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How are qualifying and non-qualifying corporate bonds distinguished for non-corporation tax purposes? DAVID HUGHES BBS (TCD), ACA, AITI, FTII has the solution.
How are qualifying and non-qualifying corporate bonds distinguished for non-corporation tax purposes? DAVID HUGHES BBS (TCD), ACA, AITI, FTII has the solution.
THIS ARTICLE EXAMINES the key characteristics that delineate whether a loan note is a qualifying corporate bond or non qualifying corporate bond for purposes other than those of corporation tax. This distinction has always been crucial as the tax status of loan notes determines whether gains on the loan notes are non chargeable by virtue of section 115, Taxation of Chargeable Gains Act 1992. The advent of taper relief has reinforced the importance of this distinction by creating the potential where shares are exchanged for loan notes, to extend the relevant period of ownership for taper relief purposes.
It is important to realise that it is not always beneficial to secure non-qualifying corporate bond status. For instance where the maximum rate of business taper has been obtained, it may be prudent to close the relevant period of ownership.
Definition of qualifying corporate bond
Section 117(1) sets out the meaning of corporate bond as:
'… a security, as defined in section 132(3)(b) -
'(a) the debt on which represents and has at all times represented a normal commercial loan; and
'(b) which is expressed in sterling and in respect of which no provision is made for conversion into, or redemption in, a currency other than sterling.'
Section 132(3)(b) provides that 'security includes any loan stock or similar security whether of the Government of the United Kingdom or of any other government, or of any public or local authority in the United Kingdom or elsewhere, or of any company, and whether secured or unsecured'.
Section 117(6A) extends the definition of corporate bond to any debenture issued on or after 16 March 1993 which is not a security (as defined in section 132), but is issued in circumstances such that it would fall by virtue of section 251(6) to be treated for the purposes of section 251 as such a security, and would be a corporate bond if it were a security as so defined.
Section 251(6) deems a debenture issued by any company on or after 16 March 1993 to be a security (as defined in section 132) in various circumstances, including fact patterns where the debenture is issued on a reorganisation as defined in section 126(1) or is issued in exchange for shares in or debentures of another company in a case unaffected by section 137 where one or more of the conditions mentioned in paragraphs (a) to (c) of section 135(1) is satisfied in relation to the exchange.
Readers will no doubt be aware of the controversy surrounding the Revenue suggestion that in order to qualify for taper relief a security must fall within the expression 'debt on a security' (see Inland Revenue Tax Bulletin June 2001). Consideration of this issue is, however, outside the scope of this article.
For the above purposes 'normal commercial loan' has the meaning set out in paragraph 1(5) of Schedule 18 to the Taxes Act as read with section 117(1), Taxation of Chargeable Gains Act 1992, and is as follows:
'"normal commercial loan" means a loan of or including new consideration and –
'(a) which does not carry any right either to conversion into shares or securities of any other description except corporate bonds (within the meaning of section 117 of the 1992 Act) or to the acquisition of any additional shares or securities;
'(b) which does not entitle that loan creditor to any amount by way of interest which depends to any extent on the results of the company's business or any part of it or on the value of any of the company's assets or which exceeds a reasonable commercial return on the new consideration lent; and
'(c) in respect of which the loan creditor is entitled, on repayment, to an amount which either does not exceed the new consideration lent or is reasonably comparable with the amount generally repayable (in respect of an equal amount of new consideration) under the terms of issue of securities listed in the Official List of the Stock Exchange.'
Section 117(2) provides that:
'For the purposes of subsection (1)(b) above –
'(a) a security shall not be regarded as expressed in sterling if the amount of sterling falls to be determined by reference to the value at any time of any other currency or asset; and
'(b) a provision for redemption in a currency other than sterling but at the rate of exchange prevailing at redemption shall be disregarded.'
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Example |
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Ms Excel acquired 20 per cent of the ordinary share capital of her employer Zorac Ltd for £1,000 on 6 April 1999. On 6 April 2001, Zorac Ltd is acquired by Rapids plc and she exchanges her holding for £1,000,000 six per cent (2004) loan notes in Rapids plc. Ms Excel, who remains an employee throughout the period, is eligible for business asset taper relief on both the original shares in Zorac Ltd and the loan notes received in Rapids plc. The loan notes are redeemed on 6 April 2004. |
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The tax treatment of the transactions outlined above will depend on whether Ms Excel's loan notes are qualifying or non qualifying corporate bonds. |
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If the loan notes are qualifying corporate bonds |
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6 April 2001 |
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Sale proceeds |
1,000,000 |
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Cost |
(1,000) |
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Pre-tapered gain |
999,000 |
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Business taper relief |
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(two years ownership: 25 per cent reduction) |
(249,750) |
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Gain |
£749,250 |
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Section 116(10) provides that the transaction will not be treated as involving a disposal. |
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6 April 2004 |
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The gain of £749,250 held over above will be deemed to accrue on 6 April 2004 under section 116(10)(b). |
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If the loan notes are non-qualifying corporate bonds |
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6 April 2001 |
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Section 135 provides for the application of section 127 to the transaction so that there is deemed to be no disposal and the original shares and new securities are treated as the same asset. |
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6 April 2004 |
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Sale proceeds |
1,000,000 |
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Cost |
(1,000) |
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Pre tapered gain |
999,000 |
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Business taper relief |
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(over four years ownership: 75 per cent reduction) |
(749,250) |
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Gain |
£249,750 |
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Tax saving |
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By ensuring that the loan notes are non qualifying corporate bonds, Ms Excel's chargeable gain is reduced by £749,250 - £249,750 = £499,500. On the assumption that she is a higher rate taxpayer this produces a tax saving of £499,250 @ 40% = £199,800. |
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The escape routes
In summary, it is thus clear that to obtain non qualifying corporate bond status the security should either:
- fail to constitute a normal commercial loan; that is the security must be:
- convertible into shares or securities other than corporate bonds within the meaning of section 117; or
- contain a right to acquire further shares or securities; or
- provide that interest be calculated by reference to profit etc.; or
- provide for repayment of an amount exceeding the new consideration lent;
- be expressed to be convertible or redeemable into a currency other than sterling.
Clauses determining tax status
In practice, the method most commonly used to ensure a security falls to be treated as a non qualifying corporate bond is to incorporate a clause into the loan note instrument providing:
- a right to require redemption in a foreign currency; or
- a right to subscribe for additional securities; or
- a right of conversion into shares.
Set out below is an example of a draft foreign currency clause.
Draft foreign currency clause
A loan note holder may elect that the principal amount of the loan notes shall be redeemed in United States dollars. In which case the company shall on the payment date pay to the loan note holder an amount in United States dollars obtained by converting the principal amount outstanding of such loan notes into United States dollars (at the spot rate for the purchase of United States dollars with sterling prevailing at the date, 30 days prior to the redemption date).
Provided that:
(a) if the amount payable in United States dollars would otherwise exceed an amount in United States dollars obtained by converting 100.8 per cent of the sterling principal amount outstanding of such loan notes into United States dollars at the spot rate for the purchase of United States dollars with sterling at 12am on the redemption date the latter amount shall be substituted therefor;
(b) if the amount payable in United States dollars hereunder would otherwise be less than the amount in United States dollars obtained by converting 99.2 per cent of the sterling principal amount outstanding of such loan notes into United States dollars at the spot rate for the purchase of United States dollars with sterling prevailing at 12am on the redemption date the latter amounts shall be substituted therefor.
Points (a) and (b) cap the exposure to exchange rate fluctuations. That is, the maximum gain or loss is limited to 0.8 per cent of the principle amount.
Commercial drivers
When advising on which method is most appropriate, the main consideration is to ensure that the route chosen has as little commercial impact as possible so as not to undermine the transaction's economic viability.
The prospective purchaser may be expected to be less than enthusiastic about granting convertibility rights since these potentially provide the vendor with a right to acquire an equity stake in the purchaser.
Where the foreign currency clause route is followed an attempt will normally be made to mitigate any exchange exposure faced by the parties to the transaction. See the draft foreign currency clause above. In this regard a balance must be struck between capping exchange rate exposure, and running an increased risk of Revenue challenge on account of artificiality.
Belts and braces
In order to increase the likelihood that the loan note instrument will be able to withstand Revenue scrutiny, there may be merit in ensuring that the loan note instrument contains a second (fall back) clause designed to guarantee non-qualifying corporate bond status. This might be, for instance, a clause containing a right to subscribe for additional securities. Notwithstanding this additional feature, no doubt it would remain open to the Revenue to challenge any instrument where the terms appear to be inappropriately tax-driven.
Changes in tax status
It is possible to alter the characteristics of a loan note so that its tax status switches from qualifying corporate bond to non qualifying corporate bond or vice versa. For example, a qualifying corporate bond status could be switched to non-qualifying by inserting an appropriate foreign currency clause into the loan note instrument. Where the tax status of a loan note is changed section 132, Taxation of Chargeable Gains Act 1992 applies so that the transaction may be treated to be a conversion of securities. For a more detailed consideration of the application of section 132 in such circumstances and whether such change in status may trigger a disposal see my article, 'Tinker With Care', Taxation, 19 April 2001 at pages 68 to 69.
Treat with care
In conclusion, the distinction between qualifying and non-qualifying corporate bond status is of fundamental importance. It should be possible to ensure if required that a loan note falls to be treated as non-qualifying, by including an appropriate clause in the loan note. Caution, however, is advisable as clauses that appear blatantly artificial are particularly prone to Revenue attack.
David Hughes is a senior tax manager with Levy Gee and can be contacted on 020 7467 4229. The views expressed in this article are those of the author and not necessarily those of Levy Gee.
