Retrospective Change Of Law Announced For UK Debt Buybacks

Introduction

In a Written Ministerial Statement (the "Ministerial Statement"), delivered on 27 February 2012, the UK Government has announced measures to counteract two tax avoidance schemes entered into by a UK bank (the "Bank"), the UK Bank being a signatory to the Code of Practice on Taxation for Banks.

Unusually, it has been announced in the Ministerial Statement that legislation in respect of one of the tax avoidance schemes will be retrospective to a date before the date of the Ministerial Statement itself. There is also a strong suggestion in the Ministerial Statement, that similar arrangements will be closed down retrospectively in future, specifically where (as has been the case with the Bank and the arrangements it entered into):

the arrangements are contrived to avoid tax arising on the profits from certain debt buybacks; or the arrangements involve financial products designed to create tax credits that can be repaid or offset against a bank's other income and the tax in question has not been paid. The Government's justification for the retrospective nature of the legislation in these circumstances is that the arrangements are "wholly unacceptable, against the intentions of Parliament and the spirit of the law".

The 'nuclear option' of changing UK tax legislation retrospectively will therefore be deployed, and has been threatened where similar future schemes are attempted. Given the importance of these developments, this Clients & Friends memorandum considers the circumstances leading to, and possible consequences of, the Government's action.

The UK taxation of indirect debt buybacks prior to 27 February 2012

The release of an obligation on a debtor to repay a debt generally results in the debtor being taxable on the amount released unless a statutory exemption applies. One such exemption applies where the debtor is connected, for the purposes of the loan relationships regime, with the creditor releasing the debt. Under the connected companies rules in the UK loan relationships regime, a creditor is prevented from bringing into account as a loan relationship debit any impairment or release of a debt owed to it by a connected debtor.1 This general rule is subject to a number of exceptions and operates regardless of the accounting recognition of the impairment or release in the creditor's solus accounts.2 Similarly, a debtor is not required to bring into account a loan relationships credit in respect of the impairment or release of a debt by a connected creditor.3 This general position is also subject to a number of exceptions.4

As a repurchase of debt by a debtor involves a release by operation of law, the same tax consequences might be thought to result from a debt buyback between connected companies as from a release of debt by a creditor connected to a debtor. However, since March 2005 the Government has introduced legislation to prevent connected companies achieving tax-free indirect releases of debt in certain circumstances. The transactions which have been targeted have, very broadly, involved the release of debt owed by a corporate debtor to an unconnected creditor by means of arranging for a company connected with the debtor to acquire the creditor's loan relationship or to acquire the unconnected creditor itself. Irrespective of the precise legislative language used by the parliamentary draftsman, the Government's policy objective in carefully limiting the scope of tax-free indirect debt buybacks to a specified set of tailored safe-harbours can, generally, be discerned.

Provisions introduced in Finance Act ("FA") 20055 deemed there to be a release of all or part of a debt represented by a loan relationship in certain circumstances. These provisions, which became rewritten into Corporation Tax Act 2009 ("CTA 2009") s.361, provided that where a company ("C2") acquired a loan relationship owed by a debtor company connected to C2 ("D") from an unconnected third party ("C"), and the price paid by C2 was less than the carrying value in D's accounts, the loan relationship was deemed to have been released if either:

the acquisition was not an arm's length transaction; or importantly, there was a connection between C2 and D in the period of three years beginning four years before the date of the acquisition of the loan relationship. Other legislation in FA 2005, later rewritten into CTA 2009 s.362, provided that where a company ("X") was a creditor under a loan relationship owed by an unconnected company ("Y") and X later became connected with Y, an amount equal to any impairment which would have been recognised by X had a period of account ended immediately prior to that connection arising was deemed to have been released.

The drafting of CTA 2009, s.361 led to groups wishing to retire impaired debt to arrange for a newly formed connected company to acquire the debt at a discount on arm's length terms without a tax charge arising on a "deemed release" owing to the age of the newly formed company falling outside the connection test. In the financial crisis of 2007-2009, many companies and financial institutions, seeking to consolidate balance sheets, improve return on equity or enhance covenant compliance, utilised the provisions of CTA 2009, s.361 to achieve tax-free indirect debt buybacks.

Owing to the perceived circumnavigation of CTA 2009, s.361, in particular where companies were establishing new companies to acquire group debt at a discount and avoid a taxable deemed release, the relevant legislation was amended in FA 2010. The Government expressly stated that its intention with these legislative changes was "to ensure that only those debt buybacks that are undertaken as part of genuine corporate rescues will benefit from the buyback profits not being subject to tax".6

Accordingly, the circumstances under which a (potentially) taxable deemed release under CTA 2009 s.361 could arise were widened considerably.7 The connection test in CTA 2009 s.361 was repealed and three new, significantly less generous, exceptions were introduced where:

there has been a change in ownership in D, but for which it is reasonable to assume that D would have met an insolvency condition8 within one year of the change of ownership, and the loan relationship was acquired on arm's length terms (it being reasonable to assume that the acquisition would not have taken place without the change in ownership) (the "corporate rescue exception"). This assumption is particularly difficult to apply in practice owing to the inherent subjectively (and therefore uncertainly) of the test of whether it is "reasonable to assume" D would have met an insolvency condition; C2 acquires a loan or security in return for a new loan or security (respectively) with the same nominal value and substantially the same market value, on arm's length terms(the "debt-for-debt exception"); or C2 acquires the loan relationship on arm's length terms in return for ordinary shares in C2, ordinary shares of a company connected to C2 or an entitlement to such shares (the "debtfor- equity exception").9 Importantly, where a creditor had acquired a loan qualifying for the corporate rescue exception or debt-for-debt exception and where that debt was subsequently released, such a release was treated as a release of "relevant rights".10 This required the debtor to bring into account a (taxable) credit equal to the discount received by the creditor on acquiring the loan, less the amount of any credits brought into account by the creditor with respect to that discount. This provision made it very difficult for bought-in debt to be released intra-group without a tax charge, which might result in such debt remaining outstanding. Paradoxically, the tax rationale for retaining such debt (on which the acquiring creditor would be taxed on the discount recognised) within a financially...