The UK generally distinguishes between “loan relationship” debts (e.g. loan receivables) and other debts (e.g. trading debt in respect of outstanding consideration for the sale of goods or services). It is possible to turn a trading debt into a loan relationship by issue of a debenture in respect of it.
Tax treatment in the hands of the creditor
With respect to loan relationships, the release of indebtedness should generally result in a tax deduction for the creditor. However, the creditor can not claim a deduction in respect of a release where it is at any time in the accounting period of release ‘connected’ to the debtor, save in case of (a) a debt for equity swap where the debtor and creditor were not connected before the swap or (b) in certain circumstances where the debtor is insolvent (e.g. if the creditor company is in insolvent liquidation, insolvent administration or insolvent administrative receivership). Companies will be considered ‘connected’ where during an accounting period one company had control of the other or both companies were under the control of the same person. A company shall be taken to have control of another company if it exercises, or is able to exercise or is entitled to acquire, direct or indirect control over the company’s affairs.
To the extent that a loan relationship is not waived, a creditor may still accrue a loss in its accounts where the value of the loan receivable is impaired. A corresponding deduction will generally be allowed for tax purposes. However, again, if the creditor and debtor are connected, deduction will only be allowed in the two abovementioned situations.
There are restrictions on deducting losses on debts where the debtor has surrendered losses by way of consortium relief. This anti avoidance rule was introduced to prevent the same economic loss being effectively used twice.
With respect to trading debts, HMRC consider that the release or impairment of indebtedness should entitle the creditor to tax relief, unless the debtor and creditor are ‘connected’ in the same way as relief for loan relationships is provided. Changes to be introduced for accounting periods beginning on or after 1 April 2009 will clarify this.
UK regulations do not provide for an automatic informal capitalisation rule in case of forgiveness of debt. However, they allow a voluntary capitalisation whereby debt is swapped for equity. Where the creditor and debtor are not ‘connected’, the creditor will generally be allowed a deduction equal to the difference between the carrying value of the loan receivable and the market value on the date of the swap. If the creditor and debtor are connected before the acquisition of the shares the relief is not allowed. If a connection arises because of the debt for equity swap then relief should again generally still be available for the creditor. Relief in this respect is the subject to the same restrictions as above (e.g. where consortium relief has been claimed).
Tax treatment in the hands of the debtor
With respect to loan relationships, the release of indebtedness results in a credit for the debtor company and, hence, a taxable profit. However this rule is subject to exceptions and accordingly the debtor is not taxed on the release where (a) the release is part of a statutory insolvency arrangement; (b) the debtor and creditor are connected in the relevant accounting period; (c) the creditor is the subject of certain insolvency procedures; or (d) the release is in consideration of, or of any entitlement to, an issue of ordinary share capital of the debtor company.
To the extent that a loan relationship is not waived, but remains outstanding, there should be no corresponding credit by the debtor and there is no taxable profit in the debtor’s accounts.
With respect to trading debt for which a tax deduction has previously been obtained, the release of indebtedness results in a credit for the debtor company and, hence, a taxable profit (unless the release is part of a statutory insolvency arrangement). However, for accounting periods beginning on or after 1 April 2009 new rules have been introduced to treat such releases in the same way as for loan relationships.
There is no tax charge where a release of a loan relationship and, for accounting periods beginning on or after 1 April 2009, a trading debt is in consideration of, or entitlement to, shares forming part of the ordinary share capital of the debtor company.
Under current legislation, a borrower is entitled to a corporation tax deduction for loan interest payable in an accounting period, and the creditor is taxed on the same amount. However, in certain circumstances interest not paid within 12 months of the end of the accounting period in which it accrues, is not tax deductible until the interest is actually paid.
Where interest is waived, in circumstances where a loan waiver would be taxable but the late paid interest rules apply, it is possible that the company could be taxed on the interest waiver with no corresponding deduction for the interest accrual. In such circumstances, it should be considered whether to capitalise the interest or “pay” it with funding bonds which are subsequently waived. Such planning would need to consider the withholding tax implications.