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Release of corporate debt: watch out for hidden tax charges

In the UK most corporate debt is taxed under a separate set of tax rules known as the loan relationship rules.

In the UK most corporate debt is taxed under a separate set of tax rules known as the loan relationship rules.

It is important to consider the loan relationship rules whenever any corporate debt is to be assigned or released whether as part of a re-organisation, potential sale or general debt restructuring.

When does a loan relationship arise?

A loan relationship arises where a company within the charge to UK corporation tax is a creditor or debtor in respect of a “money debt” and either:

a)     the debt arises from a transaction for the “lending of money”; or

b)    an instrument (e.g. a loan note) is issued by any person for the purpose of representing security for, or the rights of a creditor in respect of, any money debt.

Note that a company does not need to be UK resident to be within the charge to UK tax (and the residence and status of the other party to the transaction is also irrelevant).

A money debt is essentially one that falls to be settled by the payment of money (in any currency).

Certain money debts that do not arise from the lending of money and which are not evidenced by an issued instrument, for example FOREX gains and losses, are also brought within the loan relationship rules.

Loan relationships can arise in respect of debt incurred for both trading and non-trading purposes.

The effect of a release of loan relationship debt

Release of debt can spring a potentially nasty surprise for unwary debtors.

As a general rule, a creditor's release of debt results in a taxable credit (profit) for the debtor company and a tax debit (expense) for the creditor. Therefore unless there are losses available to offset against any such taxable credit, the release of a debt may give rise to a tax charge for the debtor which is often overlooked and not factored in to the structuring of any release until it is too late.

Are there any exemptions from the charge to tax?

Yes.

The general rule is subject to a number of exceptions whereby the release will not give rise to a tax charge for the debtor company. It is therefore important to consider whether any of the exceptions applies before any release of the debt.

In summary, on a release of debt there will be no tax charge for the debtor where:

a)     the parties are “connected” at any time in the accounting period in which the release occurs. The creditor does not benefit from a tax deduction in respect of the release, but nor is the debtor subjected to a tax charge;

b)    the release is part of a “statutory insolvency arrangement” (such as a CVA);

c)     the debtor company is in insolvent liquidation, administration or administrative receivership and the parties are not connected; or

d)    the release is in consideration of or of any entitlement to an issue of ordinary share capital by the debtor company (a debt for equity swap).

It is anticipated that a further “corporate rescue” exemption will be enacted in the forthcoming Finance Bill which will exempt from tax releases of debts (on or after 1 January 2015) where, “immediately before the release, it is reasonable to assume that, without the release and any arrangements of which the release forms part, there would be a material risk that at some time within the next 12 months the debtor company would be unable to pay its debts.”

The effect of an assignment of loan relationship debt

Any “profit” or “loss” on the assignment of a debt by the original creditor will generally give rise to a taxable credit or debit.

A loss will arise to the original creditor where the purchaser buys the debt at a discount to face value. In this case, the original creditor will be entitled to a tax deduction for the amount of the discount.

There should not generally be any tax implications for the debtor however provided the debt remains outstanding in full so that there is no release or writing down of the debt in the debtor's accounts.

If, however, an impaired debt is acquired at a discount by a company that is (or immediately after the acquisition becomes) connected with the debtor, the debt is treated as released to the extent of the discount and this amount is treated as a taxable credit in the debtor’s hands. Care is therefore required where debt is acquired by a connected company.

Summary

The UK tax legislation is not intended to present any barriers to debt restructuring but it does contain a number of potential traps and pitfalls. Before releasing or assigning any debt it is therefore essential to assess the tax implications for both the debtor and creditor at an early stage so as to prevent any unexpected surprises (and costs) and allow for changes to be made to the structure if necessary.

If you would like to know more about taxation arising on any restructuring of corporate debt, or have any other tax-related queries, contact Haydn Rogan, a partner in the Corporate department on 0161 214 0517 or by email to haydn.rogan@weightmans.com.