The Government announced on 14 October 2009 in a written ministerial statement that changes will be made in next year’s Finance Bill, with retrospective effect to 14 October 2009, to amend the UK tax rules applying where existing debt is purchased at a discount by a company connected to the debtor.
Background and current law
In the present economic conditions many banks and other businesses have issued debt that is trading at a discount to the amount borrowed. Given the uncertainty and volatility in the financial markets, many banks and other businesses are seeking to buy back their debt.
Under existing legislation, if debt is purchased at a discount by either the debtor or a company connected with the debtor, the debtor will generally be taxed on the amount of the discount. However, there is an exception to this general rule that provides that the debtor will not be subject to tax on the discount where the purchaser of the debt acquires it in an arm’s length transaction, and the purchasing company was not connected with the debtor at any time during the three-year period ending 12 months before the purchase. Therefore, provided that the acquisition was at arm’s length, and debtor and purchaser were not connected prior to one year before the acquisition, no tax charge would arise on the acquisition of the debt or on subsequent release.
The purpose of the one year, arm’s length window was to facilitate corporate rescues. The government is concerned that this exception is too widely drafted, and that the provision enables groups to avoid a tax charge on the discount on any debt buy-back simply by purchasing the debt into a newly established company that, as it is newly established, cannot have been connected with the debtor during the relevant three-year period. The setting up of a connected company to acquire debt, while within the letter of the law, was not considered by HM Revenue & Customs (HMRC) or HM Treasury to be within the spirit of it. Hence the announcement of the proposed change of law. This amendment is an attempt to ensure that the exception is only available in cases of genuine corporate rescues.
Proposed changes
The new rules will be introduced in the Finance Bill 2010 and apply retrospectively from 14 October 2009. It is proposed that, instead of the condition requiring the purchasing company not to be connected with the debtor for a prescribed period, the following three new conditions will be introduced to limit the availability of the conditions:
- there must be a change in the ownership of the debtor in the period of 12 months before the debt purchase;
- the debt purchase must have been intrinsic to the change of ownership; and
- before the change of ownership, the debtor must have been suffering from severe financial problems.
The ministerial statement also provides that, even if a connected company purchases the debt without a tax charge arising on the discount, a subsequent cancellation of the debt would still be taxable (meaning that the new rules will only defer the tax charge until the debt is ultimately cancelled).
Implications
At this stage draft legislation is not available and until any new legislation is passed there will be considerable uncertainty going forward. However, on 22 October 2009, HMRC published some comment on the ministerial statement (the commentary). The commentary sheds some light on what is meant by the three exceptions:
- The expression ‘change in ownership’ will be as defined in s769 of the Income and Corporation Taxes Act 1988. Broadly, there is a change in ownership if more than 50% of the debtor’s ordinary share capital changes ownership. HMRC is also considering whether this condition can be extended to changes of ownership that occur shortly after the debt purchase.
- A debt purchase will be ‘intrinsic’ to the change of ownership where it is reasonable to assume that the debt purchase would not have taken place but for the change in ownership and arises from that change of ownership.
- ‘Severe financial problems’ will be accepted as existing if it would be reasonable to assume that without the change of ownership the debtor would have become insolvent.
The commentary also gives some guidance on how the new rules will apply to:
- debt restructurings in progress at, or already undertaken before, 14 October 2009;
- refinancing of repurchased debt; and
- debt equity swaps.
Grandfathering provisions
The new rules will not apply to debt purchases where the offer to acquire the debt was made directly to the creditors on or before 14 October 2009.
The new rules relating to taxation of the purchase discount on a later cancellation of debt will not apply to purchases of debt that took place on or before 14 October 2009 within the old rules, nor will they apply to the cancellation of debt whose purchase was grandfathered.
Refinancing, Debt Equity Swaps and Cancellation
An exemption from the new rules will apply where debt is repurchased in consideration of the issue of new debt of equivalent face value, but subject to different terms (such as covenants or maturity date) and there is no economic profit. Changes will also be made to the legislation to ensure that there is no tax charge where, rather than the debtor issuing shares to creditors in consideration for the debtor being released from the debt, another group company issues shares to the creditor in consideration for the debt being assigned to it.
The commentary is somewhat unclear on the tax charge that will result on a future cancellation of the debt. Is the tax charge only on the previously untaxed purchase discount or is it on the full amount released? The commentary says that an amendment will also be made to ensure that the creditor is not denied a debit when a debtor is taxed on cancellation. However, the previously untaxed discount should not be shown in the accounts of the creditor as the creditor acquired the debt at a discount from the seller and so if it is only the purchase discount that is taxed in the hands of the debtor, there should be no need for a corresponding debit for the creditor. This rather suggests that it will be the full amount of the cancelled debt that is taxed, not just the previously untaxed discount on purchase.
Conclusion
It is unfortunate that there is now significant uncertainty going forward and it is to be hoped that draft legislation will be released as soon as possible.
However, as from 14 October 2009, what is clear is that setting up a connected company to acquire debt is unlikely to work from a tax perspective. Groups considering a debt buy-back should monitor developments in this area closely.
By Charlotte Sallabank, partner, Jones Day.
E-mail: csallabank@jonesday.com.
