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How have the changes introduced by the Finance (No 2) Act 2015 (F(No 2)A 2015) affected the corporate rescue exemption? Graham Robinson, tax partner at PwC, considers the development of the corporate rescue exemption in light of these changes.
The loan relationship rules have various provisions to deal with situations where a company is relieved of a debt obligation for a price below its book value. For example, if a company owes £100 but is able to agree with the creditor to settle the liability for £90—the difference of £10 being a ‘discount’ which is effectively a profit for the borrower. However, the way in which these transactions are dealt with is governed by two policy objectives:
However, these debt relief transactions are generally also, in some form, transactions where a debt is settled for less than its full book value. Therefore, an exemption is needed from the general principle that profits on repaying debt at less than full value are taxable. Without such an exemption, a financially distressed company could be forced into insolvency because a transaction to relieve its debts is not viable, because it would result in an unaffordable tax liability.
The structure of the legislation within the loan relationship rules is to tax any accounting credit arising from a loan obligation (eg the discount described above). However, in order to relieve financially distressed companies, the legislation includes a number of exemptions where the rules are not applied.
The main exemptions applicable to companies in distress were contained in section 322 of the Corporation Tax Act 2009 (CTA 2009). These exempt credits arising if the borrower is in insolvency proceedings, or in the case of a cancellation of debt in exchange for an issue of ordinary shares. Notably, these rules did not provide any relief for any other type of debt forgiveness transaction between unconnected companies.
Consequently these rules did not easily assist in the circumstances of financial distress as they applied to many companies. In general, when a company is in financial distress and is negotiating with its creditors, the parties will be otherwise unconnected. Consequently, the exemption for debt forgiveness from connected parties is not relevant. Furthermore, it will not often be attractive for the lender to become an equity holder in the distressed borrower, and so the exemption where debt is cancelled in exchange for the issue of ordinary shares is often not attractive (and for reasons explained below it would often not be straightforward for those shares to be immediately sold). Absent further planning, this left only the exemption for a borrower actually in insolvency proceedings. Consequently, the borrower could sometimes be in a situation where the tax consequences of a negotiated settlement with creditors were significantly worse than the consequences of insolvent administration.
The situation is complicated further by the interaction of the ‘connected companies’ provisions. In general, debt releases between companies under common control are not taxable, without any further conditions. Therefore, in the past there were situations where, provided the companies had become connected, the release of the debt was not taxable. This type of transaction was prevented by anti-avoidance rules contained in CTA 2009, ss 361, 362. Subsequently, a Targeted Anti-Avoidance Rule was introduced (CTA 2009, s 363A) which stated that any transaction designed to prevent CTA 2009, ss 361, 362 from applying was deemed to be ineffective.
However, it is common for a company in financial distress to be taken over in a ‘rescue’ transaction by new owners, whether they are the creditors, or third parties. It would generally be desirable for those owners to acquire the debts owed by the company, along with its shares. The CTA 2009, ss 361, 362 rules had the ability to cause significant difficulty in these situations, as they generally applied where a debt worth less than full value became a connected party debt. This was a commonly desirable commercial feature of such ‘rescue’ transactions.
CTA 2009, ss 361A–C contained exceptions from CTA 2009, s 361 intended to allow this type of transaction. These offered exemption from the charge where a debt was acquired at a discount, and paid for by an issue of ordinary shares (CTA 2009, s 361C). They also offered a deferral of the charge where the debt was acquired in exchange for the issue of another debt (CTA 2009, s 361B), or in cases of financial distress (CTA 2009, s 361A).
However, CTA 2009, ss 361A and 361B were not widely used. Fundamentally, a deferral of the tax charge arising from repurchasing the debt at a discount did not significantly change the economics of the deal from the point of view of the potential ‘rescuer’. From the rescuer’s point of view, it would again be preferable to allow the distressed company to go into administration, at which point assets could be acquired with no tax liability attached.
Therefore, until the change of law in F(No 2)A 2015 , the only exemptions which were generally used to restructure the debts of a distressed company were CTA 2009, s 322 (release of debt in exchange for an issue of ordinary shares) and CTA 2009, s 361C (acquisition of discounted debt in exchange for an issue of ordinary shares). Both of these required that the original lender received the shares. In many cases the lender would be a financial institution, or other party, not interested in owning the equity of the business. Therefore the ordinary shares would be sold in a related transaction.
However, in these situations it was not always clear that the conditions for the CTA 2009, s 322 exemption were actually met. Furthermore, the very broad nature of CTA 2009, s 363A made it very difficult to conclude that CTA 2009, s 361 did not apply—it was hard to deny that the transaction had been structured to prevent CTA 2009, s 361 from applying. If HMRC were to successfully argue either of these points on a debt restructuring, the result would be that the entire ‘discount’ (ie the difference between the book value and fair value of the distressed company's debts) would become a taxable profit.
This lack of clarity led to significant commercial uncertainty. Generally advisers were not able to reach a satisfactory level of comfort on these points on commercial debt restructurings, because of the broad nature of the law and associated guidance. It became common practice for any form of debt-for-equity transaction for a distressed company to be dealt with by a clearance letter to HMRC, requesting confirmation that CTA 2009, s 322 applied and that CTA 2009, s 363A did not apply. In the years of the financial crisis there were many such transactions, and each clearance was costly and time consuming for the parties and HMRC.
The new exemption is intended to enable restructuring of distressed debt to be undertaken much more simply and efficiently. Clauses are added to CTA 2009, s 322, 362, and a new CTA 2009, s 361D, so that a credit arising on cancellation of a debt is exempt from tax provided that it is:
‘reasonable to assume that without the release [of debt] and any arrangements of which the release forms part, that there would be a material risk that at some time within the next twelve months the company would be unable to pay its debts.’
In addition, the new CTA 2009, s 323A ensures that debt modification transactions (ie making the terms of a debt less onerous) are treated in the same way.
Consequently, if this condition is met, any credit arising from the release or modification of debt is exempt from tax. It does not matter whether the debt is released in exchange for shares, or other debts, or for no consideration at all. This eliminates the need to structure any corporate rescue transaction so that each lender takes ordinary shares, and then sells them to the party who actually wants them. This in turn significantly reduces the likelihood that there will be a risk that other anti-avoidance such as CTA 2009, s 361 might apply, and therefore makes it easier to be comfortable with the tax consequences of a transaction without a specific clearance from HMRC.
Unlike the previous corporate rescue exemption (CTA 2009, s 361A) the profit is permanently non-taxable, rather than the tax charge being effectively deferred.
It will still be necessary for advisers to consider the terms of a restructuring transaction carefully to ensure that the exemption conditions are met. As well as the condition that there is a real risk of insolvency within twelve months, it should be noted that where there is a ‘rescuer’ who acquires the shares and debt of a company, the debt release must arise within sixty days of the companies becoming connected for the exemption from a charge under CTA 2009, s 361 to be available.
The original draft of the Finance Bill announced that the changes would be effective for transactions carried out after Royal Assent to the Bill. This remains the case for the changes to CTA 2009, ss 361, 362.
However, a late amendment to the Bill changed the commencement date for the additional exemption in CTA 2009, s 322 to apply to transactions entered into after 1 January 2015. This reflects the fact that HMRC had stated that they expected that the exemption would be available from that date. It seems likely that some distressed companies had placed reliance on that statement, and the decision was made, late in the process, to respect that reliance.
As noted above, in general the new exemptions should enable significant simplification of transactions to restructure distressed debt. However, it will continue to be important to analyse the transaction carefully to ensure that the exemptions apply.
The main uncertainty and area of difficulty will be in determining whether it is ‘reasonable to assume’ that a company will be unable to repay its debts within twelve months. A company may have projections or forecasts, but inevitably these will be the result of a number of estimates and judgments about the future. It is not obvious how it should be determined whether or not they give rise to a ‘reasonable assumption’. Furthermore, if a company claiming the exemption asserts that its view was reasonable, and HMRC asserts that it was not reasonable, it is not clear what criteria should practically be used to resolve the question. Presumably, one would expect that in a distress situation forecasts of the company’s position will have been reviewed and tested by suitably experienced individuals and advisers, and in many cases reports and correspondence with these people will provide evidence of the situation. However, this may not always be the case, and some companies may find their position is unclear.
Given the ‘cliff edge’ nature of the legislation (ie if the exemption criteria are not met, a large gain may be taxable) it may be advisable in these situations to seek clearance from HMRC to confirm that the exemption applies.
It should also be noted that the directors of a company will have to consider carefully the interaction with UK company law. If they consider it ‘reasonable to assume’ that the company may be unable to repay its debts, they may also need to consider insolvency law to determine whether that requires steps to be taken.
Graham Robinson specialises in the tax and treasury issues that arise when companies enter into asset backed contribution arrangements. He is a qualified treasurer as well as a tax adviser, and has 16 years’ experience in structuring financial solutions for large companies.
Interviewed by Barbara Bergin.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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Stephen qualified as a solicitor in 2005 and joined the Restructuring and Insolvency team at Lexis®PSL in September 2014 from Shoosmiths LLP, where he was a senior associate in the restructuring and insolvency team.
Primarily focused on contentious and advisory corporate and personal insolvency work, Stephen’s experience includes acting for office-holders on a wide range of issues, including appointments, investigations and the recovery and realisation of assets (including antecedent transaction claims), and for creditors in respect of the impact on them of the insolvency of debtors and counterparties.
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