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M&A Matters - Normal commercial loans: some pitfalls to avoid

M&A Matters - Normal commercial loans: pitfalls

Robert Norris, Director at KPMG in the UK, and Mark Eaton, Director at KPMG in the UK, outline examples of instances where a non-commercial loan may be inadvertently established.


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When is a loan not a normal commercial loan?

Various conditions apply as to whether or not a debt is seen as a normal commercial loan.  It would not be termed a normal commercial loan, for example, if it entitles the lender to any amount of interest which exceeds a reasonable commercial return on the new consideration lent. 

If, say, a company issues a loan note with a face value of £100 and receives £100 cash from the lender, the new consideration received is the £100 of cash: the interest can then be tested to see if it represents a reasonable commercial return to the lender on this amount.  In practice, however, the position may be less straightforward - as we explain later in this article.

What are the implications if a loan is not a normal commercial loan?

Where a debt is not a normal commercial loan, there may be implications concerning tax groupings, the substantial shareholding exemption, and the new corporate interest restriction regime.

These parts of the tax code provide for favourable treatment where there is a certain level of ownership.  In order to prevent these rules from being manipulated, the required level of ownership takes into account the entitlement to profits and assets available for distribution on a notional winding-up, consistent with real economic ownership. 

The entitlement to profits and assets is tested by reference to the rights of “equity holders” which, in addition to the holder of ordinary shares, can include a loan creditor in respect of a loan which is not a normal commercial loan.  The related party treatment within the corporate interest restriction regime also takes account of rights inferred from a non-normal commercial loan.

First of all, we will look at the relevance of a debt not being a normal commercial loan.

  • If the funds raised by a group company are not in the form of a normal commercial loan, the effect will be to reduce the share of profits and assets to which the company’s parent is entitled. This may result in the company and its subsidiaries being excluded from the group.  For example, if a subsidiary borrows in a form other than a normal commercial loan and, because debt ranks ahead of equity, the lender is entitled to more than 50% of the assets on a winding up, this could break the capital gains group.  Similar rules apply, for group relief and stamp taxes (though with a 75% threshold). 
  • A related issue can arise with intra-group debt if an assessment is being made as to whether a vendor company can apply the substantial shareholding exemption to the gain arising on the sale of a subsidiary.  One of the conditions for the exemption to apply is that the vendor company has a substantial shareholding in the company being sold.  This requires that the vendor company holds shares in the target company which entitle it to not less than 10% of the ordinary share capital, profits available for distribution to equity holders, and assets on a winding up available to equity holders.  To give a simplified example, suppose the parent owns 100% of the share capital of its subsidiary and has previously made a loan of £95 to the subsidiary which is not a normal commercial loan.  If the assets of the subsidiary are, say, £100, the parent could be entitled to all of the assets available for distribution but only 5% would arise by virtue of its holding of shares in the subsidiary.  As a result, the 10% requirement is not satisfied and the substantial shareholding exemption would not apply.
  • When applying the corporate interest restriction, a group may elect to calculate the amount of the interest disallowance using the ‘group ratio method’.  This is based on a measure of net interest payable and economically similar expenses taken from the consolidated financial statements, where amounts owed to a related party are excluded.  The rules to identify related parties are complicated.  For example, persons will be regarded related parties if a 25% investment condition is met. This is tested by reference to holdings of “equity” which includes non-normal commercial loans.

This illustrates the importance of understanding whether or not a debt is a normal commercial loan. 

Examples of instances where a non-commercial loan may be inadvertently established

Exchange of loan notes on a refinancing

Let us suppose a company has previously borrowed from third parties on fixed interest terms.  Prior to maturity, the borrowing is exchanged for new third party fixed interest borrowing at a lower, current market rate.  The lenders are entitled to compensation because the interest rate on the existing debt is higher than current market rates.  The implications for the new borrowing may depend on whether the compensation is settled in cash or in additional loan notes.

Suppose that a lender currently holds £100 of loan notes for which £100 was paid on issue.  The market value of the existing loan notes is now £110. The extent to which the £10 additional payment is cash settled will depend, in part, on choices to be made by the lenders.  The £100 of existing loan notes could be exchanged for £110 of new loan notes with no cash payment or, say, £104 of new loan notes and £6 of cash.

It may be assumed that the interest rate on the new loan notes is a market rate. This could still, however, be treated as a more than a reasonable commercial return. For example, if £100 of existing loan notes are exchanged for £110 of new loan notes, the new consideration received for the £110 of new loan notes might be restricted to the £100 of cash received for the existing loan notes.  A market rate payable on £110 may exceed a reasonable commercial return on the original loan notes of £100.  

While “in the round” the refinancing may be considered to be at arm’s length (i.e. agreed on terms consistent with a third party arrangement), careful consideration needs to be given to the reasonable commercial return requirement.  You could say that interest payable on the new loan notes is more than a reasonable commercial return to the lender on the new consideration provided, because the new consideration received (possibly restricted to £100) for those loan notes is less than their face value (£110).  

In practice, it may be possible to structure the arrangements to avoid such issues and, if an uncertainty is material, HMRC can be approached for clearance. 

Novation of loan notes – guarantee call

When a group that is in financial difficulty undertakes a refinancing, a company may take on additional debt.

This could be the case if a guarantee is called and the lender agrees that the amount due from the guarantor company will be left outstanding as an interest bearing debt. While the guarantor may have the right to recover the amount from the original borrower, that right may have little value. Alternatively, if there is a consensual arrangement, part of the debt may be released with the “right sized” debt then being transferred to a company within a sub-group. New consideration does not have to be provided in the form of cash and it may be possible to structure the arrangements so that assets, representing sufficient new consideration, are transferred to the new borrower. 

In either case, it will be necessary to assess whether sufficient new consideration is received by the company for taking on the debt obligations. Otherwise, the liability may not be a normal commercial loan. A key point here is that the new consideration received by the original borrower does not carry over to the new “borrower”.

Novation of loan note – intra-group

We sometimes see situations where a loan relationship liability is transferred between two UK subsidiaries within a group.  The intra-group rule for transfers of a loan relationship might apply to determine the consideration paid and received for the transfer, so there is neither a gain nor a loss for loan relationship purposes. But this deemed consideration does not carry over to the normal commercial loan provisions.  It is vital to check that the new “borrower” has received new consideration equal to the amount borrowed.  Otherwise, this could lead to the new “borrower” and its subsidiaries being degrouped and losing the ability to surrender losses as group relief.

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