Spanish Tax Issues in Debt Restructurings: The Tax Treatment of Cancellation of Debt

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1 Spain Spanish Tax Issues in Debt Restructurings: The Tax Treatment of Cancellation of Debt Miguel Lorán* The author reviews the Spanish tax treatment of the cancellation debt that may take place when debt is restructured. When third-party lenders take control of the borrower and restructure the debt, potential tax issues may arise if the debt is subsequently renegotiated and cancelled. The Spanish accounting and tax authorities have issued a questionable set of interpretative criteria which may result in adverse tax consequences, which are reviewed in this article. 1. Introduction In the current market environment, the restructuring of indebtedness in Spain is also an area of increasing activity, and companies under stress have been forced to renegotiate their existing relationships with lenders. In a distressed debt context, this has resulted in a wave of transactions where, in some cases, specialized investors are acquiring portfolios of loans, while in other cases, where existing lenders have to enforce their securities, the lenders are releasing part of the outstanding debt and becoming owners of the businesses. These new market trends are giving rise to a number of new legal, regulatory, accounting and tax issues, which are very often interconnected. One of the tax issues that is receiving special attention from the Spanish tax and accounting authorities is the taxation of the cancellation of debts when the borrower and the lender are related parties. This scenario is subject to differing tax treatment across Europe and in the United States. In some places the difference between the fair value of a loan and the accounting value of the liability is subject to tax upon cancellation; under some other tax regimes, the taxation of such difference is deferred or subject to a preferential tax treatment; and under still other tax regimes, the entire accounting value of the liability is treated as an informal equity contribution with no tax impact. The Spanish accounting regulator and the tax authorities addressed debt restructuring issues in several rulings in 2009, which were confirmed in 2011, establishing a set of interpretative criteria relating to the accounting and tax treatment of the cancellation of indebtedness. In the absence of a specific regulation on this issue, the accounting and tax authorities have taken a liberal interpretation, which in turn gives rise to a number of practical difficulties in the major debt restructurings currently underway in Spain. This article focuses on the particular issue of the tax impact for borrowers upon a restructuring of distressed debt when the lender becomes a related party. The potentially adverse tax impact of the criteria proposed by the tax authorities are presented, along with the author s dissenting views on certain issues and some alternatives aimed at preventing adverse implications. 2. Debt Restructurings Affected by New Interpretative Criteria This article focuses on the tax implications of the cancellation of all or part of existing third-party debt in the process of the acquisition of control by third-party lenders. In this context, with syndicates of lenders including a large number of different counterparties, with different layers of debt and different levels of security, if the renegotiation of existing debt fails, the process of debt restructuring often involves the following situations: a majority or all of the lenders, through a consensual arrangement or through the enforcement of their security, become the owners of the equity of the borrower, normally through a new holding structure; and the lenders, depending on the specific restructuring mechanics, would either assign the existing debt to the new holding structure to be simultaneously renegotiated or partially waived to be left at sustainable levels; or would release the debt in exchange for new and sustainable debt, and equity instruments, through the new holding structure. The above-described situations would result in the lenders becoming, directly or indirectly, equity holders of the borrower, and the reduction and renegotiation of the existing debt to be accommodated to the capacity of the business. The interpretative criteria established by the Spanish accounting and tax authorities specifically address the following actions, which are relevant to the above-described debt restructuring: the acquisition of debt at discount; the renegotiation of the terms and conditions of the debt; and the partial or total debt waiver or debt-for-equity exchange after an acquisition of debt at discount. 3. Accounting and Tax Legal Framework 3.1. Accounting principles applicable to debt restructurings The Spanish accounting principles applicable to loan instruments are generally set forth in Valuation Rule 9 of * Partner, Freshfields Bruckhaus Deringer LLP, Madrid. Miguel Lorán Meler, Freshfields Bruckhaus Deringer LLP. The author can be reached at 269

2 Miguel Lorán the Plan General de Contabilidad 1 (effectively, Spanish GAAP). The accounting principles relevant to the debt restructurings under review are generally consistent with the principles set forth in the International Accounting Standards (IAS) 32 and 39. A loan instrument will be recorded initially at its fair value, adjusted for transaction costs, and will be subsequently valued at amortized cost using the effective interest method. The renegotiation of a loan instrument would give rise to a reassessment of the liability only when the terms and conditions of the renegotiated instrument are substantially different. This principle follows sec. 40 of IAS 39. According to section 3.5. of Valuation Rule 9 of Spanish GAAP, this is deemed to happen when the present value of the cash flows of the initial loan and the renegotiated loan differ by at least 10%. In such case, Spanish GAAP clarifies that the initial loan must be substituted by the new one, with the difference being recognized in profit or loss Tax principles applicable to debt restructuring Spanish corporate income tax follows generally accounting profit and loss as calculated in accordance with Spanish accounting rules, and subject to any adjustments set forth under tax law. There are no specific tax provisions that require a tax adjustment in this particular context, and therefore the accounting principles are relevant to assess the tax impact of the debt restructuring. 4. Debt Restructuring under the New Interpretative Criteria The Spanish accounting regulator, the Institute of Accounting and Accounts Auditing (Instituto de Contabilidad y Auditoría de Cuentas), and the Spanish tax authorities have coordinated a technical response to these transactions, through several rulings issued in 2009 and confirmed in 2011 (the Rulings). 2 The interpretative criteria set forth in the Rulings are considered below, in relation to each of the actions that would take place in the debt restructuring under analysis Acquisition of debt at discount The Rulings do not propose any relevant alternative interpretation criteria in connection with the acquisition of a loan, and confirm the consequence of the application of the accounting principles. With regard to the acquisition of debt at discount, Spanish GAAP does not include a specific principle, and the valuation rules to recognize loan instruments would not result, from the perspective of the borrower, in any obligation to reassess the valuation of the liability. The tax authorities therefore confirm that, as a result of the acquisition of debt at discount, no accounting or tax impact would arise from the perspective of the borrower Renegotiation of terms and conditions of the debt Regarding the renegotiation of the terms and conditions of the debt, the Rulings also strictly follow the accounting principles. In this case, there is a specific principle, mentioned above, whereby the existing loan is substituted by the renegotiated loan when the present value of the two instruments differs by at least 10%. The tax authorities confirm that the profit or loss resulting from the recognition of the new terms and conditions would have full tax effects in the financial year of the renegotiation. It is not uncommon in Spain that the renegotiation of terms and conditions of existing debt, in a distressed debt context, is effected by conversion of part of the existing debt into a profit participating loan. In certain circumstances, 3 a profit participating loan can be included in net assets for the purpose of determining the capital adequacy ratio, without losing its accounting and tax treatment as a debt instrument. The conversion of normal debt into profit participating loans is a common way to bolster the net assets of the company, by accepting subordination and linking the return on the loan to the borrowing entity s business in some way. The Institute of Accounting and Accounts Auditing confirmed recently the accounting standards applicable to these hybrid instruments. 4 In particular, when it is not possible to carry out a reliable cash flow estimate, the accounting regulator has ruled that a profit participating loan must be assessed in accordance with the methods applicable to participation accounts (cuentas en participación). This would imply valuing the loan at cost, increased or decreased by the profit or loss which falls to be attributed to the contracting party who is not carrying on the relevant business. And this may be very well the case in respect of profit participating loans where interest is entirely contingent upon the generation of profits by the borrower, or when interest is calculated according to the borrower s business. In the author s experience, although the general principle is that the renegotiation of loans must follow the abovementioned substitution of the instrument with profit or loss impact (and the subsequent tax impact), when the renegotiation is effected by conversion of the normal loan into a profit participating loan, one should be able to argue that because profit participating loans have their own valuation rules, if it is not possible to carry out a reliable calculation of expected cash flows, the substitution of loans cannot take place thereby avoiding profit or loss recognition and ultimately the tax impact. 1. Approved by Royal Decree 1514/2007 of 16 November. 2. Official Bulletin 79 of the Spanish Institute of Accounting and Accounts Auditing (Boletín Oficial del Instituto de Contabilidad y Auditoría de Cuentas, BOICAC), Rulings 4 and 5; and Bulletin 80, Ruling 5. Binding rulings issued by the Directorate of Taxes (Dirección General de Tributos), V (16 July 2009) and V (22 February 2011). 3. Profit participating loans, as regulated by Art. 20 of Royal Decree-Law 7/1996 (Art. 20 of Royal Decree-Law 7/96), must include a variable interest (which may or may not include an element of fixed interest), which falls to be determined by reference to the results of the borrowing entity and subordination to general creditors. In addition, profit participating loans may be the subject of early repayment only if such repayment is compensated for by a corresponding increase in shareholders equity. 4. Official Bulletin 79 of the Spanish Institute of Accounting and Accounts Auditing, Ruling 6; Bulletin 78, Ruling DERIVATIVES & FINANCIAL INSTRUMENTS SEPTEMBER/OCTOBER 2011 IBFD

3 Spanish Tax Issues in Debt Restructurings: The Tax Treatment of Cancellation of Debt 4.3. Debt waiver or debt-for-equity exchange after an acquisition of debt at discount This is the point where the criteria established by the Spanish accounting and tax authorities have given rise to controversy, creating a number of difficulties in the implementation of many of the debt restructurings in Spain. The Institute of Accounting and Accounts Auditing in Ruling 5 of Bulletin 79 has proposed a technical solution to a situation where the cancellation of the debt, either through a debt waiver or through a debt-for-equity exchange, takes place after an acquisition of the debt at discount by the shareholder of the borrower. The standards applicable to waivers are included in Valuation Rule 18 of Spanish GAAP, regarding donations and other transactions for no consideration. This rule provides different standards for transactions carried out between a company and its shareholders and transactions between a company and other unrelated parties Debt waiver between unrelated parties Where a third-party lender agrees to waive a loan for no consideration, the consequence would be a cancellation of the liability with corresponding profit recognition. Such profit would be fully taxable in the financial year of the cancellation. Valuation Rule 18 provides that the donation would be valued at the fair value of the amount transferred by the lender (in the case of monetary donations) or the fair value of the asset received (in the case of non-monetary or in-kind donations). The author believes that in this particular context where the donation is the waiver of a liability, the amount of the donation would be the outstanding amount of the liability, which will amount to the amortized cost of the loan according to the above-mentioned Valuation Rule Debt waiver between a company and its shareholders On the other hand, where the lender is a shareholder or the owner of the borrower, Valuation Rule 18 provides that the donation may not be recognized as profit, but is to be recognized directly in net assets, following the same valuation principles that apply to donations from unrelated parties. The debt waiver agreed by a shareholder which originally granted the debt or which acquired the debt from a third party, would not be recognized as a profit but as direct contribution to net assets. The tax authorities and the accounting regulator have expressed two particular points of interpretation: If the donation (the debt waiver) is made by a shareholder in a proportion different to its participation in equity (e.g. not all shareholders make a proportionate donation), only the proportionate donation will be recognized directly in net assets; the excess will be recognized as a (taxable) profit. This proposition seems to be aimed at granting the treatment of contributions to net assets not to all contributions made by shareholders, but only to contributions made under such conditions, i.e. in proportion to its participation in the capital of the company. If there is a discrepancy between the valuation of the loan by the borrower and lender, in particular if the loan has been acquired at discount, the waiver will be recognized directly in net assets only in the amount of the purchase price paid by the shareholder; the excess over the carrying value of the liability will be recognized as a gain in profit or loss. The interpretation assumes that there are two separate items that need to be reflected separately: the donation, which would amount to the fair value of the asset from the perspective of the lender; and the excess upon cancellation of the liability from the perspective of the borrower. The Institute of Accounting and Accounts Auditing bases this interpretation on a principle of equivalence of the transactions for both parties. Specifically, the accounting regulator indicates, in its Ruling 5 of Bulletin 79, that the borrower must recognize a contribution to net assets only in the amount that the loan would be worth for the lender, i.e. the purchase price of the loan. The valuation of the donation, also from the perspective of the borrower, seems to be also limited to the purchase price of the loan. In the author s opinion, this interpretation is not strictly accurate, based on the following reasons: From the perspective of the borrower, the liability that is cancelled is still valued at that time following the Spanish accounting standards for liabilities. The waiver, from the perspective of the borrower, implies the cancellation of the obligation to pay the principal amount together with the other cash flows as provided under the loan agreement. Spanish GAAP does not provide any indication that the donation (the debt waiver in this case) must be valued by the borrower taking into account the particular circumstances of the lender, including the acquisition at discount of the loan, which may have to do more with the specific circumstances of the lender and the debt markets, rather than with the solvency of the borrower. Unless the loan agreement is renegotiated, the borrower still owes the amounts reflected in the loan agreement, and the method of amortized cost remains applicable. The Rulings address only the consequences of the previous acquisition of the debt at discount, assuming that the purchase price in a private deal by a single shareholder/ lender can be deemed a fair valuation of the instrument, without taking into account further valuation aspects. There is no accounting principle under Spanish GAAP that supports a reclassification of the liability as a consequence of a reassessment of the fair value by the lender, or as a consequence of a transfer for a discounted consideration. This discount may be a consequence of the specific circumstances of one of the lenders, and cannot be deemed an automatic measure for reassessment of the liability, neither in a situation of debt waiver nor otherwise. If the lender were a third party, the debt waiver would be recognized as a profit. In a shareholder-subsidiary 271

4 Miguel Lorán situation, the consequence of the net assets accounting (as opposed to profit and loss) is based in the special situation of the shareholder. For this purpose, it is not relevant whether the fair value of the loan is different from the amortized cost of the same instrument. It is the valuation method followed by the borrower which should be relevant to value the contribution to net assets. In terms of valuation of the direct increase of net assets, the debt waiver is not a transaction with two separate components, nor would Spanish GAAP allow for such interpretation. It is a single transaction with a single accounting impact for the borrower, and therefore the borrower should cancel the liability against a direct contribution to net assets. If the shareholder-subsidiary situation arises as a consequence of the acquisition of the shares by a thirdparty lender that had acquired the debt at discount previously, the subsequent debt waiver would not necessarily reflect accurately a fair value of the loan, as the shareholder-subsidiary situation would not have been taken into account at the time of the acquisition of the loan. The interpretation proposed by the accounting and tax authorities seems to be aimed at a specific situation where the shareholder acquires debt at discount. A specific situation with a very specific tax objective seems to be driving the accounting treatment of a much broader context of situations. The tax implications of the principles set out in the Rulings would be to report taxable income in the amount of the difference between the amortized cost of the liability and the purchase price paid by the shareholder and lender, which would be subject to corporate income tax at the relevant tax rate. Needless to say, in a distressed debt context the potential need to finance a cash payment of taxes can be a major obstacle to the restructuring. No deferral of taxation or preferential tax treatment for this cancellation of debt income is anticipated, as is the case in other European jurisdictions. As indicated above, in the author s opinion, the amount of the donation, and therefore the amount of the increase in net assets, should be the amount of the liability that is cancelled. Any interpretation restricting the amount of the donation to the purchase price, with profit recognition for the excess, would lack support in the applicable Spanish accounting standards and would only be justified as an artificial accounting mechanism to give rise to taxable income Debt waiver in the context of a tax consolidated group The tax ruling issued in summarizes the accounting interpretation described above, to confirm again that the difference between the valuation of the liability and the purchase price of the loan will be subject to corporate income tax. It also sets out the tax treatment of the same transaction when it takes place within a tax consolidated group. When analysing whether the fact that borrower and lender are members of the same tax group would allow eliminating the above-mentioned taxation, the tax authorities propose another interpretation of the tax law which, in the author s opinion, is not strictly accurate. The tax authorities refer to the regulations on the drafting and filing of consolidated accounts. 6 According to those regulations, when a liability of a company within the group is acquired by another company within the group, the consolidated accounts would reflect, as profit or loss, the difference between the purchase price and the accounting value of the liability. This profit or loss recognition in the consolidated accounts would imply, according to the tax authorities, that such profit or loss would have been realized against third parties and therefore should not be eliminated in a subsequent debt waiver. This reasoning, in the author s opinion, does not follow strictly from the corporate income tax legislation or the legal provisions for the filing of consolidated accounts. Tax consolidation and the filing of consolidated accounts operate at different levels, in the case of tax consolidation by aggregation of individual taxable income, and at the consolidated accounts level by combination of financial statements. The supporting evidence of this argument is that the discount in the acquisition of the loan from a third party would be recorded as a profit in the consolidated accounts, and this would happen regardless of any subsequent waiver or capitalization. It would be merely a rule for the preparation of the consolidated accounts. The profit that would arise in the subsequent waiver would be from a transaction between a company and its shareholder, and the triggering event of that profit would be the debt waiver (and not the acquisition at discount). As a transaction between two companies within a group, it should be eliminated because there is no exception for this particular case in the tax regulations Debt-for-equity exchanges In the rulings both in 2009 and 2011, the Spanish tax authorities follow, in connection with conversion of debt into equity through a share capital increase, the same reasoning explained above in connection with debt waivers, i.e. the borrower reflects a taxable profit in the amount of the difference between the purchase price and the accounting value of the liability. In this case, the proposed interpretation requires some additional technical analysis, due to the particular characteristics of the share capital increase, where the borrower might increase capital in the amount of the carrying amount of the liability, with direct substitution of the liability by the relevant capital or reserves. The proposed interpretation is based in the assumption that the shares issued by the borrower in exchange for the 5. V (22 February 2011). 6. Royal Decree 1159/2010 of 17 September on the drafting of consolidated accounts. 272 DERIVATIVES & FINANCIAL INSTRUMENTS SEPTEMBER/OCTOBER 2011 IBFD

5 Spanish Tax Issues in Debt Restructurings: The Tax Treatment of Cancellation of Debt liability are worth the purchase price paid for the loan. The difference between the carrying value of the liability and the purchase price must be reflected as a profit, and subject to tax. If, as will normally be the case, the borrower increases the equity, capital and reserves, in the same carrying value of the liability, it will be necessary to make an additional entry reducing the amount of the new reserves with a corresponding profit, in the above-mentioned amount of the difference between the purchase price and the carrying value of the liability. This solution is not strictly accurate. The same reasons explained above in connection with debt waivers are valid here, supplemented by the following specific reasons: From a corporate law perspective, a share capital increase by means of a set-off of receivables is specifically regulated. In this scenario, the borrower would increase capital, with or without additional reserves, typically in the amount of the carrying value of the liability that is set off, regardless of the valuation allocated by one, some or all of the lenders subscribing for capital in the transaction. From the perspective of the borrower, the amortized cost of the liability would reflect the valuation to be converted into equity in that transaction, with no adjustment required in the corporate, accounting or tax provisions. The IFRS Board has issued guidelines regarding debtfor-equity exchanges (IFRIC 19, Extinguishing Financial Liabilities with Equity Instruments). Although these guidelines are not applicable to situations where the lender is a shareholder of the borrower, as in the case under analysis, the guidelines refer to the valuation methods for the debt upon conversion into an equity instrument. In particular, the guidelines contemplate the situation where it is not possible to assess the fair value of the equity instrument issued in exchange for the liability (which might be the case if the equity instrument is not publicly traded), and the method proposed is the fair value of the liability cancelled. Again, this would open the possibility for cancellation of the liability with no gain, allocating to net assets all the carrying value of the liability Recharacterization remarks The tax authorities included a relevant remark in Ruling V of 16 July The fact that the assignment of the debt at discount to a new holding structure and the acquisition of the shares by the lenders take place almost simultaneously as part of a single transaction or debt restructuring, can be seen as an indication that the transaction is in fact a cancellation of debt negotiated with third-party lenders. If this is the case, the tax authorities take the position that the tax treatment would not be the treatment for cancellation of debt with shareholders, but the tax treatment of cancellations of debt with third parties, giving rise to recognition of a taxable gain in profit or loss. This is particularly important in the context of the debt restructurings under analysis because most of the steps leading to the acquisition of control by the lenders, and the renegotiation and cancellation of debt, are agreed and documented in restructuring framework agreements where all the transactions are contemplated as a single restructuring process. It will be essential in those cases to analyse further the risk of the cancellation of debt being treated in full as a taxable gain Alternatives Until further clarification is achieved, there seems to be an area of controversy where the Spanish accounting and tax authorities are taking an aggressive position against debt restructurings, assessing a cancellation of debt gain equal to the difference between the discounted purchase price of loans and the carrying value of the liability. Although the author disagrees with this approach, as explained in this article, some protections may be worth exploring. The cancellation of debt normally aims at reducing the interest burden and improving the debt ratio. A similar result can be achieved if the debt to be cancelled is renegotiated as a subordinated debt instrument in the form of a profit participating loan, where interest is linked mainly to certain performance ratios. If the instrument is properly structured, it would retain the characterization of a debt instrument for Spanish tax purposes, even if no actual interest is accrued, as expressly provided under corporate income tax legislation, and at the same time would allow the prevention of a technical discussion about debtfor-equity accounting standards. The fact that profit participating loans, as indicated in 4.2., have their own special valuation rules when the interest is linked to a variable performance element, also makes it possible to avoid substitution of the old liability for the profit participating loan, or at least to prevent a significant difference in valuation that would result in debt-for-debt profit recognition. 273

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