Tax treatment in the hands of the creditor
The tax treatment of the forgiveness of debt within a group of companies depends on whether or not such forgiveness is of a “normal nature”. In order to be considered as being of a normal nature, the ‘advantage’ granted by a parent/creditor to its subsidiary/debtor must involve valid business reasons.
If the debt waiver is considered abnormal, the creditor may not deduct the amount of the debt waiver. However, it is generally not considered abnormal where a creditor waives its receivable from an affiliated company in financial distress, specifically if there is a risk that recovering the debt could result in the insolvency or bankruptcy of the affiliated company and thus have an impact on the creditor’s commercial or financial image.
If the debt waiver is considered ‘normal’, the tax treatment will further depend on whether the debt waiver was of a financial or commercial nature.
The debt waiver is of a financial nature when (i) the creditor has a direct or indirect stake in the debtor, and (ii) the nature of the debt, the link between the companies and the reasons of the debt waiver are of a financial nature.
The debt waiver is of a commercial nature if it has been granted in order to maintain a business relationship between the debtor and the creditor i.e. for the creditor to maintain its customer base or to preserve its source of supply.
A debt waiver of a financial nature is deductible only up to a certain amount. As waiving a debt owed to a parent company increases the net asset value of the subsidiary, the deduction of the debt waived is only permissible up to the amount of the negative net asset value of the subsidiary, if any, and the positive net asset value after debt waiver allocable to the other shareholders. In other words, the debt waiver is not deductible in proportion to the creditor/shareholder’s stake in the positive net asset value increase.
When the debt waiver is of a commercial nature, the loss is fully deductible in the hands of the creditor. This charge has to be deducted from the result of the financial year during which it takes place.
In tax consolidated groups, debt waivers can not be taken into account in computating the group’s global results. As a consequence, they have to be neutralised by applying certain adjustments. If the debtor subsequently exits the tax consolidated group, a recapture may be applied to the global result if and to the extent a debt waiver was granted during the past five years.
If the debt waiver contains a recapture clause on return to better fortune, the eventual reimbursement of the reinstated debt leads to taxation in the hands of the creditor but only for any sums which were initially deducted for tax purposes.
Tax treatment in the hands of the debtor
If the debt waiver is considered to be ‘abnormal’, the debtor is taxable on the amount of the debt waiver. If the debt waiver is considered ‘normal’, the tax treatment will again further depend on whether the debt waiver is of a financial or commercial nature.
If a debt waiver is of a financial nature, the part which is deductible for the creditor / shareholder constitutes a taxable profit in the hands of the debtor subject to corporate income tax at a maximum rate of 33.1/3%. The part that is not deductible for the creditor is not taxable in the hands of the debtor provided that (i) the creditor is the parent company of the debtor for tax purposes, and (ii) the debtor undertakes to increase its capital by an amount equal to the debt waiver within the following two years. If these conditions are not fulfilled, the whole debt waived is taxable in the hands of the debtor.
If a debt waiver is of a commercial nature, the forgiven debt is taxable in the hands of the debtor.