We discuss below changes to UK tax law in respect of corporate debt which take effect from the beginning of this year which will improve the UK tax position for distressed debt of a UK company.

Background

Currently, if a UK company is released from a debt owed to an unconnected creditor, the default position is that this will be a taxable event for the debtor company and its accounts will recognise a (taxable) credit in respect of this release. Further, where a debt that was previously held by an unconnected party to the debtor company becomes "connected" a "deemed" release of debt may arise, which may give rise to the same issues (although there is a limited exception where debt becomes connected as part of a corporate rescue). In addition, if an "amend and extend" restructuring of debt is undertaken and this gives rise to a "substantial modification" or a reduction in the net present value of the cashflows arising under the relevant loan by at least 10 per cent, the debts may need to be re-recognised in the parties' accounts and this may result in the UK debtor recognising unfunded taxable credits.

It is important to note, however, that there are exemptions to the tax charge for debtor companies described above, most notably for debt/equity swaps and certain formal insolvency and restructuring procedures. However, these rules generally need to be considered carefully in a restructuring scenario.

The UK tax laws also need to be considered carefully on behalf of any UK creditors; for example, whether the creditor will get bad debt relief (generally not the case where the creditor controls the debtor).

What has changed?

Since Summer 2013, the Government has been consulting on modernising the loan relationships rules, and on the rules governing the taxation of derivative contracts. This ambitious project has led to changes to the legislation and in December 2014 further changes were proposed in draft legislation to be included in Finance Bill 2015. Some of these changes are relevant to the tax analysis for the restructuring of UK distressed debt and take effect from 1 January 2015.

The changes are: 

• A credit arising to a UK debtor on a release forming part of a qualifying restructuring will not be taxable for that UK debtor if, immediately before the release, it is reasonable to assume that (absent that release and any associated restructuring) there would be a material risk that, at some point in the following 12 months, the debtor company would be unable to pay its debts (having regard to contingent and prospective liabilities).
• A similar provision provides that a modification or replacement of a loan relationship that gives rise to a "substantial modification" of that loan relationship for accounting purposes – for example, as a result of an "amend and extend" restructuring of borrowing terms described earlier – shall also not give rise to a taxable credit for a UK debtor if there is material risk that the debtor would be unable to meet its debts within the next 12 months in absence of that restructuring.
• Draft guidance was published by HMRC on 12 January 2015 which gives an insight as to how these provisions are likely to be interpreted. For a "material risk" to arise, the guidance suggests there must be a significant risk of insolvency that is of concern to directors, but it does not follow that directors will be in breach of their company law obligations by continuing to trade. A "reasonable assumption" of this risk is likely to be formed if circumstances arise that may result in insolvency practitioners being instructed; the guidance gives examples that include breaches of financial covenants, enforcement actions taken by creditors and insolvent balance sheets.

There is also an amendment – to take effect from 1 January 2016 - to help ensure that no unexpected tax charge arises on a UK debtor company under the "deemed release" rules described earlier if a company moves between insolvency procedures.

Comment

These changes apply to the position of a UK tax resident debtor and are to be welcomed as they will generally assist tax payers in making it easier to implement a restructuring without triggering an unexpected UK tax charge in the debtor company. They will have effect for restructurings undertaken now, and are particularly helpful for companies that are to be refinanced and adopt "new" UK GAAP accounting.

Against this is the proposed introduction of a new anti-avoidance rule that is drafted in broad terms and is to apply from 1 April 2015. Under this proposed rule, it will be necessary to consider whether any restructuring effected after that date has a main purpose of enabling a company to obtain a tax advantage under the UK's loan relationship rules (e.g. avoid a UK tax charge, or increase a UK tax deduction).

Overall the effect of the changes is positive for the restructuring of UK distressed debt and is consistent with the overall premise that tax should not be a barrier to these types of commercially-led transactions (although, in light of the fact that the rules are complex and subject to ongoing change, they should be reviewed carefully).