extent of the discount.
Until yesterday this used to be subject to an exception, with the deemed waiver avoided where:
- the acquiring company and the borrower were not connected in the 3 year period ending 12 months before the debt is acquired, and
- the creditor is selling the debt to the acquiring company on arm's length terms.
Tax neutral buy backs before the change
The need for an exemption from the anti-avoidance rule in the case of companies in financial difficulties is perhaps clear, but it was never clear to practitioners why the exemption was formulated in the manner set out above. In practice, the exemption allowed a company to structure a buy back of its own debt using a newly incorporated subsidiary, or newco (so the first condition to the exemption is satisfied), which would acquire the debt from creditors at the discounted arm's length price. Newco would many times then agree to waive the newly acquired debt, as such a waiver, taking place as it does between connected parties, is tax free.
In practice this has meant that a company could always structure a debt buy back on a tax neutral basis, but that there were traps for the unwary: a "simple" buy back by the company itself, or the acquisition of debt by a group member created a tax charge, but an acquisition using a newco was tax neutral.
It is noted that neither the anti-avoidance rule nor the exemption to it refer to any motive tests, and in the absence of these many buy backs of debt by companies which recognised the financial opportunity to acquire their own debt at a discount have in recent years been structured using the newco route described here.
The new rules
The announcement made yesterday abolishes the exemption altogether, but introduces a new one, which appears restricted to very limited circumstances involving companies in financial difficulties. The new exemption applies where:
- there has been a change in ownership of the debtor company in the 12 months before the debt buy back;
- the debt buy back is "intrinsic to the change of ownership"; and
- before the change of ownership, the debtor was suffering from "severe financial problems".
The Treasury believe that these changes will ensure that only debt buy backs "that are undertaken as part of genuine corporate rescues will benefit from the buyback profits not being subject to tax". It is difficult at this stage to assess the full scope of the new exemption from the anti-avoidance rule, but its scope does appear narrow, and specific to a limited type of corporate rescue transactions only. We would expect further guidance on what would amounts to "intrinsic to the change of ownership" and "severe financial problems".
An additional sting in the tail associated with the new exemption is that even where it applies, any subsequent waiver of the debt by its new creditor will be taxed in respect of the previously untaxed discount. This would represent a departure from the general rule already noted above, that a waiver between connected parties is not taxable.
If you are involved in a buy back at a discount you should consider the impact of the new rules very carefully. While the changes should not impact on transaction which have already completed, there do not at present appear to be 'grandfathering' provisions. This means that buy backs offers which have been made but not completed may be captured by the new rules. Similarly, some restructuring transactions contemplate debt buy backs at future dates, or in response to external triggers. Such transactions should now be reviewed, although it is recognised that absent grandfathering in some cases this may require renegotiation of agreements which are already in place.
For reasons which are outside the scope of this note, it has been common for some years in the case of securitisations to provide for a right, post an enforcement event, for the issuer to appoint a third person to acquire all outstanding bonds for nominal consideration. To ensure that such acquisition did not give rise to a charge to tax on the issuer, it has been contemplated that a newco will be introduced in due course as the third person who would acquire the debt. It would appear that such structuring will no longer be effective, and where relevant (i.e. where the securitisation regulations do not apply to the issuer) the position should again be reviewed.
Debt buy backs structures going forward
Whilst the newco route is no longer available, it does not follow that the only way to structure a debt buy back in a tax neutral way is to fall within the new limited exemption for companies in financial difficulties.
It should be possible, in appropriate circumstances, to structure discounted buy backs by means of debt waivers by way of a capitalisations issue of shares, or a combination of a capitalisation issue and a debt buy back which need not give rise to a taxable waiver. Furthermore, subject to the details of any new legislation, the same economic effect may be achieved using a full or partial debt cancellation (or waiver) by means of a scheme of arrangement, and specific reliefs contained in the legislation in the context of waivers implemented by way of a scheme should provide tax neutrality.
Given the apparent narrow scope of the exemption heralded by the new rules, it may be the case that alternative structures such as the ones described here may turn out to be more attractive.
For existing legislative material see in particular section 361 CTA 2009, formerly contained in paragraph 4A Schedule 9 FA 1996.