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Debt restructuring and related tax considerations in light of COVID-19

05 May 2020

COVID-19 has brought with it highly uncertain economic conditions for businesses. Like most other businesses, many PE houses, along with their portfolio companies, have spent lots of time looking at their cash reserves in a bid to weather out the lockdown period and beyond. Working capital management, cost-cutting and a review of debt facilities have all been part of the strategy to maximise their portfolios’ cash position. 

In the case of debt facilities, whilst understandably all efforts will have been driven towards agreement and renegotiation, related tax considerations are not always top of mind. UK tax law in this area is especially complex and could be a nasty sting in the tail not felt until the accounts and tax filings come around.  We set out below some of the more common debt restructuring options and related tax considerations.

Debt modifications

Simple debt modifications e.g. rate reductions, interest holidays, extension of loan terms, can have tax implications.  UK borrowers might be treated as making an accounting profit as a result of such modifications, which could be taxable.  Accounting standards can require a profit or loss to be recognised where there is a ‘substantial’ modification of the debt. For example, IFRS 109 considers as ‘substantial’ a delta of 10% between the discounted net present value of the cash flows of the new debt compared to that of the old. Some non-substantial modifications can also result in accounting and tax consequences. Depending upon the parties to the debt, the circumstances in which any accounting profits arise and the availability of tax attributes within the group, there may be methods by which taxable profits can be mitigated.

Debt-for-equity swaps

The lender may be willing to enter into a debt-for-equity swap in distressed debt scenarios. This could be, for example, swapping loan notes issued to the PE fund for equity, or mezzanine finance and (in rarer cases) bank lending being the subject of an equity swap. For a UK borrowing company, such arrangements could be exempt under UK tax law, though HMRC is clear in its guidance that the drafting is key in such scenarios. Debt-for-equity swaps may also result in other tax considerations e.g. because the lender has acquired control of the borrowing company/group.

Debt releases

In the context of debt releases, an accounting profit will usually arise to the borrower for any part of the liability that has been released. Where the borrower is a UK company, this release could be taxable unless the debt is with a connected party (usually within a controlled group relationship) or where it can rely on an insolvent trading condition.

Managing the sting in the tail

After the 2008 financial crash, UK tax law relating to debt restructures increased in complexity, with the tightening up of legislation in some areas, whilst at the same time, providing some much needed exemptions for genuine distressed debt situations. The amounts involved in any debt restructuring are often significant and identifying the potential tax implications early on will maximise the ability to navigate the complex rules or at least serve as an early warning to what could otherwise be some quite unpleasant surprises further down the road.

If you have any further enquiries please contact Shaheda Natha or Cory Blackmore.

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