Introduction
The increasingly unpredictable economic landscape has
created uncertainty and distress for businesses across a broad
range of sectors and markets. Borrowers have been working
to stabilize their businesses and ensure they have the liquidity
to continue to trade through these difficult times. Lenders
have been working to assist and support their borrowers by
providing amendments and waivers under existing facilities as
well as new money (where the circumstances permit).
But what happens if things don’t go to plan?
We know from past experience that borrowers and lenders have
a number of debt restructuring scenarios that they commonly
consider: from partial waivers to debt-to-equity swaps; from
conditional waivers to the sale of distressed debt. But especially
in a cross-border context, specific local tax consequences
can significantly impact the choice between one scenario and
another.
Norton Rose Fulbright has performed research across selected
jurisdictions (i.e. the US, Australia, Canada, South Africa,
France, the UK, Germany, Luxembourg and the Netherlands)
on various debt restructuring scenarios and the local tax impact
on debtors and creditors. This research has provided us with
insight into various pitfalls that might occur from international
debt restructurings.
This note discusses three commonly used debt
restructuring scenarios:
- Sale of distressed debt
- Debt-to-equity swaps
- Debt waivers.
The goal is to flag key tax items across selected jurisdictions
for each scenario, because we know from experience that,
although certain international trends can be seen, any
international debt restructuring requires careful consideration
of the relevant local tax regimes.
1. Sale of distressed debt
The sale of distressed debt is a mechanism for a creditor to
reduce their balance sheet exposure to debts which may
currently be non-performing or have a significant risk of
future default. In such circumstances, the debt would be sold
at a discount to face value in view of the distressed financial
circumstances of the debtor.
Certain private equity and other investment funds are known
to have an appetite for the purchase of distressed debt on
secondary markets (which may come in the form of an
individual loan or a large portfolio) at a reduced price in order to
realize a profit by either:
- In the case of a liquid market, rapidly selling on the debt
- Negotiating a financial restructuring of the company
and/or awaiting the financial recovery of the debtor and
consequently the future repayment of the debt.
As well as sales to unconnected parties, it may also be that the
parties want to arrange a disposal to a connected party. This
may occur, for example, where a debtor wants to acquire a debt
into a group to remove the controls placed on it by the third-party creditor.
The sale of distressed debt is achieved by way of assignment
or novation, depending on the terms of the debt. Consent of the
debtor to a sale may be required. Individual debt sales are usually
carried out on standardized documents, whereas portfolio sales
are more likely to be negotiated on a bespoke basis. Alternatively,
the creditor may sub-participate its interest in the loan, in which
case it remains the lender of record but transfers the credit risk of
the debtor to the participant. This may not result in the distressed
loan coming off its balance sheet.
Key tax considerations
The selling creditor will want to ensure that they are able to
claim relief for any loss they have incurred with respect to the
debt. A buyer will want to ensure that their base cost in the
loan is the price paid; that they do not suffer any immediate tax
charge and that there are no transfer taxes that arise as a result.
The debtor will want to ensure that there are no adverse tax
charges arising for them in relation to the sale and that the
sale does not adversely impact on the deductibility of interest
payments going forward. It will also be important for
the parties to consider the impact on the withholding tax treatment
of interest payments and the allocation of risk under the loan
documents. A change in lender may mean that interest can no
longer be paid gross or new treaty applications are required.
Both parties will want to ensure there is no tax charge for
the creditor.
Research findings
Below we will summarize our key findings for the sale of
distressed debt, where we distinguish between general
international tax trends (i.e. how do the majority of the
jurisdictions treat the sale of distressed debt) and specific tax
issues (i.e. which jurisdictions take a different approach than
others and therefore may need further consideration if a local
tax payer is involved in the sale of distressed debt):
General trends
- The selling creditor’s position upon a sale is largely
consistent across the jurisdictions, with a creditor realizing
a tax deductible loss upon the sale of the debt at a discount.
This loss typically reflects the difference between the
carrying value of the loan and the sale proceeds, assuming
that the sale is on arm’s length terms. There may be no tax
loss where the selling creditor and buying creditor
are connected.
- The transfer of a creditor’s right to a debt to another entity
does not generally affect the corporate income tax position
of the debtor (whose obligation to repay is generally
unaffected by the sale). Some jurisdictions impose a tax
charge on the debtor where the buying creditor is connected
with the debtor.
- The buying creditor will generally not suffer an immediate
tax charge and its base cost in the debt will be the price it
paid (again assuming that the acquisition is on arm’s length
terms).
- The transfer of a debt should not give rise to transfer taxes
unless the debt has equity like characteristics such as
results-dependent interest or is convertible into equity.
Specific issues
UK and US
In circumstances where the buying creditor and debtor
are related parties, the debtor may be subject to tax on the
difference between the carrying value of the debt and the
amount the incoming creditor paid for the acquisition.
France
The general rule which states that the debtor’s tax obligations
will be unaffected on the sale of a debt will apply provided that
the debtor is notified of the change in creditor.
Luxembourg
If the sale is set up on beneficial terms for the incoming
creditor, a taxable gain may be charged on any hidden capital
contribution or distribution which that creditor receives.
The Netherlands
Stringent anti-avoidance provisions are in place to ensure
that a creditor cannot avoid Dutch tax liability from an upward
valuation of a loan which has previously been written-down
(where the parties are affiliates).
Canada
If a debt is sold to an incoming creditor that meets certain interest
tests in the debtor for less than 80 percent of the principal amount
of the loan, then a taxable credit may arise in the debtor.
2. Debt-to-equity swaps
A debt-to-equity swap, substitution or restructuring is a capital
reorganization of a company in which a creditor (usually a bank,
possibly together with other banks, bondholders or creditors)
converts indebtedness owed to it by a company into one or
more classes of that company’s share capital.
There is no preordained structure for a debt-to-equity swap.
Much depends on the existing debt and capital profile of the
company and the intended result. The main commercial issues
to be settled between the company (effectively representing its
shareholders) and its principal bank (and other creditors) are:
- How much debt is to be substituted by share capital?
- What proportion of the total equity should the shares issued
to the creditor comprise?
- Which class of shares should be issued to the creditor? Are
there any restrictions on the type of shares issued?
- Should the creditor accept any restriction on its ability to
dispose of the shares issued to it?
To a large degree, the negotiating position of the bank will
depend on whether or not the reconstruction involves new
money from other investors being injected by way of share
capital. Institutional investors considering putting new money
into the company will usually drive a harder bargain than the
company itself.
Key tax considerations
The creditor will be interested in:
- Tax relief for the debt that is capitalized.
- The tax base cost in the new shares issued on the
debt capitalization.
- Tax charges on the issuing company on the
debt capitalization.
From a debtor perspective, the key aspects are:
- Will release of the debt result in taxable income?
- Will the issuance of new shares cause a cancellation
of losses?
Research findings
Below we will summarize our key findings for debt-to-equity
swaps, where we distinguish between general international
tax trends (i.e. how do the majority of the jurisdictions treat
a debt-to-equity swap) and specific tax issues (i.e. what
jurisdictions take a different approach than others and therefore
may need further consideration if a local tax payer is involved in
a debt-to-equity swap):
General trends
- Creditors involved in a debt-to-equity swap are generally
able to convert their debt into equity in a tax neutral
transaction, where the tax book value of the shares received
equals the tax book value of the converted debt.
- The position may be different if the creditor is a related
party of the debtor. A number of jurisdictions have
legislation that prevents a creditor from depreciating a
debt and subsequently converting the debt into equity in a
tax neutral way.
- A debtor that issues new shares to the creditor as part of
the debt-to-equity swap may suffer a reduction of its tax
losses. If the release of the debt is considered to give rise to
taxable income, this may impact existing tax losses. Certain
countries apply specific debt forgiveness rules that prevent
taxation at the debtor level in case the release of the debt
exceeds available tax losses.
- In addition, the issue of new shares to a creditor outside
the debtor’s group may result in a (substantial) change
of shareholder and thus trigger tax loss cancellation rules
in a number of jurisdictions, or a change of ownership for
tax purposes.
Specific issues
Germany
When a German debtor is relieved from its debt (including as a
result of a debt-to-equity swap), the cancellation of the debt will
trigger a taxable gain to the extent the debt was depreciated
by the creditor. This is the reason that straight-forward debt-to-equity
swaps are very rare in Germany.
UK
The UK has prescriptive rules which govern the circumstances
in which debt-to-equity swaps will give rise to relief for the
creditor and avoid a taxable credit for the debtor. For example,
the release must be in consideration for ordinary share capital
which rules out use of fixed rate preference shares. Care must
be taken to ensure that the relevant conditions are met.
The Netherlands
A debt-to-equity swap is generally a tax neutral event
for debtors, where both the release of the debt and issuance
of shares are accounted for at nominal value rather than
market value.
3. Debt waivers or modifications
A debt waiver, debt cancellation or debt forgiveness is a
transaction in which a creditor (usually a shareholder but also
third-party creditors such as banks, bondholders or suppliers)
voluntarily relinquishes its right (in whole or in part) to payment
under a debt instrument. The waiver serves the purpose of
relieving the debtor from a financial obligation; it is a common
element in restructuring scenarios, including UK Schemes of
Arrangement and US “Chapter 11” procedures (and is expected
to form a part of WHOA schemes). The debt waiver is often part
of a package of relief used in an effort to ensure the survival
and prospects of the debtor.
There is no set structure for a debt waiver. In principle, it may be
implemented by a simple and short waiver declaration.
Debt modification
As an alternative to a waiver, the terms of the debt may be
amended so any repayment is contingent on certain conditions
being satisfied. However, agreeing the conditions for payment
may be a complex task as the agreement needs to anticipate
under which circumstances the company is required to pay
the debt.
As a part of restructuring negotiations, creditors may require
some form of reward if the restructuring proves successful.
These benefits can take a number of forms, including
increased pricing, a cash sweep, exit fees and/or equity-like
debt instruments. For this purpose, the debt can be (partially)
waived, amended and/or swapped for a new instrument at
the time of the restructuring. Payment of the debt could be
conditional on the financial situation of the debtor improving
such that its debt capacity allows for a (partial) servicing of the
debt.
Waiver and conditional reinstatement
In Germany, creditors can agree to a waiver of debt on the
basis that such debt will be reinstated if certain conditions are
satisfied, e.g. if and to the extent the debtor recovers financially.
Similar to the modification of debt, the agreement on the terms
of the reinstatement of the debt can be rather complex. From a
tax and accounting perspective, such transaction is treated as a
full waiver and the creation of new debt once the reinstatement
takes place. Other jurisdictions outside Germany do not treat
a waiver with a conditional reinstatement as a waiver of debt,
but rather as an amendment to the payment terms of the
instrument.
Main commercial issues
The main commercial issues to be settled between the
company and its creditors are:
- How much of the debt is to be forgiven? Will all creditors
participate in the measure equally (the expectation being
that creditors in the same class would be treated equally)?
Should shareholder financing take the hardest hit (the
expectation being that shareholder debt is treated akin to
equity and so should be released before third-party lenders
are expected to release their debt)?
- Should the waiver be in combination with other measures (e.g.
debt-to-equity conversion)? Should the measures be linked
(e.g. possibility to convert into equity upon certain triggers)?
- Under which circumstances will the debt be payable? Can
certain creditors – secured vs. unsecured or long-term vs.
short-term – take priority?
To a large degree, the negotiating position will depend on
the granularity of the creditor group. The more the company
needs to rely on the buy-in of only a few creditors, the more
bargaining power they will have when it comes to the terms of
the reinstatement.
Key tax considerations
The creditor will be interested in:
- Will the release of the debt result in a tax relief and will the
payment of the debt result in taxable income?
- In case of any changes to the terms of the debt, is it free
to structure the conditions for payment? In how far can it
mitigate abuse by the debtor?
From a debtor perspective, the key aspects are:
- Will the release of the debt result in taxable income?
- In case of amendments, will the payment of the debt result
in a tax relief?
- Is a new debt created?
Research findings
Below we will summarize our key findings for debt waivers
and modifications, where we distinguish between general
international tax trends (i.e. how do the majority of the
jurisdictions treat a waiver and reinstatement of debt) and
specific tax issues (i.e. what jurisdictions take a different
approach than others and therefore may need further
consideration if a local tax payer is involved in a debt waiver
or modification):
General trends
- Creditors involved in a debt waiver transaction are generally
able to obtain a tax relief for the debt forgiven. This treatment
is mirrored at the time the condition is fulfilled and the debt
is reinstated: the debtor realizes a taxable gain.
- For the debtor, the waiver is generally taxed since it is
released of a repayment obligation at nominal value.
- In Germany, a waiver with a conditional reinstatement
typically results in a tax relief for the debt recognized at the
time of reinstatement. Of course, in other jurisdictions where
the waiver is not recognized as such, neither the waiver/
modification of payment terms nor the reinstatement would
be taxed.
- If the loan is cross-border, a new loan may be created,
so that new double tax treaty clearances are required.
Specific issues
Germany
The waiver of shareholder debt may be treated as a (hidden)
contribution in kind, if and to the extent the debt is valuable.
The conditional debt waiver is also used as a loss-refresher to
carry a loss beyond a change-of-control which would typically
cause a forfeiture of tax losses.
US
A conditional debt waiver is accepted as a waiver and potential
reinstatement if, at the time of the waiver, it is unlikely that the
debtor becomes solvent again. Given that many restructuring/
insolvency regimes work on the assumption of a successful
turnaround, the conditional waiver may often not be recognized.
UK
Where a loan is amended so that repayment is made to be
contingent or conditional then care will need to be had that this
does not cause the loan to be treated as equity.
Concluding remarks
The current economic environment may create the need for
multinationals to reconsider their debt positions. At the same
time, distressed debt and other investment funds (such as private
equity investors) are actively looking for investment opportunities.
But especially in a cross-border context, each debt restructuring
scenario is impacted by specific local tax consequences.
In this note we have summarized some general trends and
specific tax issues that could arise from a sale and purchase of a
distressed debt, debt-to-equity swaps and debt waivers. One of
the key take-aways from our international research is that although
certain international trends can be seen, any international debt
restructuring requires careful consideration of the applicable local
tax regimes.
At Norton Rose Fulbright, we have extensive experience in
helping clients navigate the complex debt restructuring issues,
including the aforementioned tax issues. Please speak to your
usual Norton Rose Fulbright contact if you would like to discuss
any of the issues raised in this briefing in further detail.
Based throughout Europe, the United States, Canada, Latin
America, Asia, Australia, Africa and the Middle East, our
bankruptcy lawyers handle some of the most complex and
sensitive domestic and cross-border assignments across
the globe. The strength of our global bankruptcy, financial
restructuring and insolvency practice lies in our multidisciplinary
experience and international reach.
We have represented major interests in some of the world’s
most high-profile bankruptcy and workout cases, including the
US Trustee of Lehman Brothers Inc., JPMorgan Chase, Bank of
America, Citibank, the Commonwealth Bank of Australia, the
Royal Bank of Canada, NextEra Energy, Japan Airlines, Nortel
Networks and Export Import Bank of China.
Please visit our website from more information or speak to your
usual Norton Rose Fulbright contact if you would like to discuss
any of the issues raised in this briefing in further detail.
|
|