Floating To Oblivion

DAVID HUGHES BBS (TCD), ACA, AITI, FTII, warns of the dangers of accepting floating rate loan notes in exit situations where business taper relief is at issue.

THE IMPLICATIONS OF the anti-avoidance provision contained in paragraph 10 of Schedule A1 to the Taxation of Chargeable Gains Act 1992 (periods of limited exposure to fluctuations in value not to count) may prejudice entitlement to business asset taper relief on an exit involving the issue of Acquirer Co's floating rate notes to the non corporate shareholders of Target Co. This article assumes that in all cases the loan notes under consideration are non qualifying corporate bonds, and that the interest rate attaching to the note is linked to the base rate. Statutory references are to the Taxation of Chargeable Gains Act 1992, unless otherwise specified.

Floating rate loan notes

Floating rate loan notes are ones whose interest rate is reset during the life of the note, e.g. by reference to movements in the base rate.

There has already been certain comment on whether floating rate loan notes would be eligible for business asset taper relief. This revolved around the issue as to whether such notes would qualify to be treated as a 'debt on a security' and hence fall within the narrow definition of securities qualifying for taper relief suggested by the Inland Revenue in the June 2001 Tax Bulletin. This particular concern appears to have been alleviated by the commitment of the Revenue (see Revenue press release dated 15 November 2001) to introduce legislation to ensure that debentures that are deemed to be securities for certain purposes by section 251(6) will also be treated as securities for taper relief purposes. That this is not a panacea for all ailments is made clear by paragraph 7 of the press release which states:

'Holders of such instruments will therefore not have to address the question whether the debentures actually are securities when considering the rate of taper relief. Holders will still need to consider whether the debentures meet the other conditions for business asset taper relief.'

A particular problem for loan notes received in exchange for shares is the anti-avoidance provision contained in paragraph 10 of Schedule A1 restricting taper relief in certain circumstances where there is limited exposure to fluctuations in value. Loan notes, by their nature, have much of the business risk of ownership removed, in comparison to equity stakes. On the assumption that repayment is guaranteed, i.e. that the bank will not default, the only remaining potential source of fluctuation in value would be that of variations in value due to movements in the interest rate.

In the case of guaranteed floating rate notes, any potential movement in value due to fluctuations in the market interest rate is restricted by reference to the fact that the rate of interest attaching to the note is periodically reset during the life of the note by reference to the market interest rate. For example, if the bank guaranteed loan note tracks the base rate daily (by way of formula), all such risk would be virtually eliminated.

The pertinent extract from the legislation, together with the Revenue's interpretation of 'substantial extent' is set out below.

Paragraph 10 of Schedule A1

'(1) Where, in the case of any asset disposed of ("the relevant asset"), the period after 5 April 1998 for which that asset had been held at the time of its disposal is or includes a period during which-

Revenue commentary

The Revenue has specifically commented on the application of paragraph 10 to the exchange of shares for loan notes in the Capital Gains Manual at paragraph 17916:

'In a take-over, shares in one company may be exchanged for loan notes (which are not qualifying corporate bonds) in a different company in such a way that section 135 applies the same asset rule in section 127 (see CG52500+). The loan notes are treated as the same asset as the shares for which they were exchanged. As loan notes will typically not bear the same degree of exposure to fluctuations in value as the shares for which they were exchanged, it might be thought that paragraph 10 applies to treat the exchange as a transaction which has the effect of limiting exposure to fluctuations in value. In practice, however, where the loan notes are issued as part of the normal commercial arrangements in an exchange, the Revenue does not consider that paragraph 10 applies. This will usually be so even where the loan notes are underwritten by a third party guarantee (for example a bank guarantee) as part of those arrangements. In more complex or non-commercial circumstances, where the loan notes are issued to exploit the operation of taper paragraph 10 may, however, apply.'

Advisers may understandably be pleased that the Revenue has gone on record with its view that loan notes underwritten with a third party guarantee may qualify. Nevertheless it is important to underline the fact that it has made clear that it believes that in 'more complex or non commercial' cases involving the issue of loan notes, paragraph 10, among others, may apply.

I suggest that it is fairly uncontroversial that floating rate notes are more complex than fixed rate notes merely by virtue of the mechanism required to determine the interest rate applying from time to time.

The question of whether any loan note could be considered to be non-commercial is, to some extent, a subjective one. In my view a floating rate note ipso facto is as commercial as any other debt instrument. In practice, the Revenue may tend to focus on the reason for their issue. Where the loan notes are issued at the behest of the purchaser, the Revenue may perhaps be expected to accept their commercial nature. Where, however, the vendor declines a cash offer and requests loan notes purely to tap into a higher rate of business taper relief, it is reasonable to suspect that the Revenue may be inclined to consider that these fall into the non-commercial category.

As a practical matter, where a vendor requests any type of loan note when cash is on offer, there must be a risk of section 138 clearance being refused.

Finally, the question as to whether the loan note has been issued to exploit the operation of taper is a classic catch 22 dilemma. If it is a qualifying corporate bond, it has not been issued to exploit the operation of taper; where the note is a non-qualifying corporate bond, the drafter of the note will in most cases have been asked to ensure its non-qualifying corporate bond status.

Example

Acquirer Co issues floating rate loan notes to James, the sole shareholder of Target Co, redeemable in 2004. Initially a six per cent rate of interest applies. However, this rate is recomputed at quarterly intervals by reference to a formula linked to the base rate.

It is clear that the risk of fluctuation in value of the note due to changes in the interest rate is limited by reference to the limited period in which the divergence may persist. It is unlikely that the note could be subject to a 20 per cent fluctuation in value. In principle therefore paragraph 10 applies so that the period of ownership of the notes would not count for taper relief purposes.

In advising on the impact of the length of any particular 'reset' period, the following factors are among those which should be taken into account.

Is the note guaranteed?

Where the note is not guaranteed, there is a far greater risk of fluctuations in value of the note. Indeed, in the worst case scenario, the note could become worthless. The author would argue that in circumstances where a floating rate note is not guaranteed, paragraph 10 should not be in point.

The length of the note

The length of the note may impact on the effective reset period. For example, where a loan note is issued with a redemption date 15 months hence, a reset after 12 months produces a latter period of just three months where the value of the note may fluctuate.

The purpose of this article is to draw readers' attention to potential concerns arising from the issue of floating rate loan notes in the context of business asset taper relief. It is unclear whether the Revenue will take the point on floating rate loan notes, where the exploitation of taper was not the intention. Nevertheless, the anti avoidance provision contained in paragraph 10 is very broad, and provides the scope for such an attack.

David Hughes is a consultant with the tax solutions group at WJB Chiltern and can be contacted on 020 7571 8647. The views expressed in this article are those of the author and not necessarily those of WJB Chiltern.

Issue: 3851 / Categories: