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New Year’s (Debt) Resolution

Leontia Doran

By Paddy Harty

In this article Paddy takes a look at the potential tax consequences that many property investors now fi nd themselves facing as they exit arrangements made at the height of the property boom.

The property boom during the early noughties took place on both sides of the Irish border. The aftermath is well documented and many borrowers are entering the end game having endured a “Russian doll’ series of lenders – many debtors of Irish banks have watched their debts move from the original lender to NAMA to third party debt purchasers (Cerberus etc.). Many are now in final negotiations with those lenders on their exit. For many borrowers, their 2017 New Year’s resolution is to achieve debt resolution and get back into business unencumbered.

The Borrower, to date, has been totally focused on their exit and has been trying to maximise asset values and rental income for their new master who in most cases has dangled the carrot of debt write off and release from personal guarantees in front of him. As part of this, tax is normally not a consideration as in the borrowers reckoning – as the borrower sees it, the assets that are being realised are usually being sold at less than their historical cost.

There are two main issues to consider with clients in these situations, firstly tax liabilities or losses that will arise on the sale of assets held personally to clear down debt and then secondly the treatment of the ultimate debt write off, if agreed by the lender. This article looks at each of these aspects.

Asset sales

(i) Investment Assets

In the UK if an asset is held as an investment and is disposed of for less than its original cost to the seller, then the disposal creates a capital loss which can be offset against capital gains arising in the same tax year or carried forward for offset against future capital gains. A technical restriction applies where losses arise from disposal to connected parties, so called ‘clogged losses’, but that situation is not within the scope of this article. Crucially, capital losses CANNOT be carried back so it is essential that clients dispose of all assets in the same year where gains on some assets may arise. Alternatively to be safe, loss-making assets should be sold first to create the capital loss as there can be hitches in asset sales that can push the date of sale of the loss-making asset into the next tax year and that loss cannot then be carried back.

UK corporates within a capital gains tax (“CGT”) group can elect to deem the transaction giving rise to the capital loss as having happened in another group company either partially or wholly. This can be efficient if other group companies have chargeable gains which can be reduced in the current year or future years by the capital losses being transferred by election (this election happens under section 171A TCGA 1992). This is a divergence from the normal UK corporate group relief rules for trading losses which are only relievable against group company profits of the same accounting period.

In the Republic of Ireland the situation is broadly similar with some important exceptions. Where investment assets are disposed of and there is an associated debt write off by the lender then the amount of debt written off reduces the original base cost of the asset. Section 42 of Finance (No 2) Act 2013 introduced a new section into section 552 TCA 1997 which ensures that only the true economic cost of the asset is allowed as a Capital Gains Tax (CGT) deduction. This took effect from 1 January 2014 where debt has been released before or after the CGT disposal however the restriction cannot turn a loss into a gain.

Example: Individual disposing of an investment asset with associated debt write off.

Syd borrowed €10m to acquire a building in Dublin for €15m in 2004. His loans were acquired by an American Hedge fund that has now ordered the building to be sold for €6m on the understanding that Syd will not be pursued for the outstanding Debt of €4m.

Sales Price

6m

Cost price

(15m)

CGT loss

(9m)

However s552 (1B)(b) reduces the cost price by the amount of the debt write off and therefore the CGT loss will be:

Sales Price

6m

Cost Price

15m

Debt released

(4m)

(11m)

Net Loss for CGT

5m

(ii) Trading Assets

If the asset is held as trading stock, then the sale below cost should create a trading loss. However, since the financial crisis truly began in 2008 many taxpayers holding development land as stock have been justifiably writing the value of this down in line with falling market values and in accordance with Generally Accepted Accounting Principles. As the market has recovered however, these development lands should be revalued upwards in trading accounts and on disposal, trading profits can result often with no tax relief available because in corporate group situations the previously generated losses may have been utilised. I have seen several situations where the lenders have forced asset sales and tax liabilities have resulted with no liquidity to fund the liability a so called “dry tax charge”.

Debt Write Offs

Individuals

In the UK, if any individual borrows to acquire an investment and subsequently has a debt forgiven by a lender, this event does not give rise to a tax charge. However care needs to be taken to examine the break down of the debt being written off as it often is an amalgamation of capital plus accrued interest. If the client has had a deduction for the accrued interest (against rental income) then its release is taxable. A similiar tax treatment applies for the release of the accrued interest in the Republic of Ireland.

In the Republic of Ireland however the capital amount of the debt write-off reduces the base cost of the asset as detailed in the above example. This is an important difference between the two tax systems and advisers need to be wary as many Northern Irish property developers acquired assets on both sides of the border funded by Irish banks with some of these debts now being released.

Corporates

A UK corporate borrower benefiting from a debt write off may be subjected to a corporation tax charge. However, this can be mitigated with careful planning. Corporate borrowers (like their personal counterparts) that hold development land as stock will have written their stock values down over the years and their balance sheets typically show large deficiencies of capital. This in itself is often detrimental to the company’s trading as it can affect its ability to tender for work. An obvious solution is to liquidate the company and start again, however that will not be desirable where the company has a long track record with many accreditations secured which would take years to obtain from scratch. Personal reputations are also a factor and often competitors are waiting in the wings for the inevitable liquidation. Help is at hand however in the form of a corporate reconstruction and if debt is written off as part of an insolvency action such as a Creditors Voluntary Arrangement (CVA) then the write off is exempt from taxation (S322 CTA2009).

Indeed, the UK government has recently introduced legislation to avoid the company having to go to the expense of a CVA to secure exemption from the charge to tax on a debt write off where it can be shown that there is no reasonable prospect of the debt being paid.

An additional strategy would be for the shareholders of the debt ridden company to acquire the debt from the lender for nominal consideration and immediately subscribe for more share capital in the company up to the level of the debt write down. The lender will normally make such a sale conditional on the entire debt write off being converted into equity, however if a partial conversion is permitted then the shareholder ends up owning second hand debt. The recapitalisation of the balance sheet will often restore the company to a solid footing in the eyes of customers, credit agencies etc., and normal trading can resume which is why this is a very important restructuring technique. The second hand debt holder could call in the loan in the future however this will create a personal capital gain for him at 20% tax rate which is still an effective way to extract money from the recovered company.

Example

Roger is the 100% shareholder in Floyd Limited. In 2006, Floyd Limited borrowed £10m to acquire development lands at Battersea for £10m. By 2016 the lands have been written down to £2m, there are £6m of trading losses in Floyd which is still trading, although the Battersea loan is still standing at £8m with expectation that only a further £2m will be generated from the sale of the remaining Battersea site. This will leave £6m of uncollectable old par value debt. Roger’s accountant, David, has negotiated with the bank who propose to issue 2 facility letters, the first is a performing facility of £2m to be cleared from the sale proceeds. The second is a non-performing facility that will be sold to Roger for £1 on the condition that he undertakes a debt/equity swap.

As a result of the debt/equity swap the share capital of Floyd Limited will be increased by £6m (although this share capital has a base cost of £1 to Roger) and this will re-capitalise the company which has a Reserves deficit of £6m. The trading losses carried forward should still be available for offset against profits of the same trade.

The situation in Ireland is somewhat different in that Finance Act 2013 section 18 which inserted section 87B TCA 1997 treats the loan write-off as an income receipt of the trade of dealing in land for an individual. This section does not apply for a company.

Conclusion

We are now well into debt resolution for many beleaguered borrowers who are usually powerless to resist asset sales and consequential debt write offs. It is essential however that clients carefully weigh up the tax implications of these matters as issues such as the order of asset sales and the method of debt write off need to be carefully considered to avoid unwelcome tax bills. Amounts may need to be withheld from asset sales proceeds to meet tax liabilities – often, post sale, there is little chance of recovering money to meet tax liabilities.

Finally any debt write off agreed with lenders needs to be properly evidenced in writing and thus it is essential to engage the services of a lawyer well versed in these matters to prepare the necessary legal documents.

Paddy Harty is a Director in PKF-FPM and specialises in income tax and capital tax planning and cross-border transactions.

Email: p.harty@pkffpm.com