Much coverage is being given to “Vulture funds” acquiring Irish distressed debt at the moment and this article will not seek to cover much of that ground. The ground it will cover is the tax consequences for a small or medium company having their debt sold by the bank to a special purpose vehicle, and what steps they urgently need to take to keep themselves out of trouble with the tax man.
It is worth noting that the issue is not being caused by the funds acquiring the debt, although that acquisition is the trigger. Its cause is a combination of badly drafted tax law and standard form loan documentation which the foreign investor bought as part of the loan book. International funds may not even be aware of the issue for Irish SME borrowers and it is to be hoped that the matter can be fixed in this years’ Finance Bill.
The normal course of events
Most small or medium businesses borrow off two sources, banks or related parties. Loans from directors or related companies are usually interest free whereas loans from the bank usually carry interest.
Those of us used to dealing with cross border transactions and large groups are quite used to interest withholding tax, whereas most SMEs and their advisers are not.
What Irish tax law says is that interest paid by a company is generally subject to 20% withholding tax. If Company A borrows off Company B and interest of 100 per annum is due, Company A must pay 20 to the Revenue Commissioners and 80 to Company B. Company B can then credit the 20 against their tax liability and recover any excess off Revenue.
However, where Company B is a bank this withholding tax does not apply. Company A pays the full 100 to Bank B. And because small companies generally only borrow off the bank, they think the general rule is that interest is paid gross, as distinct from the general rule being that interest is paid net of 20% tax subject to a number of exceptions of which a regulated banking entity is one.
Other exceptions include interest paid to group members, certain foreign companies with which Ireland has an effective tax treaty, along with a number of others.
There are two others of crucial importance here. The first is that interest may be paid gross to a company within the meaning of the Taxes Consolidation Act 1997 s110, and the second is that the interest may be paid gross where the prior consent of the Revenue Commissioners has been sought and granted.
There are a couple of points to note about debt sales by banks to foreign funds. The first is that in many cases the bank restructured the loans before they were sold. Given the disparity in bargaining power this is possibly something which the Central Bank should have kept a closer eye on when many SMEs fall under consumer protection legislation.
The loans now generally provide that the lender is to be paid a specified amount, and that if any tax applies the SME must pay more interest so that the lender receives the same amount. This is called a “gross-up clause” and generally it should not be included where the lender can recover the tax off the taxman, only where the tax is irrecoverable. But in many SME loans it now includes recoverable tax meaning the lender is indemnified against a loss which they don’t have to bear.
Using the above example of interest of 100, if Bank B now sells the debt to Company C, Company A must now gross up the interest under the gross-up clause. This means that it has to pay 125 of gross interest, 100 to Company C and 25 to the Revenue Commissioners. Company C can then recover this 25 of tax off the Revenue Commissioners in so far as it exceeds their tax liability. The net effect is that the interest rate has just increased by 25% from the point of view of the borrower. The income of the company which bought the debt has just increased by 25% too. And all because the bank sold the loan book to a non-banking entity without due consideration of the practical implications of our tax laws.
The second, and related point, is that in most cases the SME had no visibility to the sale. They simply received a letter from an asset manager informing them that they were now to pay the interest to the asset manager on behalf of a named special purpose company (“SPV”) which had acquired their debt. Certainly none of the letters which I have seen alert the SME to the potential tax consequences of doing so.
Shouldn’t the SPV/ Asset Manager tell the SMEs there’s a problem?
But there may be a very good reason why the letter doesn’t alert the SME to the problem. One of the exceptions to the withholding tax rule is that interest can be paid gross to a company within the meaning of s110 of the Taxes Acts. Tax structuring logic dictates that many of the special purpose vehicles bought to acquire Irish debt will have made an election to be treated as securitization vehicles within the meaning of s110. So the special purpose vehicle could hold the view that no withholding applies because it has made this election, the asset manager who interacts with the SPV could hold the same view, which leads us into the problem of the badly worded tax law.
The party who bears the risk for not operating the withholding tax is the borrower, the SME. And the SME cannot know whether the SPV is a qualifying s110 company. Revenue will not generally confirm to the SPVs themselves that they are treating the s110 election as valid. It would be literally criminal for Revenue to confirm that information to the borrower, since it would involve sharing details of the tax affairs of a third party (the SPV).
Which means that in order to comply with tax law the SME has to withhold. But due to the gross-up cause this has the effect of increasing their interest rate by 25%. Since compliance with the terms of the s110 election is under the control of the purchaser of the debt, if there was any parity of bargaining power the gross up clause should not have been included in the loan documents, since the purchasing entity can control whether withholding tax should apply.
Even if it does apply, it should be recoverable for the fund and thus it seems unconscionable that it should increase the cost of the debt for an SME when the trigger for the tax is not only completely outside their control, but under the control of the entity which acquired the debt.
If the acquiring entity agreed to warranty that they would be making a s110 election and that they would comply with the terms of their s110 election, and indemnify the SME against any withholding tax risk this would be the reasonable position.
Such a warranty without an indemnity would be worthless since the SME cannot rely on it against Revenue, even with an indemnity it could be valueless since the SPV could be liquidated by the time a Revenue audit or due diligence identifies the issue a number of years down the road.
However, as things stand, the debt was renegotiated before the SPV came into the picture, so it couldn’t give warranties, as it wasn’t a party to that contract. The SME had no bargaining power, so it is unlikely that the bank would have provided clauses to protect the SME which a purchaser of the debt might object to if they wanted to use a different acquisition vehicle. Leaving the standard form loan documents exacerbating this issue via the gross up clause.
Many SMEs are paying the interest without realising they should be paying the tax man, and they are potentially at risk for tax, the interest and penalties. This risk could be identified many years in the future, after the SPV in question has been liquidated.
If the SME start paying the tax, a gross-up clause will increase their interest rate, and the tax will be recoverable by the SPV, hurting the SME who was just getting back on their feet.
Is there anything to be done?
Yes. While in an ideal world this should have been dealt with via the loan documentation by removing the gross up clause since an Irish SPV could recover the withholding tax and therefore should bear the risk, this seems impossible at this stage. However, Taxes Consolidation Act s247(3)(d) allows a company to pay interest gross with the prior written consent of the Revenue Commissioners.
SME companies whose loan has been sold to a non-banking entity should review their loan documentation. If neither the loan agreement nor any supporting documentation include a gross-up clause they should start operating withholding tax. But as the operation of the withholding could put them in breach of their loan or covenants if there is a gross-up clause care needs to be had here. If the loan documents contain a gross-up clause they should write to their local tax office seeking to invoke this provision. If unsure as to whether the loan contains a gross-up clause Revenue consent to pay the interest gross removes all risk for the SME and should be sought.
This provision does not require that the Revenue Commissioners tell the company anything about the tax affairs of the lender, it simply gives them the power to authorise gross payment of the interest. Since one would assume that most SPVs set up by international investors would have excellent compliance records, there seems to be little need for Revenue to insist on the withholding tax being applied.
It should be hoped that the Finance Bill should clarify the scope of the s110 exemption from withholding tax. As drafted it operates for related companies who can know the lender is a qualifying s110 company, but it cannot work for third party borrowers who cannot get any certainty as to the tax status of the SPV. If instead it applied to companies who certified, on a specific form, that they did qualify as s110s and bore the associated risks of completing that form incorrectly, then this issue could be resolved by removing the risk for the SME while creating a small administrative burden for the asset managers and international investors.
In the current climate of pouring opprobrium on the “vulture funds” the last thing which foreign investors want is to be blamed for causing additional hardship for Irish SMEs when the problem lies in a combination of bad tax law, and unfairly worded contracts.