News & Analysis

UK tightens COD loophole

A buyer of company debt will have to prove that they are undertaking a 'genuine company rescue' in order to avoid paying taxes on cancellation of indebtedness income.

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The UK's Financial Services Secretary to the Treasury, Lord Myners, on Thursday announced that the government intends to propose a bill to change the tax treatment of debt buybacks.

Currently, when a company buys its own debt it is taxed on the discount profit from the transaction. The same rule applies when a related party, such as a private equity firm, buys the debt.

Until now, there has been an exception for “genuine company rescues”: where the creditor company is arm's length to the purchaser, and where the purchasing company was not connected to the debtor any time during the three-year period ending 12 months before the purchase.

The Treasury intends to narrow that exception, in response to perceived abuses of it, Myners said in a ministerial statement.

“In the present financial conditions, many banks and other businesses have issued debt that is trading at a discount to the amount borrowed. Many, for good commercial reasons, are seeking to buy their debt back from the market,” he said. “However, some are taking advantage of the rules set up to help company rescues in order to avoid being taxed on the profit they make when their debt is cancelled for less than the amount they borrowed. They do this by setting up a new company to buy the debt.”

In order to ensure that only genuine rescues are permitted to avoid taxation of cancellation-of-indebtedness income, the Treasury will require that there must have been a change in ownership of the debtor in the period of 12 months before the debt purchase; the debt purchase must have been intrinsic to the change of ownership; and before the change of ownership, the debtor must have been suffering “severe financial problems”.

Even if these conditions are met such that the debtor is not taxed on the discount at the time of the debt buyback, any future cancellation of the debt by the new creditor will result in the debtor being taxed on the previously untaxed discount, Myners said.

According to law firm Lovells, the changes will be retrospective and will take effect from 14 October.