Vol 7 (2010) - Issue 3

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UK Tax Traps on Restructuring

As anticipated, the current economic climate has resulted in a significant number of restructurings of groups in financial difficulties. They cover a range of different situations. There may be consensual transactions where the debtor is trying to restructure its balance sheet by obtaining new finance in return for the lender acquiring an equity stake or a release of debt in return for equity or share warrants (which may take place within or outside the framework of a statutory procedure such as a scheme of arrangement or a corporate voluntary arrangement (CVA)) or a debt buy back. The complexity of these procedures has been compounded by the complex capital structures, including those seen in the leveraged buy-outs, of the last ten years.
This article is focusing on some of the UK tax issues typically encountered in these situations. Each case will inevitably be unique and no finite list of tax issues can be presented at the outset. Whilst this article looks at tax issues of UK groups and UK lenders, debtors and creditors in other jurisdictions will be faced with similar issues but may need to find different solutions which have the desired tax consequence under local law.
There are particular features of restructurings that may be more likely to give rise to tax consequences that should be identified early on in the transaction.

Is there a release of debt?
Where a debtor company is released from an obligation to pay a debt, an accounting profit would normally arise. As a result for a UK corporation tax payer, the release of an obligation under a debtor loan relationship would normally give rise to a taxable credit. However, there are exceptions and it is important deals should be structured to fall within these exceptions.
The three main exceptions which may apply are where debt is exchanged for equity, the debtor and creditor are connected or where the release is in the course of an insolvency procedure.
However, the exceptions need to be carefully reviewed. The exception for debt to equity swaps requires that the debtor account for the debt on an amortised cost basis and also that the shares issued in consideration for the release of the debt are shares in the debtor company. This can give rise to a requirement to reorganize the debt in the debtor group prior to the debt for equity swap if, for example, the creditor requires shares
in the top company or to avoid a degrouping if shares are issued in lower tier subsidiaries. For example, the debt may need to be novated up to the top company before the shares are issued. (The novation should not result in a credit or debit arising as the transaction should be treated as taking place for a consideration equal to the notional carrying value of the liability so that no profit will arise). Alternatively the debt for equity swap can take place in the debtor company and the shares subsequently exchanged for shares in the top company (but consideration must be given to whether any additional stamp duty charge arises on this route).
The shares which are issued must be ordinary shares, i.e. they must be shares other than shares which give the holder a right to a dividend at a fixed rate but no other right to share in the profits of the issuer. The provision to lenders of a more contingent right to equity may therefore be difficult. For example, it would be difficult to issue warrants as consideration for the release of a debt and bring the transaction within the exception for debt to equity swaps.
The debt to equity swap exception can apply irrespective of the value of the shares issued. Therefore even issuing a very small number of shares in respect of the release would appear to fall within the exemption. HMRC do however refer to the application of the transfer pricing rules in the HMRC manual in connection with debt to equity swaps. However it is not clear how this is in point although it may be more relevant for the remaining debt if the lender now has an equity interest.
It is also important to address whether the equity is being issued in respect of accrued interest, as this can result in a UK withholding tax liability arising in the absence of any exemption or Double Tax Treaty applying. This can be avoided when shares are issued in consideration of the release of the debt rather than in satisfaction of the debt so that no interest is paid (although this could have consequences for certain
interest which accrues to connected parties where interest is not deductible until paid).