Are you structuring your debt in the most tax efficient way?

In a time of high interest rates and the trend for private equity owners to use highly leveraged structures, many businesses have faced uncertainty with loan covenant pressure, even where their underlying business remains fundamentally sound in the medium to long term. Meanwhile with the number of stressed and distressed loans on their books putting pressure on capital buffers, lenders may be motivated to reprice their support to match their returns to the higher level of risk they are taking.

With new funding sometimes difficult and expensive to obtain, many companies are (in conjunction with their lenders) considering the different ways to restructure their existing debt obligations to keep within lending covenants. In some distressed cases, as an alternative to formal insolvency procedures such as administration or even liquidation, banks and other lending institutions may agree to cancel debt in exchange for an issue of new share capital in the borrower. Capitalising debt has the advantage of reducing the borrower's financing costs and significantly improving its prospects of weathering a downturn.

The tax legislation provides for corporate rescue situations where funding debt is either waived or capitalised by way of a debt-equity swap. Properly structured, it is usually possible to ensure in such transactions that the borrower is not subject to tax on the amount of any debt forgiven, whilst the lender is entitled to impairment relief based on the amount of the debt cancelled provided there was no previous connection between the lender and the borrower. However, satisfying the necessary conditions for exemption is far from straightforward and transactions of this nature can often have wider tax implications which need to be fully considered.

Pitfalls with debt-equity swaps

It is important to consider both the structuring of the debt equity swap as well as the amount of share capital held by the lender as a result of the debt capitalisation. In some cases, this can result in adverse tax implications, for example, if the equity held by the lender is sufficient to inadvertently remove the borrower from its existing tax group.

Where de-grouping occurs, the borrower can be prohibited from surrendering its tax losses to other related companies and where assets have been previously transferred intra-group this could trigger capital gains de-grouping charges and/or a claw back of stamp duty land tax. Additionally, any tax losses of the borrower could be placed in jeopardy where there is a change in ownership of the borrower as a result of the transaction, with the consequence that future use of those losses could be denied where, for example, there is or has been a major change in the nature or conduct of the borrower's business.

Furthermore, where a lender becomes connected with a borrower, the deemed release rules may be relevant - these could give rise to taxable income for the borrower in the case of underwater debt. An investigation will need to be performed to ascertain whether the borrower is likely to be able to meet the terms of the corporate rescue exception (eg, by demonstrating a likely inability to pay debts as they fall due within the next 12 months, absent the restructuring).

Modifying loans

Finally, even where there is no debt for equity swap, simply modifying the terms of a loan can give rise to taxable income for the borrower where there is a substantial modification of the debt which relaxes the terms eg, longer maturity, interest holidays, etc. This is particularly true under IFRS 9 which may apply for accounting periods starting on or after 1 January 2018. Accounting advice should be sought to establish whether it is still possible for the borrower to reflect the restructured obligation in its balance sheet at par.

We can provide advice and assistance to businesses wishing to restructure both external and intra-group debt tax-efficiently. For further advice on how we can help please get in touch with your local BDO contact or David Porter.