HMRC has now published guidance in its Corporate Finance Manual on the changes to the connected party loan relationships rules which relate to debt buy-backs. A release of a debtor loan relationship owed by a company which is connected to the creditor does not generally result in a credit being brought into account by the debtor or a debit being allowed for the creditor. This treatment does not apply in certain circumstances where a company acquires a loan relationship at a discount from a third party which is owed by a company with which the purchaser is connected at the time. In these circumstances, there is a deemed release of the loan relationship in an amount equal to the difference between the third party’s carrying value for the loan and the amount paid by the purchaser (i.e. the discount).
For many years there was an exception to this “deemed release” where the loan relationship was purchased by a company which was not connected to the debtor within a three year period beginning four years before the acquisition. This allowed groups to establish new companies with the sole purpose of buying in debt at a discount without triggering a “deemed release” (and corresponding taxable credit in the debtor company).
This was perceived by the Government as abusive and pursuant to two announcements, one on 14 October 2009 and one on 9 November 2009, the scope of the exceptions to the deemed release provision were narrowed with the substitution of three new exceptions: (i) the corporate rescue exception, (ii) the debt for debt exception and (iii) the debt for equity exception. Guidance issued by HMRC has clarified how HMRC will interpret the corporate rescue exception and the debt for debt exception.
The corporate rescue exception applies where there is a change of ownership of the debtor company within the year before or the 60 days following the debt buy-back (i.e. a “rescue” of some sort). One of the conditions which must be met in relation to the corporate rescue exception is that is must be “reasonable to assume” that, but for the change of ownership, the debtor company would have gone into insolvent liquidation, administration or receivership (the “insolvency condition”). HMRC will accept that this condition will be met where (i) the insolvency is avoided not only by change of ownership but by steps taken subsequently, (ii) enforcement action might have been taken against another company in the debtor’s group as a result of guarantees given in respect of the debtor’s borrowing and (iii) there is evidence that the insolvency condition would be met but the company has not publicly acknowledged its potential insolvency because of a need to engage in sensitive discussions with auditors and lenders over banking covenants and its ongoing status.
The debt for debt exception applies where a loan relationship is replaced, in an arm’s length transaction by a new loan relationship which has the same nominal value and substantially the same market value. Loans represented by securities must be replaced by loans represented by securities and other loan relationships must not be replaced by loans represented by securities (i.e. the exchange must be like-for-like in this respect). HMRC have clarified that while the nominal value of the exchanged debts needs to be the same and the market value needs to be substantially the same, minor differences in interest, repayment and other terms will not prevent the exception applying.
Furthermore, while the legislation states that the consideration for the release of the old debt must “consist only” of the new debt, HMRC will accept that the consideration may also include an agreement to pay accrued but unpaid interest on the old debt and will also accept that the old debt can be exchanged for a mixture of shares and new debt (in which case the consideration must be apportioned – with the debt for debt exception applying in part and the debt for equity exception applying in part). Note that the main difference between (i) the debt for debt and corporate rescue exceptions and (ii) the debt for equity exception, is that a later release of debt bought back in under the debt for debt and corporate rescue exceptions will result in a deemed release (and a corresponding taxable credit) for the debtor in the amount of the discount on the original buy-back of the loan. This will not be the case on a later release of debt bought back using the debt for equity exception.