What problems arise when a group needs to restructure its existing debt? This article looks at what would be the next step if a group is not securing effective tax relief for its financing costs: debt restructuring and its related tax impact.
The previous article in this series, Issues with Securing Effective Tax Relief for Financing Costs, focused on whether or not a group is securing effective tax relief for its financing costs in the current economic environment. This article will look at what would be the next step if a group is not securing effective tax relief for its financing costs: debt restructuring and its related tax impact.
The tax issues associated with debt restructuring are complex and this is particularly the case when we are dealing with cross-border debt. But for those who deal with debt restructuring, this is nothing new.
What is Different in the Current Economic Environment?
In a normal economic environment, debt restructuring issues typically arise in highly leveraged private equity groups where debt restructuring is a regular feature of daily life. While debt restructuring does happen in more typical multinational groups, it invariably takes place around a key event such as the disposal of a non-performing business.
In the current environment, however, debt restructuring is likely to be more commonplace in multinational groups as balance sheets deteriorate due to exceptional and unpredictable trading conditions with companies no longer being able to support advancement with the existing levels of debt and payables.
While there are a number of possible actions when considering debt restructuring, two of the more familiar actions are a debt waiver (i.e. where the lender releases the borrower from its obligation to repay the debt) or a debt conversion (i.e. where the lender and borrower agree that the debt will be ‘converted’ into shares in the borrower company).
What are the Problems?
First, there are the tax issues arising in respect of debt waivers. With intra-jurisdiction debt waivers there is a reasonable expectation is that a debt waiver, whether this be a third party or intra-group, should be either taxed or ignored on both sides, but this should always be checked. I have come across a number of instances where this isn’t the case, and in one particular situation the debt waiver was subsequently found not to be tax neutral because the waiver hadn’t been put into effect by a formal deed of release.
With cross-border debt waivers, the position is much more complex, particularly with intra-group debt waivers, and achieving tax neutrality becomes a challenge. The following two examples illustrate some of the problems that can arise in cross-border situations:
- A shareholder resident in Territory A waives a formal loan due from its subsidiary, which is resident in Territory B. In some cases while the shareholder won’t obtain tax relief on the amount waived, the subsidiary could be taxed on the amount released, e.g. as a capital contribution.
- A subsidiary resident in Territory A waives a formal loan due from its shareholder, which is resident in Territory B. In many circumstances this can be treated as a distribution in the subsidiary such that no tax relief is obtained on the amount waived. The shareholder, however, may be taxed on the waiver as a dividend and may therefore pay tax on the amount waived.
Therefore, the key message is that tax neutrality, particularly in relation to cross-border loan waivers, cannot be assumed and, in some cases, may not be achievable. In such cases, alternative cross-border planning mechanisms for eliminating the debt will need to be considered.
Second, there are the tax issues arising in respect of debt for equity conversions and in many ways the issues to consider here are similar to those in respect of debt waivers. As with debt waivers the most difficult scenarios invariably arise in relation to cross-border transactions.
This is best illustrated by way of a simple example:
A company resident in Territory A has £100 of debt and has agreed with a lender, which is resident in Territory B to convert the debt into shares. If the £100 debt is converted into shares with a value of £100, the expectation is that there shouldn’t be any direct tax consequences arising from the conversion, although this should, of course, be checked.
If the £100 debt is converted into shares with a value of £75, then arguably the borrower has been released from £25 of debt and the question arises as to whether or not this is a taxable release. Accordingly, consideration will need to be given to the same issues mentioned above in relation to debt waivers.
Again, the key message is that tax neutrality, particularly in relation to cross-border transactions, cannot be assumed even with a straightforward example. As with debt waivers, alternative mechanisms need to be considered to the extent that tax neutrality is not achievable.
What Action Should Treasurers and Finance Professionals be Taking?
Whenever I am involved in a debt restructuring, the key issues for me as a tax professional are to understand, first, how the debt arose, e.g. loan financing, trading balance, etc, and, second, what is going to be done to the debt and how.
Obtaining accurate information is absolutely critical to the efficacy of the subsequent tax analysis and this is particularly the case for interim professionals who have little prior knowledge of the organisation. In the absence of such information, expected tax neutral restructurings can, on subsequent enquiry by the tax authorities, give rise to an adverse tax mismatch and a resulting cash tax cost. The position is further complicated in relation to cross-border transactions and it should be accepted that alternative mechanisms will need to be sought if the overall commercial objective is to be achieved without giving rise to a tax cost.
Martin Bardsley, Senior Director with Alvarez & Marsal Taxand UK, serves as head of the firm's Treasury & Financing Tax practice and also leads Taxand's Global Financing service line. Taxand is a global network of leading tax advisors from independent firms in nearly 50 countries.
Martin brings over 20 years of experience in providing corporate and international tax advice to a wide range of multi-national clients and has significant experience in advising on Treasury and Financing transactions, both in the corporate and financial industry sectors. Prior to joining Alvarez & Marsal, Martin spent 17 years with the tax groups of PricewaterhouseCoopers and KPMG, 13 of which were spent in London focusing on Treasury and Financing Tax. Martin also completed a long-term secondment to a major FTSE 100 multinational firm during 1998 and 1999 where he was tax adviser to the Treasury, Corporate Finance and Asset Management teams.
For more information contact Rob Stephenson, Managing Partner of Maven Partners on 0207 061 6421.
