Restructuring debt – new tax reliefs, new requirements

Changes to the legislation on tax reliefs in debt restructuring offer greater flexibility to companies in financial difficulties. However, the subjectivity of the new rules and their untested nature could create additional uncertainty.

Profits realised by companies on repaying debt at less than full value are, in general, taxable at a rate of 20% in the UK. However, HMRC provides tax reliefs for companies in financial difficulty so that they can relieve their debts without incurring onerous tax liabilities. In the past, utilisation of these reliefs has typically required lenders to swap debt for equity, or the distressed company to enter an insolvency process. The legislation has now been changed and, as a result, provides greater latitude in the cancellation of debt in a restructuring scenario.

What is the new tax relief?
The new relief is intended to make the restructuring of distressed debt simpler and more efficient. Clauses have been added to the existing legislation which extend the available relief. A credit arising on the cancellation or favourable modification of a debt is exempt from tax provided it is:

‘reasonable to assume that without the release [of debt] and any arrangements of which the release forms part, that there would be a material risk that at some time within the next twelve months the company would be unable to pay its debts.’

Removing the requirement for a debt for equity swap gives companies in restructuring situations more alternatives. However, the changes to the legislation mean there is greater uncertainty around the applicability of the new rules, which only gained Royal Assent last November. The draft guidance issued so far by HMRC, which has being applied in a number of restructuring situations already, is yet to be tested and could still be withdrawn and changed.

The ‘reasonable to assume’ test
The main area of difficulty will be in determining whether it is ‘reasonable to assume’ that a company will be unable to repay its debts within twelve months. The phrase ‘unable to pay its debts’ is based on section 123 of the Insolvency Act 1986. Citing the Insolvency Act puts emphasis on the balance sheet and cash flow insolvency tests used under the Act. Meanwhile, the terms ‘reasonable to assume’ and ‘material risk’ of being unable to pay debts, taken together mean that there must be a realistic likelihood of the company going into insolvency.

Practically, the company and its directors will need to make a commercial assessment of their available options and give due consideration to the insolvency tests outlined under the Act. This could include a review of financial forecasts, valuations and offers for the business. It could also encompass an assessment of the status of any negotiations with lenders or other financial stakeholders. In light of the emphasis given to the Insolvency Act, we envisage that in most circumstances an Insolvency Practitioner or Restructuring Advisor would need to be consulted.

The risk of getting it wrong
Without a proper assessment of whether they qualify under this test, companies face substantial risks of a tax charge at the prevailing corporation tax rate (currently 20%) on income equal to the amount of debt released. The qualification criteria could also hamper balance sheet restructuring if there is little evidence of genuine inability to repay debts within twelve months. Given these uncertainties, all financial stakeholders in a restructuring need to ensure that sufficient focus is given to the new rules in implementing any restructuring solution.

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Jay Marwa | Director
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Matthew Little | Senior Manager
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