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Debt Assignment: How They Work, Considerations and Benefits

Daniel Liberto is a journalist with over 10 years of experience working with publications such as the Financial Times, The Independent, and Investors Chronicle.

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

Investopedia / Ryan Oakley

What Is Debt Assignment?

The term debt assignment refers to a transfer of debt, and all the associated rights and obligations, from a creditor to a third party. The assignment is a legal transfer to the other party, who then becomes the owner of the debt . In most cases, a debt assignment is issued to a debt collector who then assumes responsibility to collect the debt.

Key Takeaways

• Debt assignment is a transfer of debt, and all the associated rights and obligations, from a creditor to a third party (often a debt collector).
• The company assigning the debt may do so to improve its liquidity and/or to reduce its risk exposure.
• The debtor must be notified when a debt is assigned so they know who to make payments to and where to send them.
• Third-party debt collectors are subject to the Fair Debt Collection Practices Act (FDCPA), a federal law overseen by the Federal Trade Commission (FTC).

How Debt Assignments Work

When a creditor lends an individual or business money, it does so with the confidence that the capital it lends out—as well as the interest payments charged for the privilege—is repaid in a timely fashion. The lender , or the extender of credit , will wait to recoup all the money owed according to the conditions and timeframe laid out in the contract.

In certain circumstances, the lender may decide it no longer wants to be responsible for servicing the loan and opt to sell the debt to a third party instead. Should that happen, a Notice of Assignment (NOA) is sent out to the debtor , the recipient of the loan, informing them that somebody else is now responsible for collecting any outstanding amount. This is referred to as a debt assignment.

The debtor must be notified when a debt is assigned to a third party so that they know who to make payments to and where to send them. If the debtor sends payments to the old creditor after the debt has been assigned, it is likely that the payments will not be accepted. This could cause the debtor to unintentionally default.

When a debtor receives such a notice, it's also generally a good idea for them to verify that the new creditor has recorded the correct total balance and monthly payment for the debt owed. In some cases, the new owner of the debt might even want to propose changes to the original terms of the loan. Should this path be pursued, the creditor is obligated to immediately notify the debtor and give them adequate time to respond.

The debtor still maintains the same legal rights and protections held with the original creditor after a debt assignment.

Special Considerations

Third-party debt collectors are subject to the Fair Debt Collection Practices Act (FDCPA). The FDCPA, a federal law overseen by the Federal Trade Commission (FTC), restricts the means and methods by which third-party debt collectors can contact debtors, the time of day they can make contact, and the number of times they are allowed to call debtors.

If the FDCPA is violated, a debtor may be able to file suit against the debt collection company and the individual debt collector for damages and attorney fees within one year. The terms of the FDCPA are available for review on the FTC's website .

Benefits of Debt Assignment

There are several reasons why a creditor may decide to assign its debt to someone else. This option is often exercised to improve liquidity  and/or to reduce risk exposure. A lender may be urgently in need of a quick injection of capital. Alternatively, it might have accumulated lots of high-risk loans and be wary that many of them could default . In cases like these, creditors may be willing to get rid of them swiftly for pennies on the dollar if it means improving their financial outlook and appeasing worried investors. At other times, the creditor may decide the debt is too old to waste its resources on collections, or selling or assigning it to a third party to pick up the collection activity. In these instances, a company would not assign their debt to a third party.

Criticism of Debt Assignment

The process of assigning debt has drawn a fair bit of criticism, especially over the past few decades. Debt buyers have been accused of engaging in all kinds of unethical practices to get paid, including issuing threats and regularly harassing debtors. In some cases, they have also been charged with chasing up debts that have already been settled.

Federal Trade Commission. " Fair Debt Collection Practices Act ." Accessed June 29, 2021.

Federal Trade Commission. " Debt Collection FAQs ." Accessed June 29, 2021.

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Making a Deal with the ATO for Your Tax Debt

If you owe a large tax debt you might be wondering if you can ‘cut a deal’ with the ATO. I’ve had this conversation with many clients over the years.

‘If the ATO gets rid of the interest and penalties, I can pay the balance in one lump sum’

‘Wouldn’t the ATO prefer to get something rather than nothing?’

Well, I can tell you this – the ATO will not negotiate a tax debt on a commercial basis .

You can’t simply say ‘I can pay you 80% of my tax debt right now, otherwise you can chase me for years’ and expect the ATO to accept this. It isn’t allowed to make a deal like this.

The ATO can only do what Parliament allows it to do. And Parliament does not allow the ATO to do commercial deals. If you want to cut a deal with the ATO, you need to do it within the bounds of the tax laws and rules.

What does this mean?

It means you need to find the parts of the tax laws and rules that may help you to reduce your tax debt, and see if they apply to your situation.

Here are four ways you may be able to reduce your tax debt.

Check the ATO’s Numbers

You should look at whether you agree with the way the tax debt is calculated. There may be parts of your tax debt that you can object to, in an effort to reduce the overall debt.

This strategy is often useful where some of the tax debt has been raised as a result of an audit or a default assessment. For example:

• are there deductions to which you are entitled that weren’t included in your tax assessment?
• did you pay superannuation to employees but it wasn’t taken into account when the ATO did a superannuation audit?

You should also look for any double-counting. This is important where the ATO made estimates and you later lodged your activity statement with the right figures. You may find that your tax debt includes both the estimated amounts in the ATO’s assessment and the correct amounts in your returns. This can happen when the ATO doesn’t reverse the estimates after you have lodged. I’ve seen this happen more than once.

If you’re concerned that your tax debt is more than it should be, then having it reviewed by someone who knows what they’re doing can be well worth it.

If you do identify any mistakes in the ATO’s numbers, then the best way to address this is usually an objection.

Request a Remission

You can also look at reducing your debt by requesting a remission of the general interest charge and/or penalties.

These applications are not straightforward, and I recommend you take care and seek the advice of a professional when making a request. If you make a request and the ATO says no, then you are not able to object to this decision . You can only object to certain types of tax decisions – and a decision not to remit a general interest charge is not one of them.

Getting the assistance of a tax lawyer who specialises in interest remission requests will put you in the best position for success.

Apply for a Release of your Tax Debt

Individuals can be released from certain tax debts, such as income tax debt. You cannot be released from GST, PAYG withholding or superannuation for your staff. A company or a partnership cannot be released from any tax debt.

A release of tax debt is only possible where you would suffer serious financial hardship if you had to pay the tax.

There are many factors that the ATO will consider before releasing you from any tax, such as:

• whether you have bought investments or spent your money without giving consideration to your tax debt
• whether you have other debts (such as credit cards and personal loans), and you would still be in hardship because of those debts even if the ATO granted you a release
• where your serious hardship is likely only to be short term

To be considered for this, you can lodge an Application for Release.

Make an Offer of Compromise of your Tax Debt

The ATO can compromise tax debts in very limited circumstances . There is a 17-page practice statement about this on the ATO website.

In short, there are very stringent requirements to be met before the ATO will compromise on a tax debt. These include:

• the debt must not be disputed
• you must be up to date with all of your tax lodgments
• the arrangement must have benefits for the ATO. For example, a saving in the cost of collection, or collection of a larger amount than the ATO could otherwise recover
• the amount you offer to pay as compromise cannot be for less than your total net assets
• the ATO cannot agree to a compromise where the only reason to support the proposal is that you would suffer hardship if you had to pay your tax debt

It is expected that you look at all other available options before a compromise will be considered.

The ATO only receives a relatively small number of offers of compromise each year (around 30 per year, according to my research). This is because the criteria are so strict and the application process quite in-depth.

Approaching the ATO

If you’re struggling with a tax debt, I recommend having an expert review your tax position. They can identify aspects of your debt that may be challenged and help you to approach the ATO in the right way.

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Assignment of debts, statutory demands and offsetting claims

It is not uncommon for a creditor (assignor) to transfer their right to receive payment of a debt (assignment) to a third party (assignee). The assignee will then seek payment from the debtor.

The assignee of the debt can issue to the debtor company a statutory demand for the payment of the debt if the debt exceeds the statutory minimum, which is currently $2,000.

For the assignee issuing the statutory demand, there will be threshold issues as to whether notice of the assignment has been given to the debtor and whether appropriate details of the assignment are contained in the statutory demand.

Assignee has the same rights and obligations as the assignor

The assignee of the debt takes the assignment subject to the rights and obligations of the assignor.

This was demonstrated in the recent decision of Mascarene Pty Ltd v Slater [2016] VSC 395 relating to a building dispute.

In Mascarene a judgment debt was assigned and the assignee issued a statutory demand.

The Court held that the assignee was not prevented from seeking payment of interest as it had the same rights as the assignor, as if the assignment had not taken place.

However, the assignee also took the assignment subject to the obligations that would have applied to the assignor in respect of the debt.

In seeking to set aside the statutory demand the debtor company claimed it had an offsetting claim against the assignor for reinstatement costs relating to building works.

Although the assignee was not a party to the building contract and not personally liable for the reinstatement costs, the debtor company was successful in claiming the setoff and reducing the amount of the statutory demand by the amount of the reinstatement costs.

It is clear that an offsetting claim cannot be sidestepped by assigning the debt.

The assignee of a debt receives the benefit of the debt subject to the rights of the assignor but also subject to the assignor’s obligations in respect of the debt.

A statutory demand can be issued in respect of an assigned debt however the assignment does not prevent the debtor company from disputing the existence or amount of the alleged debt or seeking to raise an offsetting claim.

If you would like more information about these issues, please contact Graham Roberts on +61 7 3231 2404.

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This publication is for information only and is not legal advice. You should obtain advice that is specific to your circumstances and not rely on this publication as legal advice. If there are any issues you would like us to advise you on arising from this publication, please let us know.

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Australian Taxation Office issues final guidance on thin capitalization arm’s-length debt test and draft guidance on “outbound” interest-free loans

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Executive summary

On 12 August 2020, the Australian Taxation Office (ATO) released long-awaited debt deduction related guidance. The guidance is comprised of:

• Final Taxation Ruling  TR 2020/4  and Practical Compliance Guideline  PCG 2020/7  (replacing the draft PCG 2019/D3) in relation to the application of the arm’s-length debt test for thin capitalization purposes
• Draft Schedule 3 to PCG 2017/4 ( PCG 2017/4DC2 ) in relation to outbound interest-free loans between related parties

As noted, the guidance has been a long time coming. The ATO has delayed issuing this guidance, and other non-pandemic related guidance, to focus on critical COVID-19 issues. The release of this guidance appears to indicate that the ATO is focusing back on other tax issues held in abeyance due to the pandemic.

Both sets of guidance have been keenly anticipated, with many taxpayers uncertain as to how to treat these issues knowing that ATO guidance was pending. This Alert summarizes some of the key issues and a detailed Tax Alert will be forthcoming.

Detailed discussion

Application of the arm’s-length debt test in the thin capitalization rules.

The ATO has released its final Taxation Ruling TR 2020/4 (Income tax: thin capitalisation – the arm’s length debt test) and Practical Compliance Guideline PCG 2020/7 (ATO compliance approach to the arm’s length debt test) following the consultative drafts released last year.

TR 2020/4 replaces TR 2003/1, which is being withdrawn. The new TR provides further guidance to taxpayers on the unchanged existing law and aims to create a foundation for a more uniform application of the rules in practice.

TR 2020/4 also considers key legislative technical issues and provides clarity on record-keeping requirements and the interaction with the ”arm’s-length” principle under the transfer pricing rules. Of particular note are the following points set forth in the guidance:

• The arm’s-length debt test (ALDT) standard is “higher than a prediction of a possible level of debt and calls for a prediction based upon evidence.” The ATO is clear that it expects taxpayers to demonstrate an outcome that is “probable,” rather than seeking the highest amount as a mere possibility.
• The arm’s-length debt amount (ALDA) is a commercially reasonable position of the notional ”stand-alone” Australian business, and not the capital structure and leverage preferences of shareholders.
• All relevant legislative factors need to be considered even where it is ultimately determined that a factor is not relevant.
• Fair market values of assets can be used for performing an ALDT analysis.
• Taxpayers relying on the test are obligated to comply with the record keeping requirements. However, a failure to prepare the requisite records does not result in an inability to rely on the ALDT.
• The ALDA could be different to the arm’s-length capital structure for transfer pricing purposes.

PCG 2020/7 sets out the ATO’s compliance approach and should be read in conjunction with TR 2020/4. There is no change to the structure but some feedback on the earlier draft PCG was incorporated (including key points of EY’s submission). Consistent with the draft guidance, the final guidance requires taxpayers to demonstrate that their notional debt levels, taking into account the reconstructed balance sheet, profit and loss statement, cash flows and credit rating, to address all of the quantitative and qualitative measures of an arm’s-length debt amount by reference to comparable entities. The guidance includes reference to specific financial ratios that the ATO believes address the “relevant factors” specified in the law and provides an example calculation.

There are two changes of note in the final guidance:

• Taxpayers are still required to ”self-assess” their risk zone position in light of the guidance. However, the guidance has been updated to include additional risk zones (white, low, low-moderate, medium and high), giving taxpayers greater scope to distinguish their risk. The risk zone then determines the level of compliance resources that the ATO will likely devote to reviewing the taxpayer’s position. There are still specific low-risk zone criteria for inbound, outbound and regulated utilities taxpayers.
• It provides clarity on what constitutes a ”commercial lending institution.” In particular, the guidance excludes government-owned organizations from this definition (e.g., Clean Energy Finance Corporation).

Both sets of guidance apply before and after the date of issuance. In the case of the PCG, the guidance has effect from income years commencing on or after 1 January 2019.

The guidance is likely to mean an additional compliance burden for many taxpayers who will need to assess current and historic positions with potentially related additional documentation requirements.

EY has been in close consultation with the ATO on the ongoing development of this guidance. We provided a detailed submission to the ATO in response to the draft guidance, of which some feedback has been adopted by the ATO. We will continue to maintain a dialogue with the ATO to ensure the test is applied in a manner consistent with the commercial realities for taxpayers.

We also note that the ATO recently issued a thin capitalization concession for taxpayers impacted by COVID-19. Many taxpayers are experiencing impairment of asset values or requiring additional debt drawdowns to sustain their business through business interruptions. Given this, more taxpayers will potentially seek to rely on the ALDT for thin capitalization purposes. The ATO concession effectively allows taxpayers that would otherwise rely on the Safe Harbor Debt Amount to apply a simplified approach to the ALDT provided certain assumptions can be met.

Interest-free loans between related parties

PCG 2017/4DC2 is an update to PCG 2017/4 (ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions) to include a draft Schedule 3 dealing with outbound interest-free loans between related parties. This draft Schedule outlines the factors under which the risk score assigned to outbound interest-free loans made between related parties may be modified for the purposes of Schedule 1 of this Guideline. The risk ”scoring mechanism” framework resembles the framework present elsewhere in PCG 2017/4. As with the ATO’s overall PCG framework, taxpayers are required to ”self-assess” their position in light of the guidance.

The ATO confirms the starting position is that an interest free outbound loan will be considered ”high risk” from a transfer pricing perspective.

Previous ATO guidance (relevant to the predecessor transfer pricing provisions) had included a description of circumstances where a legal form loan agreement might be characterized as a contribution to equity (see Taxation Ruling 92/11). Reflecting the structure of subdivision 815-B, three exceptions to the ”high risk” starting position in this Schedule are contemplated. The exceptions require evidence of one of the following:

• Zero interest rate is an ”arm’s-length” condition of the loan.
• The loan is ”in substance” an equity contribution.
• Independent entities would not have entered into the actual loan and would have entered into an equity funding arrangement.

While three exceptions are presented, there is an emphasis on evidence the ATO would expect to see in support of an alternative ”equity-like” characterization. Certain ”framing considerations” and ”relevant factors” are identified as matters to be taken into account. Four illustrative examples are included in the Schedule, each of them highlighting issues associated with factors relevant for consideration of whether the underlying transaction should be evaluated as an equity contribution.

We also understand the ATO Next Action team will resume work soon and streamlined assurance reviews under the Top 1000 Tax Performance Program will resume in October. The guidance now in final will no doubt assist taxpayers to understand their risks and inform them of approaches ATO case teams will take in these assurance-based reviews.

For additional information with respect to this Alert, please contact the following:

Ernst & Young (Australia), Perth

• Andrew Nelson, International Tax and Transaction Services

Ernst & Young (Australia), Melbourne

• Tony Merlo, Tax Policy and Controversy

Ernst & Young (Australia), Sydney

• Anthony Seve, Oceania Leader – Transfer Pricing
• Tony Do, Financial Services Transfer Pricing

Ernst & Young LLP (United States), Australian Tax Desk, New York

• David Burns

Ernst & Young LLP (United Kingdom), Australian Tax Desk, London

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Debt restructuring: International tax considerations

International.

United Kingdom |  Publication |  August 2020

Introduction

1. sale of distressed debt, 2. debt-to-equity swaps, 3. debt waivers or modifications, concluding remarks.

The increasingly unpredictable economic landscape has created uncertainty and distress for businesses across a broad range of sectors and markets. Borrowers have been working to stabilize their businesses and ensure they have the liquidity to continue to trade through these difficult times. Lenders have been working to assist and support their borrowers by providing amendments and waivers under existing facilities as well as new money (where the circumstances permit).

But what happens if things don’t go to plan?

We know from past experience that borrowers and lenders have a number of debt restructuring scenarios that they commonly consider: from partial waivers to debt-to-equity swaps; from conditional waivers to the sale of distressed debt. But especially in a cross-border context, specific local tax consequences can significantly impact the choice between one scenario and another.

Norton Rose Fulbright has performed research across selected jurisdictions (i.e. the US, Australia, Canada, South Africa, France, the UK, Germany, Luxembourg and the Netherlands) on various debt restructuring scenarios and the local tax impact on debtors and creditors. This research has provided us with insight into various pitfalls that might occur from international debt restructurings.

This note discusses three commonly used debt restructuring scenarios:

• Sale of distressed debt
• Debt-to-equity swaps
• Debt waivers.

The goal is to flag key tax items across selected jurisdictions for each scenario, because we know from experience that, although certain international trends can be seen, any international debt restructuring requires careful consideration of the relevant local tax regimes.

The sale of distressed debt is a mechanism for a creditor to reduce their balance sheet exposure to debts which may currently be non-performing or have a significant risk of future default. In such circumstances, the debt would be sold at a discount to face value in view of the distressed financial circumstances of the debtor.

Certain private equity and other investment funds are known to have an appetite for the purchase of distressed debt on secondary markets (which may come in the form of an individual loan or a large portfolio) at a reduced price in order to realize a profit by either:

• In the case of a liquid market, rapidly selling on the debt
• Negotiating a financial restructuring of the company and/or awaiting the financial recovery of the debtor and consequently the future repayment of the debt.

As well as sales to unconnected parties, it may also be that the parties want to arrange a disposal to a connected party. This may occur, for example, where a debtor wants to acquire a debt into a group to remove the controls placed on it by the third-party creditor.

The sale of distressed debt is achieved by way of assignment or novation, depending on the terms of the debt. Consent of the debtor to a sale may be required. Individual debt sales are usually carried out on standardized documents, whereas portfolio sales are more likely to be negotiated on a bespoke basis. Alternatively, the creditor may sub-participate its interest in the loan, in which case it remains the lender of record but transfers the credit risk of the debtor to the participant. This may not result in the distressed loan coming off its balance sheet.

Key tax considerations

The selling creditor will want to ensure that they are able to claim relief for any loss they have incurred with respect to the debt. A buyer will want to ensure that their base cost in the loan is the price paid; that they do not suffer any immediate tax charge and that there are no transfer taxes that arise as a result.

The debtor will want to ensure that there are no adverse tax charges arising for them in relation to the sale and that the sale does not adversely impact on the deductibility of interest payments going forward. It will also be important for the parties to consider the impact on the withholding tax treatment of interest payments and the allocation of risk under the loan documents. A change in lender may mean that interest can no longer be paid gross or new treaty applications are required.

Both parties will want to ensure there is no tax charge for the creditor.

Research findings

Below we will summarize our key findings for the sale of distressed debt, where we distinguish between general international tax trends (i.e. how do the majority of the jurisdictions treat the sale of distressed debt) and specific tax issues (i.e. which jurisdictions take a different approach than others and therefore may need further consideration if a local tax payer is involved in the sale of distressed debt):

General trends

• The selling creditor’s position upon a sale is largely consistent across the jurisdictions, with a creditor realizing a tax deductible loss upon the sale of the debt at a discount. This loss typically reflects the difference between the carrying value of the loan and the sale proceeds, assuming that the sale is on arm’s length terms. There may be no tax loss where the selling creditor and buying creditor are connected.
• The transfer of a creditor’s right to a debt to another entity does not generally affect the corporate income tax position of the debtor (whose obligation to repay is generally unaffected by the sale). Some jurisdictions impose a tax charge on the debtor where the buying creditor is connected with the debtor.
• The buying creditor will generally not suffer an immediate tax charge and its base cost in the debt will be the price it paid (again assuming that the acquisition is on arm’s length terms).
• The transfer of a debt should not give rise to transfer taxes unless the debt has equity like characteristics such as results-dependent interest or is convertible into equity.

Specific issues

In circumstances where the buying creditor and debtor are related parties, the debtor may be subject to tax on the difference between the carrying value of the debt and the amount the incoming creditor paid for the acquisition.

The general rule which states that the debtor’s tax obligations will be unaffected on the sale of a debt will apply provided that the debtor is notified of the change in creditor.

If the sale is set up on beneficial terms for the incoming creditor, a taxable gain may be charged on any hidden capital contribution or distribution which that creditor receives.

• The Netherlands

Stringent anti-avoidance provisions are in place to ensure that a creditor cannot avoid Dutch tax liability from an upward valuation of a loan which has previously been written-down (where the parties are affiliates).

If a debt is sold to an incoming creditor that meets certain interest tests in the debtor for less than 80 percent of the principal amount of the loan, then a taxable credit may arise in the debtor.

A debt-to-equity swap, substitution or restructuring is a capital reorganization of a company in which a creditor (usually a bank, possibly together with other banks, bondholders or creditors) converts indebtedness owed to it by a company into one or more classes of that company’s share capital.

There is no preordained structure for a debt-to-equity swap. Much depends on the existing debt and capital profile of the company and the intended result. The main commercial issues to be settled between the company (effectively representing its shareholders) and its principal bank (and other creditors) are:

• How much debt is to be substituted by share capital?
• What proportion of the total equity should the shares issued to the creditor comprise?
• Which class of shares should be issued to the creditor? Are there any restrictions on the type of shares issued?
• Should the creditor accept any restriction on its ability to dispose of the shares issued to it?

To a large degree, the negotiating position of the bank will depend on whether or not the reconstruction involves new money from other investors being injected by way of share capital. Institutional investors considering putting new money into the company will usually drive a harder bargain than the company itself.

The creditor will be interested in:

• Tax relief for the debt that is capitalized.
• The tax base cost in the new shares issued on the debt capitalization.
• Tax charges on the issuing company on the debt capitalization.

From a debtor perspective, the key aspects are:

• Will release of the debt result in taxable income?
• Will the issuance of new shares cause a cancellation of losses?

Below we will summarize our key findings for debt-to-equity swaps, where we distinguish between general international tax trends (i.e. how do the majority of the jurisdictions treat a debt-to-equity swap) and specific tax issues (i.e. what jurisdictions take a different approach than others and therefore may need further consideration if a local tax payer is involved in a debt-to-equity swap):

• Creditors involved in a debt-to-equity swap are generally able to convert their debt into equity in a tax neutral transaction, where the tax book value of the shares received equals the tax book value of the converted debt.
• The position may be different if the creditor is a related party of the debtor. A number of jurisdictions have legislation that prevents a creditor from depreciating a debt and subsequently converting the debt into equity in a tax neutral way.
• A debtor that issues new shares to the creditor as part of the debt-to-equity swap may suffer a reduction of its tax losses. If the release of the debt is considered to give rise to taxable income, this may impact existing tax losses. Certain countries apply specific debt forgiveness rules that prevent taxation at the debtor level in case the release of the debt exceeds available tax losses.
• In addition, the issue of new shares to a creditor outside the debtor’s group may result in a (substantial) change of shareholder and thus trigger tax loss cancellation rules in a number of jurisdictions, or a change of ownership for tax purposes.

When a German debtor is relieved from its debt (including as a result of a debt-to-equity swap), the cancellation of the debt will trigger a taxable gain to the extent the debt was depreciated by the creditor. This is the reason that straight-forward debt-to-equity swaps are very rare in Germany.

The UK has prescriptive rules which govern the circumstances in which debt-to-equity swaps will give rise to relief for the creditor and avoid a taxable credit for the debtor. For example, the release must be in consideration for ordinary share capital which rules out use of fixed rate preference shares. Care must be taken to ensure that the relevant conditions are met.

A debt-to-equity swap is generally a tax neutral event for debtors, where both the release of the debt and issuance of shares are accounted for at nominal value rather than market value.

A debt waiver, debt cancellation or debt forgiveness is a transaction in which a creditor (usually a shareholder but also third-party creditors such as banks, bondholders or suppliers) voluntarily relinquishes its right (in whole or in part) to payment under a debt instrument. The waiver serves the purpose of relieving the debtor from a financial obligation; it is a common element in restructuring scenarios, including UK Schemes of Arrangement and US “Chapter 11” procedures (and is expected to form a part of WHOA schemes). The debt waiver is often part of a package of relief used in an effort to ensure the survival and prospects of the debtor.

There is no set structure for a debt waiver. In principle, it may be implemented by a simple and short waiver declaration.

Debt modification

As an alternative to a waiver, the terms of the debt may be amended so any repayment is contingent on certain conditions being satisfied. However, agreeing the conditions for payment may be a complex task as the agreement needs to anticipate under which circumstances the company is required to pay the debt.

As a part of restructuring negotiations, creditors may require some form of reward if the restructuring proves successful. These benefits can take a number of forms, including increased pricing, a cash sweep, exit fees and/or equity-like debt instruments. For this purpose, the debt can be (partially) waived, amended and/or swapped for a new instrument at the time of the restructuring. Payment of the debt could be conditional on the financial situation of the debtor improving such that its debt capacity allows for a (partial) servicing of the debt.

Waiver and conditional reinstatement

In Germany, creditors can agree to a waiver of debt on the basis that such debt will be reinstated if certain conditions are satisfied, e.g. if and to the extent the debtor recovers financially.

Similar to the modification of debt, the agreement on the terms of the reinstatement of the debt can be rather complex. From a tax and accounting perspective, such transaction is treated as a full waiver and the creation of new debt once the reinstatement takes place. Other jurisdictions outside Germany do not treat a waiver with a conditional reinstatement as a waiver of debt, but rather as an amendment to the payment terms of the instrument.

Main commercial issues

The main commercial issues to be settled between the company and its creditors are:

• How much of the debt is to be forgiven? Will all creditors participate in the measure equally (the expectation being that creditors in the same class would be treated equally)? Should shareholder financing take the hardest hit (the expectation being that shareholder debt is treated akin to equity and so should be released before third-party lenders are expected to release their debt)?
• Should the waiver be in combination with other measures (e.g. debt-to-equity conversion)? Should the measures be linked (e.g. possibility to convert into equity upon certain triggers)?
• Under which circumstances will the debt be payable? Can certain creditors – secured vs. unsecured or long-term vs. short-term – take priority?

To a large degree, the negotiating position will depend on the granularity of the creditor group. The more the company needs to rely on the buy-in of only a few creditors, the more bargaining power they will have when it comes to the terms of the reinstatement.

• Will the release of the debt result in a tax relief and will the payment of the debt result in taxable income?
• In case of any changes to the terms of the debt, is it free to structure the conditions for payment? In how far can it mitigate abuse by the debtor?
• Will the release of the debt result in taxable income?
• In case of amendments, will the payment of the debt result in a tax relief?
• Is a new debt created?

Below we will summarize our key findings for debt waivers and modifications, where we distinguish between general international tax trends (i.e. how do the majority of the jurisdictions treat a waiver and reinstatement of debt) and specific tax issues (i.e. what jurisdictions take a different approach than others and therefore may need further consideration if a local tax payer is involved in a debt waiver or modification):

• Creditors involved in a debt waiver transaction are generally able to obtain a tax relief for the debt forgiven. This treatment is mirrored at the time the condition is fulfilled and the debt is reinstated: the debtor realizes a taxable gain.
• For the debtor, the waiver is generally taxed since it is released of a repayment obligation at nominal value.
• In Germany, a waiver with a conditional reinstatement typically results in a tax relief for the debt recognized at the time of reinstatement. Of course, in other jurisdictions where the waiver is not recognized as such, neither the waiver/ modification of payment terms nor the reinstatement would be taxed.
• If the loan is cross-border, a new loan may be created, so that new double tax treaty clearances are required.

The waiver of shareholder debt may be treated as a (hidden) contribution in kind, if and to the extent the debt is valuable. The conditional debt waiver is also used as a loss-refresher to carry a loss beyond a change-of-control which would typically cause a forfeiture of tax losses.

A conditional debt waiver is accepted as a waiver and potential reinstatement if, at the time of the waiver, it is unlikely that the debtor becomes solvent again. Given that many restructuring/ insolvency regimes work on the assumption of a successful turnaround, the conditional waiver may often not be recognized.

Where a loan is amended so that repayment is made to be contingent or conditional then care will need to be had that this does not cause the loan to be treated as equity.

The current economic environment may create the need for multinationals to reconsider their debt positions. At the same time, distressed debt and other investment funds (such as private equity investors) are actively looking for investment opportunities. But especially in a cross-border context, each debt restructuring scenario is impacted by specific local tax consequences.

In this note we have summarized some general trends and specific tax issues that could arise from a sale and purchase of a distressed debt, debt-to-equity swaps and debt waivers. One of the key take-aways from our international research is that although certain international trends can be seen, any international debt restructuring requires careful consideration of the applicable local tax regimes.

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‘A good idea’ – assignment of a liquidator’s recovery rights

• September 18, 2019
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A liquidator has transferred, with court approval, potential recovery claims to the ATO, as the major and only creditor in a liquidation. The law concerning assignment of claims is however said to remain uncertain despite changes made to facilitate such transfers.

In the case in hand, the ATO is owed $5.4m. The company – Anatax – went into liquidation in May 2015 with $333 in its bank account.

The company was registered as a tax agent and the activities of those involved and the company itself, including transfers of property, prompted an audit by the ATO.

The liquidator, Mr Nicols,

“unsurprisingly it may be thought”,

as Justice Perram said,

“believes there may be a number of causes of action available to Anatax (and also himself as liquidator) including claims …for contraventions of ss 181 and 182 of the Corporations Act … and against the entities which are currently holding those properties”.

As the Judge explained:

“Because Anatax has no money, Mr Nicols thinks it would be useful to conduct examinations under s 596A and 596B of the Act and also to issue notices to produce in order to obtain relevant books and records. However, he does not have the funding to do this.

The Commissioner suggested to Mr Nicols that it might be useful for Anatax to assign all of its causes of action to the Commonwealth and for the Commissioner to take over Mr Nicols’ role in conducting the relevant inquiries. Mr Nicols agreed that this would be a good idea and appropriate since the only creditor of Anatax is the Commissioner”.

A deed was therefore executed between the ATO and the liquidator in 2019 to give effect to this transaction.

The only issue for the court was that the deed created obligations on Anatax which extended beyond three months after its date, and the Court’s approval under s 477(2B) was necessary for the deed to take effect. In fact, the deed was expressed to be conditional on Court approval being obtained. There was no real explanation for the 4 years having passed since the date of liquidation.

  The Court was ready to find that what was proposed was proper and appropriate, in good faith and with no error of law or principle: Nicols, in the matter of Anatax Pty Ltd (in liq) [2019] FCA 1528

The apparent ready approval of this assignment was no doubt supported by the evidence, although the terms of the assignment are not shown or discussed.

In other circumstances, an assignment by a liquidator of rights of action of the company can be a difficult area of law and policy, recently described as being “afflicted by inconsistent and circular reasoning”. This is now said to be further complicated by the changes made by the Insolvency Law Reform Act 2016 to introduce a right to assign a cause of action of the liquidator or trustee, under s 100-5 of the Schedules.

In corporate insolvency, the effect of these changes has been described as allowing the assignment of “the power to bring proceedings in respect of voidable transactions under Part 5.7B”, these being claims of the liquidator, but the section

“does not seem to extend, for example, to permit assignment of a company’s (as distinct from an external administrator’s) cause of action for breach of directors’ duties arising under the Corporations Act or a right to sue for misleading and deceptive conduct arising under the Australian Consumer Law (since that is not a right conferred under the Corporations Act)”. [1]

That comment referred to what was then a pending journal article, since published. [2]

In its thorough review of the law, including the impact of s 100-5, the article states, relevantly, that

”statutory causes of action against a director for breach of statutory duties in the Corporations Act are probably incapable of assignment by a liquidator, and even if they can be assigned, they cannot be enforced by the assignee”.

Under the new law, the article continues that it is

“very unclear how the provisions of [s 100-5] will operate in the context of the existing law on the assignment of causes of action by liquidators, or in relation to the existing provisions of the Corporations Act”.

It concludes in saying:

“The upshot is that despite the laudable intention to simplify and streamline, the provisions of the Insolvency Reform Act 2016 may simply have added another layer of complexity. Some judicial clarification will be necessary”.

There would in fact be a question whether the law is beyond judicial clarification though some court challenge would assist in relation to what is said to be a growing market for these assignments.

The ATO’s legal guidance on indemnities to insolvency practitioners might also give thought to these issues.

Uncertainty also exists in relation to a similar but simpler provision in the UK – s 246ZD of the Insolvency Act 1986 – introduced in 2015 for the same purpose, to allow the liquidator to sell a right of action which the liquidator may have no funding or inclination to sue.

The section simply provides that where a company enters administration or liquidation, the insolvency practitioner “may assign a right of action (including the proceeds of an action) arising under any of the following” provisions, including fraudulent or wrongful trading, transactions at an undervalue and preferences.

Similar questions have been asked there as to whether the section aligns with the restrictions imposed by the general law or whether it give broader powers to a liquidator. [3] Other issues raised in the UK include the need to assign the claim totally in order to avoid the potential for costs being ordered against the liquidator as a party supporting the claim, which could arise if the liquidator waits on a proportion of any successful action.

Other comment

See also The practical issues of assigning a right to sue – Ryan McIlveen, Worrells, 3 December 2018; Assigning rights to sue , (2018) 30(3) ARITA J 11.

Bankruptcy?

One other point is that if this were a trustee in bankruptcy entering a deed of assignment, no creditor or court approval would have been required at all. Does s 477(2B) of the Corporations Act remain necessary?

——————————

[1] ARITA National Conference 9 August 2017, Recent developments in insolvency law , Justice Ashley Black, Supreme Court of New South Wales.

[2] An Asset Shared Can Be a Problem Doubled: Assignment of Causes of Action by a Liquidator (2019) 93 ALJ 36, Justice Robert Harper, FCCA

[3] Goode on Principles of Corporate Insolvency Law , Kristin Van Zwieten, 5 th ed, Sweet & Maxwell, at [5-06].

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Arm’s length debt test – New ATO position finalised

The ATO has simultaneously published two documents which now represent the ATO’s views on the application of the arm’s length debt test (“ALDT”) in determining borrowing capacity.

• TR 2020/4: thin capitalisation – the arm’s length debt test is now the ATO’s authoritative ruling on the ALDT though it focuses on key technical interpretative issues rather than setting out a practical approach.
• PCG2020/7: ATO compliance approach to the ALDT outlines the ATO’s compliance approach to the ALDT, and includes a colour-coded risk assessment framework.

Taxpayers who apply (or are considering applying) the ALDT in determining their maximum allowable debt for thin capitalisation purposes should consider both documents.

As mentioned in our earlier article , groups relying on the safe harbour debt amount that have been adversely impacted by COVID may wish to consider relying on the “simplified ALDT” approach which will be less onerous than a typical analysis.

ALDT within thin capitalisation regime

The aldt is generally an under-utilised option under the thin capitalisation rules – with the vast majority of australian multinational entities relying on the safe harbour debt amount..

Broadly, the ALDT requires a notional amount of debt to be determined (having regard to certain prescribed “factual assumptions” and “relevant factors” relating to the Australian business) that satisfies two requirements:

• the notional amount of debt would reasonably be expected to have been provided to the borrower from the perspective of independent commercial lending institutions (“CLIs”).

As a general observation, the ATO is known to have had concerns about groups relying upon the ALDT due to a perception it has been misapplied – though it is an option which is statutorily available to taxpayers to rely upon subject to meeting the requirements. For some groups, it may become a necessity, if existing leverage is to be retained in the face of balance sheet pressure arising from COVID-19.

Taxation ruling on ALDT – TR 2020/4

This ruling largely reflects the same principles as set out by the ato in its earlier draft ruling from august 2019. it again reaffirms that tr 2003/1 (which sets out a six-step approach to applying the aldt) has been withdrawn and is replaced by a combination of tr 2020/4 and pcg 2020/7..

Some of the key points in this new ruling are as follows:

• If a borrower “could” take on more debt, this does not mean it “would” (as the legislation requires). A borrowing decision of the entity will be influenced by the overall cost of funding and the need to ensure an appropriate return to equity investors.
• Put another way, the ALDT does not allow identification of the highest debt amount that could possibly be taken on – the amount of debt must be probable.
• There are important differences between the arm's length principle as expressed in the transfer pricing rules and how it is expressed in the thin capitalisations rules. For example, for purposes of the ALDT,  the borrower should be considered on a standalone basis, without regard to its status as a member of a global group 1 . For instance, any explicit or implicit parental support must be disregarded.
• The assessment of the ALDT (including factual assumptions and relevant factors) must occur annually and could change.

TR 2020/4 applies to years of income commencing both before and after its date of issue.

Ato compliance approach - pcg 2020/7, the primary purpose of pcg 2020/7 is to provide guidance to entities in applying the aldt. secondarily, it also provides a risk assessment framework that outlines the ato's compliance approach to the aldt depending on where a taxpayer falls within this framework..

The ATOs view in the PCG is that there are limited circumstances in which an independent Australian business would gear in excess of 60% of its net assets, outside specific industries. Therefore, where the ATO is concerned that either the arm’s length debt amount is too high or, from its own data and analysis, that the application of the ALDT is inappropriate, it will apply compliance resources to review a taxpayers assessment of the ALDT. 

Against this, it should be remembered that the statutory scheme allows taxpayers to choose which thin cap option provides them with the greatest borrowing capacity – and the ALDT is a legitimate option. Undoubtedly though, groups wishing to do so should engage in a considered analysis of the ALDT. For instance, it is quite clearly insufficient to simply provide evidence that a bank was prepared to lend the amount of debt drawdown.

PCG 2020/7 applies to years of income commencing on or after 1 January 2019 2 .

Guidance in applying the ALDT

The guidance in PCG 2020/7 sets out what the ATO considers to be an appropriate approach to applying the ALDT.  However, it also states that such guidance represents a minimum standard with respect to the level of analysis and evidence the ATO expects of a comprehensive and robust analysis 3 .

The PCG devotes 30 pages to describing its approach, including:

• How to determine arm’s length terms and condtions with respect to any debt interests that would reasonably be expected to have applied if the entity and the CLIs had been dealing at *arm’s length with each other;
• How to determine an amount of debt the notional Australian business would reasonably be expected to borrow and CLIs would reasonably be expected to lend having regard to all relevant factors; and
• Providing a worked example (although caveated by the ATO saying that the example does not reflect the detailed level of analysis or evidence required 4 ).

Where there is insufficient evidence presented to the ATO to support an entity’s arm’s length debt amount, the Commissioner may seek to amend the entity’s assessment to substitute an alternative debt amount.

ALDT risk assessment framework

The ato’s risk assessment framework in pcg 2020/7 contains a familiar colour-coded ratings table.  however, unlike unlike the “low risk” zone in other pcgs..

The “low risk” zone in PCG 2020/7 will not include many groups as it broadly comprises (i) inbound debt solely from unrelated parties which is not guaranteed by a related party, (ii) debt issued by ASX-listed entities; and (iii) debt issued by regulated utilities groups.

At the other end of the spectrum, the “high risk” zone includes entities that have no performed an ALDT consistently with the guidance provided in the PCG or there are arrangements with two or more of the following:

• subordinated cross-border related party debt comprises more than 25% of the notional Australian business' debt capital
• two years of positive (unadjusted) earnings before interest and tax (EBIT) and negative profit before tax (PBT) during the previous five-year period.

Significantly, entities falling within the “high risk” zone are not eligible to enter the ATO’s Advance Pricing Arrangement (APA) program. Further, the ATO has also indicated it is likely to use its formal powers for information gathering 5 .

In between, the “ medium risk ” zone is only available to taxpayers that have performed an ALDT consistently with the guidance provided in the PCG and where facts and circumstances pertaining to the high-risk zone are not present.  However, even in such cases, the ATO says it may apply compliance resources to review a taxpayer’s ALDT analysis.

Practically, if the ALDT is applied on related-party debt (or third-party debt with a related-party guarantee) , the position will automatically be considered at least medium (provided it is not “high risk”) irrespective of the debt quantum or gearing level. The ATOs reasoning behind this approach is that because an ALDT assessment requires a robust and complex analysis, it, therefore, poses a high risk of non-compliance.

RSM Insights

PCG 2020/7 adopts a one size fits all approach as no consideration is given to whether the relevant entity is a small-medium multinational enterprise ( SME ) or a significant global entity ( SGE ).  As such, a significant compliance burden could arise for SMEs seeking to apply the ALDT in the way described in the PCG.

The range of low-risk arrangements is narrow and the majority of taxpayers seeking to apply the ALDT are likely to fall in categories where the ATO states it will apply compliance resources to review their position.

In this respect, entities that perform an ALDT consistently with the guidance provided in the PCG should be mindful that they are unlikely to be rated lower than “ medium risk ”.  As such, the likelihood of ATO compliance activity cannot be disregarded. 

This does not mean that taxpayers' reliance upon the ALDT is unsupportable and the ALDT cannot be utilised. However, it does mean that taxpayers should anticipate potential ATO review and maintain robust evidence to support their reliance upon the ALDT. The PCG shows how the ATO expects this be done.

Reliance upon the ALDT, therefore, becomes a matter of risk appetite.

At a level of detail, the potential need to perform different arm’s length analyses under the thin capitalisation rules and the transfer pricing rules adds to complexity and will increase compliance costs.

Finally, early balancers who have lodged income tax returns for the year ended 31 December 2019 and have relied upon the ALDT should review their positions in light of PCG 2020/7.

HOW CAN RSM HELP?

If you have any questions regarding the Arm's Length Debt Test, please contact your local RSM tax expert.

1. By contrast, membership of a global group was a relevant factor for purposes of the hypothetical independent entity in the transfer pricing rules considered in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62 at [62].

2. Six months earlier than was indicated in the PCG 2019/D3.

3. PCG 2020/7, paragraphs 13 and 51.

4 . Ibid, paragraph 185.

5 . Section 353-10 of Schedule 1 to the Taxation Administration Act 1953 .