Tax: Forgiveness of distressed debt in Europe

31 March 2009

International Tax Group

In light of the recent economic events that literally shook the foundations of our global economic system, the corporate world is, more than ever, seeking ways to cut costs and avoid insolvency.

In order to anticipate the drop in consumption and lack of available cash/credit that has already hit the economy, many corporations are looking to restructure. Inevitably, that lack of cash-flow and credit will affect every level of a corporate group: from operational companies to ultimate holding companies, they may all need to take necessary measures to ascertain the damage caused by the credit crunch and enhance both the group’s and relevant subsidiaries’ viability during the recession. 

Within a group of companies, taxpayers can resort to forgiveness/waiver of intra-group debt in order to maintain the viability of their affiliated companies. This inevitably has direct tax consequences. 

The general consequences in most countries are:

  • that the debtor company realises an exceptional profit, which generally may not lead to effective taxation because of the offsetting of tax losses carried forward, and
  • that the creditor company realises an exceptional loss, which is often tax deductible.

However, many different provisions exist in each jurisdiction which may impact the taxation or deductibility treatment respectively.

Below is a more detailed overview of how debt forgiveness or debts waivers are treated for tax purposes in various European countries, specifically in the context of a debtor which is or threatens to be become insolvent. Please note that this article only reflects general principles and only with respect to entities that are subject to their respective corporate income tax regime.

Belgium

Brent Springael

Tax treatment in the hands of the creditor

The waiver of debt results in the accounting ‘loss’ of a receivable. Such loss, however, is not automatically tax deductible in the hands of the creditor.

The deductibility of such loss may be prohibited, either because it is deemed not to be incurred to retain or increase taxable income (‘general deduction criterion’), or because it is deemed to be an ‘abnormal or benevolent advantage’ granted to the debtor (‘anti-abuse rule’).

The anti-abuse rule provides that such advantages are added to the creditor’s taxable basis and thus ‘offsets’ the accounting loss. Generally, this anti-abuse rule does not apply to debts between Belgian companies. It should therefore only be invoked by the tax authorities where a waiver is in favour of a foreign debtor.

Generally, case law provides that the anti-abuse rule should not apply where the creditor waives its receivable from an affiliated company in financial distress, specifically if such distress could impact on the creditor’s commercial or financial image. However, it may still apply if the financial distress is of such a nature that a waiver of the receivable will clearly not enable the company to cure its solvency. In other words, if the debtor has crossed the line of no return to better fortune, the tax deduction by the creditor may still be countered by the anti-abuse rule.

With respect to the general deductibility criterion, the Belgian Ruling Commission generally links the tax deductibility to the condition that the waiver provides for the reviving of the receivable once the debtor returns to better fortune. There have been rulings, however, where this condition was not required (for instance in case of voluntary liquidation of the debtor where the forgiveness was justified by the fact that a bankruptcy of the company in liquidation could be avoided).

Finally, to the extent that no debt is forgiven, but simply the payment thereof temporarily waived, such waiver results in an accounting ‘reduction in value’ or ‘provision for risks and expenses’, which is generally not tax deductible unless specific conditions are met. If such waiver is obtained pursuant to a composition with creditors approved by a court, such reduction in value will be deductible.  This follows from a new law which should enter into force shortly (and no later than 9 August 2009).

Tax treatment in the hands of the debtor

The waiver of debt normally results in an accounting ‘gain’. Such gain constitutes a taxable profit subject to corporate income tax at a rate of  33.99%. However, since the debt is generally forgiven for a company in financial distress, tax losses carried forward may be available to offset such ‘gain’.

There is, however, a similar anti-abuse provision to that set out above which provides that no losses carried-forward may be offset against profits (including any debt forgiveness gain) to the extent that ‘abnormal or benevolent advantages’ have been received from directly or indirectly affiliated companies (resident or non-resident). The case law and Ruling Commission’s view as set out above will apply to whether or not an abnormal or benevolent advantage is present.

Finally, where debt is forgiven within the context of a composition with creditors approved by a court, the ‘gain’ resulting from such forgiveness will be exempt. This is a new measure that was introduced on 31 January 2009. Although it is probably not the intention of the legislature, the new law still allows for the deductibility of the debt in the hands of the debtor if such debt would ‘revive’ pursuant to a recapture clause in the debt waiver agreement because such 'revival' is accounted for as an exceptional cost. The new measure is yet to enter into force by royal decree (but should do so no later than 9 August 2009).

France

Anne Quenedey and Etienne Guillou

Tax treatment in the hands of the creditor

The tax treatment of the forgiveness of debt within a group of companies depends on whether or not such forgiveness is of a “normal nature”. In order to be considered as being of a normal nature, the ‘advantage’ granted by a parent/creditor to its subsidiary/debtor must involve valid business reasons.

If the debt waiver is considered abnormal, the creditor may not deduct the amount of the debt waiver. However, it is generally not considered abnormal where a creditor waives its receivable from an affiliated company in financial distress, specifically if there is a risk that recovering the debt could result in the insolvency or bankruptcy of the affiliated company and thus have an impact on the creditor’s commercial or financial image.

If the debt waiver is considered ‘normal’, the tax treatment will further depend on whether the debt waiver was of a financial or commercial nature.

The debt waiver is of a financial nature when (i) the creditor has a direct or indirect stake in the debtor, and (ii) the nature of the debt, the link between the companies and the reasons of the debt waiver are of a financial nature.

The debt waiver is of a commercial nature if it has been granted in order to maintain a business relationship between the debtor and the creditor i.e. for the creditor to maintain its customer base or to preserve its source of supply.

A debt waiver of a financial nature is deductible only up to a certain amount. As waiving a debt owed to a parent company increases the net asset value of the subsidiary, the deduction of the debt waived is only permissible up to the amount of the negative net asset value of the subsidiary, if any, and the positive net asset value after debt waiver allocable to the other shareholders. In other words, the debt waiver is not deductible in proportion to the creditor/shareholder’s stake in the positive net asset value increase.

When the debt waiver is of a commercial nature, the loss is fully deductible in the hands of the creditor. This charge has to be deducted from the result of the financial year during which it takes place.

In tax consolidated groups, debt waivers can not be taken into account in computating the group’s global results. As a consequence, they have to be neutralised by applying certain adjustments. If the debtor subsequently exits the tax consolidated group, a recapture may be applied to the global result if and to the extent a debt waiver was granted during the past five years.

If the debt waiver contains a recapture clause on return to better fortune, the eventual reimbursement of the reinstated debt leads to taxation in the hands of the creditor but only for any sums which were initially deducted for tax purposes.

Tax treatment in the hands of the debtor

If the debt waiver is considered to be ‘abnormal’, the debtor is taxable on the amount of the debt waiver. If the debt waiver is considered ‘normal’, the tax treatment will again further depend on whether the debt waiver is of a financial or commercial nature.

If a debt waiver is of a financial nature, the part which is deductible for the creditor / shareholder constitutes a taxable profit in the hands of the debtor subject to corporate income tax at a maximum rate of 33.1/3%. The part that is not deductible for the creditor is not taxable in the hands of the debtor provided that (i) the creditor is the parent company of the debtor for tax purposes, and (ii) the debtor undertakes to increase its capital by an amount equal to the debt waiver within the following two years. If these conditions are not fulfilled, the whole debt waived is taxable in the hands of the debtor.

If a debt waiver is of a commercial nature, the forgiven debt is taxable in the hands of the debtor.

Germany

Patrick Sinewe and David Witzel

Tax treatment in the hands of the creditor

If a creditor waives an intra-group receivable, this leads to an accounting loss in the amount of the receivable. Such loss, however, is not automatically tax-deductible in the hands of the creditor.

If the creditor is a shareholder of the debtor (there is no threshold requirement, i.e. even a 1% participation is sufficient) the waiver is deemed to be a capital contribution into the debtor and will, in principle, not be tax deductible for the creditor but will not affect his tax base either. The book value of the debtor’s shares will increase with the nominal amount of the receivable. Correspondingly, the write-down of the receivable is equalised by the increase in book value of the participation in the debtor. However, to the extent that the fair market value of the waived receivable is less than its nominal value (for instance, because the likelihood of reimbursement is low due to the debtor’s financial situation), the shareholder generally realises a loss in the amount of the difference between the nominal value (by which the participation value has been increased) and the fair market value.

If a corporation waives a receivable against another affiliated company, for instance a sister company, such a waiver constitutes a hidden profit distribution up the corporate chain to the common parent company and a contribution down the corporate chain into the sister company. The value of the hidden profit distribution and the hidden contribution is the fair market value of the receivable at the time of the waiver.

However, the German Corporate Income Tax Act includes a provision according to which a reduction in profit resulting from ‘losses’ on shareholder loans (e.g. write downs to going concern value, forgiveness of the unrecoverable portion of a debt claim), economically equivalent instruments, or securities and guarantees in relation to such loans or instruments, may be disregarded. This will be the case if the loan, instrument or security is granted by a substantial shareholder (i.e. a shareholder holding 25% of share capital either directly or indirectly), persons related to substantial shareholders, and third parties with a right of recourse against the aforementioned persons. The statute will apply even if the shareholder is no longer a substantial shareholder at the time of the reduction in profits, but previously held such status.

Tax treatment in the hands of the debtor

A waiver of the liability or loan gives rise to income for German GAAP and tax purposes.

However, if the waiving party is a shareholder, the waiver qualifies as a capital contribution for tax purposes. Such a contribution will reduce the taxable income accordingly. The value of the contribution is the fair market value of the loan or other liability. If a third party purchaser of receivables would pay less than their nominal value, then the equity of the corporation can be increased by a waiver only by the amount of this lower fair market value.

In consequence, a corporation which is in a solid financial situation will not realise any additional taxable income if a shareholder waives a loan or other receivables. However, in most cases, shareholder loans are waived because the corporation is in financial difficulties. In that case, the value of the waived liability is usually significantly lower than their nominal value and the corporation will realise extraordinary income in the amount of the difference between the nominal value and the fair market value. However, in these cases this income normally does not lead to an immediate tax liability but may be offset against current operating losses or tax losses carried forward in prior years.

The Netherlands

Pieter Camps and Arnoud Knijnenburg

Tax treatment in the hands of the creditor

A waiver of intra-group receivables creates a loss accounting-wise and may be tax deductible for the creditor. However, this may not be the case if shareholder motives are the predominant reason for the waiver. Instead, the waiver could be deemed to be a capital contribution into the debtor and will, in principle, not affect the taxable position of the creditor. The forgiveness of debt in favour of a subsidiary that would otherwise be threatened by insolvency or bankruptcy, and thus have a negative impact commercially or financially on the shareholder creditor, should generally not be considered as a ‘shareholder motive’.

In certain circumstances a waiver of intra-group debt that has been written down in a previous tax year by the creditor holding a substantial shareholding in the debtor, may result in taxable income for the creditor. A shareholding is substantial if the creditor has a participation of at least 5% in the debtor for which the participation exemption (for dividends and capital gains) applies. 

This income may be deferred by establishing a so-called ‘revaluation reserve’. This reserve should be gradually added to the profit of the creditor, thus becoming subject to corporate income tax at a maximum rate of 25.5%, following an increase of the value of the shareholding in the former debtor. Under certain circumstances the reserve will be immediately taxable, e.g. upon disposition of the shareholding.

If the waiver results in Dutch taxable income for the debtor (see below), the above rules (i.e. regarding shareholder motives and the substantial shareholder rule) may not apply. However, if the waiver results in an exempt profit for the debtor, the creditor must recognise a profit (to the extent of such exempt profit in the hands of the debtor) and may form a ‘revaluation reserve’ to defer taxation. Special provisions apply for intra-group loans to foreign affiliates.

Tax treatment in the hands of the debtor

If a creditor waives an intra-group debt and relinquishes its rights for whatever reasons, the waiver will generally constitute a taxable profit for the debtor subject to corporate income tax at a maximum rate of 25.5%.

There are, however, two main exceptions, in these circumstances.

Firstly, the forgiveness of non-recoverable intra-group debt (which includes recoverable debt, the recovery of which would trigger the insolvency or bankruptcy of the debtor) creates an initially taxable profit that may be offset by available tax losses of the debtor. In certain circumstances, the excess profit not offset by previous tax losses may be exempt. The conditions for this include that the creditor must clearly waive the debt and conclude that given the circumstances any effort to exercise its rights towards debtor would be fruitless.

Secondly, if shareholder motives are the predominant reason for the waiver, such waiver may be deemed a capital contribution into the debtor and should not affect the taxable position of the debtor. 

Poland

Mariusz Domagała & Arthur Cmoch (with Grynhoff, Wozny, Malinski)

Tax treatment in the hands of the creditor

Polish tax regulations provide three major methods for obtaining a tax deduction for irrecoverable debt: waiver or forgiveness of debt, debt write-off and revaluation write-off.

Waived debt, which is only effective if the debtor agrees to it, is normally not treated as a tax deductible cost of the creditor. However, the creditor may nevertheless treat such debt forgiveness as a tax deductible cost if the debt had been previously accounted for by the creditor as income. A creditor is not allowed to deduct waived loans or waived interest on debt/loans.

If the debtor does not agree to a debt waiver (e.g. because it would result in taxable income for him – see below), the creditor may still write off (and deduct) such debt as irrecoverable. However, irrecoverable debt is deductible only if it has been previously accounted for as income and the irrecoverability of such debt has been documented with: (i) a decision of irrecoverability accepted by the creditor as representing the factual situation, issued by an competent enforcement authority; (ii) certain court decisions/orders relating to the debtor’s bankruptcy; or (iii) a report compiled by the taxpayer stating that the expected costs of the legal and enforcement process connected with a claim would be equal to or in excess of the debt amount. In addition, a forgiveness of debt is not tax deductible, if such debt is barred by the statute of limitation.

Finally, a creditor may also proceed to a revaluation write-off (i.e., reducing the net book value of the debt below its carrying value). Although a revaluation write-off is normally not tax deductible, it may nevertheless qualify as a tax deductible cost if the amount written off has been previously been accounted for as income by the creditor and the irrecoverability has been proved as probable. The latter will be the case if: (i) the debtor died; (ii) the debtor has been crossed out from the commercial register; (iii) the debtor has been put in liquidation; (iv) the debtor has been declared bankrupt involving liquidation of all assets; (v)  bankruptcy proceedings involving the possibility of entering into composition have been initiated; (vi) the debt was confirmed by a valid court decision and directed to execution proceedings; or (vii) the debt is questioned by the debtor in judicial proceedings.

Tax treatment in the hands of the debtor

The waiver of debt, inclusive of loans but not those granted by the Labour Fund, normally results in a profit for the debtor taxable at the corporate income tax rate of 19%. The taxable profit is equal to the value of the waived debt (which includes loans). However, if the waiver of debt is related to bankruptcy proceedings involving the possibility of entering into composition, the waived debt does not qualify as income in the hands of the debtor.

As neither Polish tax regulations nor the local tax offices’ interpretation are conclusive on whether or not waived interest on debt shall result in revenue for the creditor, it is recommended to contact the local tax office for their respective view.

Spain

José Maria Cusi and Alejandro Puyo

Tax treatment in the hands of the creditor

The waiver of an outstanding debt by a creditor shall be treated as an extraordinary loss for accounting purposes. As taxable income for corporate income tax purposes is calculated from the company’s accounting results assessed upon accounting regulations, such loss is normally deductible unless income tax law provides for an adjustment.

Such adjustment would occur if the forgiveness of debt would qualify as a ‘donation’ or ‘gratuity’, which generally are not tax deductible. However, according to the doctrine of the Spanish General Directorate of Taxation, a waiver of debt by the creditor is not always considered as a donation or a gratuity as this requires the subjective factor “animus donandi” (i.e. intention to give) . Therefore, if the waiver of debt by the creditor obeys to an “animus donandi” of said creditor, then the waiver is not considered a tax deductible expense. However, if the creditor has done the utmost to get paid without succeeding, proceeding in the end to waive the debt as a business decision, the referred General Directorate has stated that the amount of waived debt shall be treated as a tax deductible expense.

Additionally, it has to be pointed out that the losses derived from a cancellation of debt under the scope of an insolvency proceeding will be tax deductible provided that certain requirements are met.

Notwithstanding the above, a different rule applies in the event that the creditor participates in the capital of its debtor.  There is no stated minimum stake required in this respect, although particular rules may apply in the event that the creditor and debtor are considered related parties for Spanish tax purposes, which includes where there is a direct participation of at least 5% (non-listed companies) or 1% (listed companies). Where the creditor participates in the debtor’s capital, from an accounting perspective the waiver of debt is deemed to be a contribution in kind to the equity of the debtor and not an extraordinary loss. As a consequence, from a tax standpoint, the tax basis of the creditor’s participation in the debtor will increase with the amount of the debt so waived. The same treatment will apply in the event that both creditor and debtor form part of a tax consolidated group under the scope of the special regime in the Corporate Income Tax Law.

Tax treatment in the hands of the debtor

From an accounting standpoint, the waiver of a debt represents extraordinary income for the debtor in the amount of debt and interest cancelled.

From a tax perspective, the foregoing income recognition leads to inclusion in the tax base of the debtor, becoming subject to tax at the corporate income tax rate of 30%.

However, in the event that the creditor holds a participation in the debtor’s capital (without a minimum stake required but with the above mentioned particularities for related parties) or both entities form part of a tax group, no income recognition shall arise for the debtor and the amount of waived debt shall increase the debtor’s equity without triggering any corporate income tax burden.

Sweden

Christian Luthman and Sara Thomas

Tax treatment in the hands of the creditor

In Sweden, debt is typically waived through either judicial settlement (Sw. offentligt ackord) (which will not be discussed here) or through private settlement (Sw. underhandsackord) between creditor and debtor.

The waiver of debt results in the accounting loss of a receivable. Swedish tax law does not contain any explicit rules regarding tax deductibility for the exceptional loss, which the creditor company realises when forgiving a debt. The effective tax treatment, however, will depend on whether the debt is commercial or financial (e.g. loan receivables).

With respect to commercial debt, the creditor has a right to deduction only if the loss is to be considered as expenditure in order to acquire and retain income (‘general deduction criterion’). In this context, case law has ruled that this will generally not be the case if the debt is waived between affiliated companies, unless it was clear that the debt waiver was for commercial purposes. This would, for instance, be the case if (i) the debtor’s financial position is weak, (ii) no liquidation distribution is be expected in the event that the debtor should be put into liquidation, and (iii) the debtor’s insolvency is not due to a transfer of value to the creditor/affiliated company or in any other way related to the relationship with affiliated companies.

With respect to financial debt, the creditor generally cannot deduct the accounting loss for tax purposes. Loss on financial debt is tax deductible only if it results from a ‘divestment’ (Sw. avyttring) which is not the case if debt is waived by the mere settlement between creditor and debtor. This would be different, for instance, if the loan receivable is sold (i.e., ‘divested’) below nominal value (which may indeed be arm’s length if the debtor is insolvent), thus realising a (tax deductible) capital loss. The latter applies as a main rule, provided that (i) the buyer is an external party (i.e., non group company), (ii) the price is at arm’s length. It should be noted that some capital losses are not deductible according to special provisions.

Tax treatment in the hands of the debtor

The waiver of debt does not necessarily mean that the debtor is taxed on the amount of the waiver. Indeed, case law has stated that the profit resulting from the settlement between creditor and debtor is not subject to taxation, if the debtor is insolvent. In addition, the settlement must provide that the forgiveness of debt is irrevocable and definitive.

However, although the settlement may not result in effective taxation in the hands of the debtor, the debt actually waived will be offset against its tax losses carried forward, thus reducing those losses for the future. The waived debt will not be offset against deficit of the year in which the settlement was reached or thereafter.

UK

Mathew Oliver

The UK generally distinguishes between “loan relationship” debts (e.g. loan receivables) and other debts (e.g. trading debt in respect of outstanding consideration for the sale of goods or services).  It is possible to turn a trading debt into a loan relationship by issue of a debenture in respect of it.

Tax treatment in the hands of the creditor

With respect to loan relationships, the release of indebtedness should generally result in a tax deduction for the creditor.  However, the creditor can not claim a deduction in respect of a release where it is at any time in the accounting period of release ‘connected’ to the debtor, save in case of (a) a debt for equity swap where the debtor and creditor were not connected before the swap or (b) in certain circumstances where the debtor is insolvent (e.g. if the creditor company is in insolvent liquidation, insolvent administration or insolvent administrative receivership). Companies will be considered ‘connected’ where during an accounting period one company had control of the other or both companies were under the control of the same person.  A company shall be taken to have control of another company if it exercises, or is able to exercise or is entitled to acquire, direct or indirect control over the company’s affairs.

To the extent that a loan relationship is not waived, a creditor may still accrue a loss in its accounts where the value of the loan receivable is impaired. A corresponding deduction will generally be allowed for tax purposes. However, again, if the creditor and debtor are connected, deduction will only be allowed in the two abovementioned situations.

There are restrictions on deducting losses on debts where the debtor has surrendered losses by way of consortium relief.  This anti avoidance rule was introduced to prevent the same economic loss being effectively used twice.

With respect to trading debts, HMRC consider that the release or impairment of indebtedness should entitle the creditor to tax relief, unless the debtor and creditor are ‘connected’ in the same way as relief for loan relationships is provided. Changes to be introduced for accounting periods beginning on or after 1 April 2009 will clarify this.

UK regulations do not provide for an automatic informal capitalisation rule in case of forgiveness of debt. However, they allow a voluntary capitalisation whereby debt is swapped for equity. Where the creditor and debtor are not ‘connected’, the creditor will generally be allowed a deduction equal to the difference between the carrying value of the loan receivable and the market value on the date of the swap.  If the creditor and debtor are connected before the acquisition of the shares the relief is not allowed.  If a connection arises because of the debt for equity swap then relief should again generally still be available for the creditor.  Relief in this respect is the subject to the same restrictions as above (e.g. where consortium relief has been claimed).

Tax treatment in the hands of the debtor

With respect to loan relationships, the release of indebtedness results in a credit for the debtor company and, hence, a taxable profit. However this rule is subject to exceptions and accordingly the debtor is not taxed on the release where (a) the release is part of a statutory insolvency arrangement; (b) the debtor and creditor are connected in the relevant accounting period; (c) the creditor is the subject of certain insolvency procedures; or (d) the release is in consideration of, or of any entitlement to, an issue of ordinary share capital of the debtor company.

To the extent that a loan relationship is not waived, but remains outstanding, there should be no corresponding credit by the debtor and there is no taxable profit in the debtor’s accounts.

With respect to trading debt for which a tax deduction has previously been obtained, the release of indebtedness results in a credit for the debtor company and, hence, a taxable profit (unless the release is part of a statutory insolvency arrangement).  However, for accounting periods beginning on or after 1 April 2009 new rules have been introduced to treat such releases in the same way as for loan relationships.

There is no tax charge where a release of a loan relationship and, for accounting periods beginning on or after 1 April 2009, a trading debt is in consideration of, or entitlement to, shares forming part of the ordinary share capital of the debtor company. 

Under current legislation, a borrower is entitled to a corporation tax deduction for loan interest payable in an accounting period, and the creditor is taxed on the same amount.  However, in certain circumstances interest not paid within 12 months of the end of the accounting period in which it accrues, is not tax deductible until the interest is actually paid. 

Where interest is waived, in circumstances where a loan waiver would be taxable but the late paid interest rules apply, it is possible that the company could be taxed on the interest waiver with no corresponding deduction for the interest accrual.  In such circumstances, it should be considered whether to capitalise the interest or “pay” it with funding bonds which are subsequently waived.  Such planning would need to consider the withholding tax implications.