Negative banking covenants - a case review
14 January 2009
Companies are taxed on amounts arising from their loan relationships under the loan relationship rules in Finance Act 1996. The tax treatment usually follows the accounting treatment, but special rules apply where the parties are connected. One of these special rules provides that the debtor under a connected party loan is not required to recognise any taxable income on the release or partial release of the debt, regardless of the accounting treatment.
In Fenlo Limited v Revenue and Customs Commissioners  STC (SCD) 1245 the Special Commissioners considered an argument by the taxpayer that corporation tax was not payable on the profit element of a partial loan release between a lender and borrower because they were "connected". A simplified version of the facts is follows.
The appellant taxpayer bought and converted adjacent residential properties into a hotel using monies borrowed over a number of years from a Mr. Yip, an individual otherwise unconnected with the taxpayer. The taxpayer subsequently entered a facility agreement with another company, ultimately controlled by Mr. Yip, along with a debenture charging its undertaking and assets by way of security for the loan.
The money was drawn down under the facility to repay Mr. Yip, leaving an outstanding indebtedness under the facility agreement of £1,200,000 on which interest was payable. The hotel was not a financial success, and after defaulting on the interest payments the taxpayer managed to settle its liabilities to the lender under the facility agreement by paying £650,000 in full settlement in 2003.
The taxpayer's financial statements for the year ended 31 March 2004 showed an exceptional item of profit of £1,072,333, being the balance of the loan released by the lender.
The taxpayer argued that the release of the balance of the loan took place in an accounting period in which the lender "controlled" the taxpayer for the purposes of section 87A of Finance Act 1996. The latter provides that "control" means, among other things, 'the power of a person to secure by virtue of any powers conferred by the articles of association or other document regulating the affairs of the [taxpayer] company that the affairs of the [taxpayer] company are conducted in accordance with his wishes'.
The facility agreement contained a series of negative covenants restricting the taxpayer's ability, for example, to change the nature of its business activities, pay its officers/employees excessive remuneration, declare or pay dividends or distributions, dispose of its assets, borrow further money or grant security over its assets to anyone other than the lender.
The taxpayer argued that because of these negative covenants the facility agreement was a document giving the lender control of the taxpayer's affairs for the purposes of section 87A.
The Special Commissioners rejected the taxpayer's argument. The covenants in the facility agreement were restricted in scope, negative in nature and were standard in agreements governing highly geared secured loans of this nature. Their purpose was to protect the financial interests of the lender by ensuring, among other things that its security was not diminished, that value did not leak out of the borrower and that reliable financial information was provided so assist in its monitoring of the loan.
Corporation tax was therefore payable on the profit element realised by the release of the balance of the loan.
While the decision may not be good news for debtor companies in financial difficulties, it is not particularly surprising. The influence the lender had over the taxpayer, common in finance transactions of this sort, was limited.
Most taxpayers and commercial lenders would probably assume that such limited influence would not be sufficient to constitute "control" for these purposes. This decision may also be useful in other contexts, such as EIS relief, where "control" can prevent the tax relief from applying.