Debt restructuring: International tax considerations

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.