Corporate groups refinance for many reasons – such as raising new funds for investment, repaying existing debt, or addressing an anticipated cash flow shortfall. The commercial terms and legal structure of financing arrangements vary considerably, so it's important to understand the tax implications in all such situations – particularly where the refinancing will involve the issuance of shares or debt with unusual features.

New funding is often introduced below the ultimate parent of the group, as lenders aim to avoid structural subordination by positioning their debt immediately upstream of valuable assets. In such cases, care should be taken to avoid triggering degrouping charges and restrictions on loss relief, and to preserve the availability of the substantial shareholding exemption (SSE) on future disposals.

Forms of new finance and their tax treatment

New funding can be injected by a variety of means.

• ‘Vanilla’ debt with standard commercial terms – corporate tax deductions should generally be available for the finance cost element of such loans, but the deductible amount depends on a range of factors, including the purpose of the loan, and the application of transfer pricing and corporate interest restriction rules, amongst others.
• Ordinary equity – no ongoing corporate tax relief is available on distributions to shareholders.
• Debt with equity-like features – including debt convertible into equity, with a very high yield, or for which the return is results-dependent. Typically, the associated finance costs will be treated, at least in part, as non-deductible distributions.
• Equity with debt-like features – preference shares with priority rights to dividends and assets on winding up may be classified as liabilities for financial reporting purposes. No tax deductions will be available for any associated financing costs.

Further tax considerations can arise if funding is injected at a level below the top holding company of the group in accordance with the ‘equity holder’ rules.

Understanding the equity holder rules

Where the equity holder rules apply, entitlement to profits and assets should be considered as well as ownership of ordinary share capital to determine if the required ownership threshold is met. These tests may require reviewing debt and equity instruments such as those discussed above.

Under the equity holder rules, a company is treated as a 75% subsidiary of another only if the second company is entitled to at least 75% of any distribution of profits by the first, and to at least 75% of its assets on a winding up. This determines whether tax losses can flow between the entities as group relief, and the extent to which assets can be transferred in a tax-neutral manner. A similar exercise is required when determining whether a 10% shareholding is held for the purposes of SSE.

Case study: tax risks of refinancing with equity-like debt

Consider a group including Holdco Limited (Holdco) and its wholly owned trading subsidiary, Tradeco Limited (Tradeco). Tradeco is currently loss making and in a net liabilities position and needs new funds. Before tax is considered, an agreement is reached for Tradeco to borrow £1m from a third party, under a loan that will be redeemable for £3m in two years’ time.

Given that the redemption premium represents a high return on the loan principal, it will likely be (substantially) reclassified as distributions for tax purposes, meaning limited tax relief will be available to Tradeco. The lender will also be considered an equity holder in Tradeco, with the following tax consequences:

• As Tradeco does not currently have distributable profits or net assets, the equity holder rules consider what would happen if £100 were available for distribution. This would go entirely to the debt provider, whose loan will rank ahead of Holdco’s shares. Holdco is therefore treated as not being entitled to any of the profits or assets of Tradeco.
• This means that Holdco and Tradeco no longer form a group for group relief purposes, so Holdco will not be able to offset the losses suffered by Tradeco against any of its other income.
• Furthermore, if any assets were transferred to Tradeco in the six years prior to the issuance of the new loan, corporation tax degrouping charges will arise.
• Property stamp tax group reliefs may also be withdrawn if relevant assets were transferred within the previous three years.
• In addition, Holdco will no longer be treated as holding a substantial shareholding in Tradeco, which could impact the availability of SSE if the shares in Tradeco are subsequently sold.

The new loan could therefore have significant adverse tax consequences.

How to avoid unexpected tax consequences when refinancing

Exposing the borrower to additional tax costs is not in the interests of the lender, so there is an incentive for both parties to work together to mitigate tax issues where possible. It is important that they go into the arrangement with a clear understanding of the tax consequences.

To avoid last minute complications and unanticipated liabilities, corporate groups should seek specialist tax advice in the early stages of refinancing discussions.

If you would like to discuss the potential tax implications of your refinancing plans and how to manage them effectively, please get in touch with James Morris or your usual RSM contact.

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