As banks and other lenders begin to come to grips with working out some of their underperforming loan books, we are seeing an increasing number of transactions that involve the acquisition of target companies that cannot repay their borrowings. In this issue of Tax Adviser Update (TAU), Ian Fleming and Jonathan Hornby provide an update on taxation developments in this area and share some experiences from recent transactions.
The Coalition Government budget included significant changes to the taxation of capital gains. Dafydd Williams considers these in an M&A context.
Acquisition of Companies with Distressed Debt
We have recently seen an increasing number of transactions that featured one or more of the following characteristics:
- The forgiveness of existing borrowing
- The acquisition of loan notes issued by target companies for less than their face value or:
- Debt for equity swaps with the lender taking an ownership interest in the target company.
While debt forgiveness between parties not connected for tax purposes has always given rise to a taxable credit for the debtor company, the latter two scenarios have provided structuring opportunities to avoid a tax charge. In we reported on some recent amendments to the law in this area. One aspect of the new rules that received a lot of coverage was the ‘Corporate Rescue Exemption,’ whereby a taxable credit could be avoided in a target company in which the debt was also purchased at a discount to face value – provided that certain criteria were met concerning the future potential insolvency of the borrower. One year later, our experience has been that purchasers are reluctant to rely on this exemption and HMRC remains reluctant to issue any advance clearance that the highly-subjective conditions for exemption are being met. Furthermore, even where the exemption is successfully claimed, it may be difficult to unwind the lending going forward, either through a future capitalisation or even repayment, so that the Corporate Rescue Exemption is not always the most desirable solution.
Debt for equity swaps remain an option. In this instance, the target company is required to issue ‘ordinary shares’ – as defined for tax purposes as consideration for the satisfaction of its outstanding debt. Subject to anti-avoidance concerns, this would enable a third-party purchaser to acquire both the original equity in the target and the new shares, without crystallising taxable income regarding the writeoff of the loan. However, HMRC's guidance on the tax treatment of debt for equity swaps was updated on 15 July 2010, and indicates a tougher stance on the circumstances in which the debt equity swap exemption will be available. HMRC’s position is that relief should not be available where the creditor has no intention of maintaining an ongoing interest in the company.
The following example is provided in HMRC’s manual, which states that in circumstances where the creditor disposes of the new shares shortly after receiving them, the requirement for releasing the debt in consideration of the shares is not met:
Source: HMRC Corporate Finance Manual (updated 15 July 2010)
Company A owes £80 million to an unrelated bank, but is unlikely to be able to repay the loan. As part of a refinancing of the group of which company A belongs, the bank agrees to release the loan. Company A issues 100 ‘B’ ordinary shares to the bank. These shares carry a right to assets in a winding-up, but are non-voting and have only limited rights to dividends. The market value of the shares on issue is only £500.
The existing shareholders in company A, however, do not wish to have the value of their holdings diluted by the issue of new shares or to have the bank as a shareholder. So contractual arrangements are put in place under which, immediately after the shares are issued to the bank, the bank will sell the shares to the existing shareholders for £500.
It is unlikely that S322(4) (the debt for equity swap exemption) would apply in this case. On any realistic view of the facts, the consideration which the bank receives for releasing the debt is not the shares, but the £500 cash.
This represents a significant shift in published policy, and any purchaser engaged in structuring that involves debt equity swaps is advised to examine this issue very closely. At the end of the day, if relief is not available, it is the target company that is left with the liability.
Capital Gains Tax and Entrepreneurs’ Relief
The Coalition Government’s Budget in June 2010 increased the capital gains tax (CGT) rate for non-basic rate taxpayers from 18 percent to 28 percent, making the mitigation of CGT a much more important consideration for management teams and private equity executives.
Entrepreneurs’ Relief is now a more valuable consideration when structuring transactions as it reduces the CGT rate to 10 percent on qualifying gains, subject to a lifetime limit. The first £5 million of gain (raised from £2 million in the June Budget) will be taxed at 10 percent, subsequently increasing to 28 percent for non-basic rate taxpayers.
For instance, if an individual sold his (or her) business for £5 million without Entrepreneurs’ Relief, their tax liability would be £1,389,900 (taking into account their personal CGT allowance). With the increase in Entrepreneurs’ Relief, the tax liability would only be £489,900 – a savings of £900,000.
The scope of the relief has not been extended, so it may not benefit private equity executives in typical circumstances, as it is generally limited to owner managers rather than investors. However, if appropriately structured it may be possible for private equity executives to benefit from the relief. This is best reviewed on a case by case basis.
Subject to a number of other conditions being met, qualifying gains under Entrepreneurs’ Relief include those arising on a disposal of:
- A business as a going concern
- Assets used for a dissolved business
- Shares or securities
- Certain assets used in a partnership or company.
In the case of share disposal, which would be the most relevant in an M&A context, the key conditions are:
- The company is a trading company or a holding company of a trading group
- For a period of at least one year before the disposal, the individual making the disposal:
- owns at least 5 percent of the ordinary share capital and is able to exercise at least 5 percent of the voting rights; and
- is an officer or employee (full or part-time) of the company or another company in the group.
Going forward, detailed consideration should be given to structuring transactions such that the maximum number of management or board members falls within the above conditions.
The key matter to address will be ensuring, where possible, that the relevant individuals hold 5 percent of the ordinary share capital and are able to exercise 5 percent of voting rights. With careful planning of the capital structure and the rights attaching to shares, it may be possible to achieve this without disturbing the intended economic ownership, i.e. issuing various classes of shares, or ratchet arrangements which are already common in private equity structures.
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