Restructuring of liabilities: Tax effects

1. Introduction

During the 90´s several companies took out debt issued in foreign currency. In the current situation, some companies find difficulty in fulfilling the commitments assumed in the originally agreed terms. This is why they are exploring different alternatives to restructure their debts.

This refinancing embraces traditional concepts like waiving and releasing, reducing stays, and other more sophisticated mechanisms such as debt cancellation according to the excess of cash held, releasing subject to the fluctuation in the quotation of foreign currency, or a combination of the foregoing.

Each of these alternatives has a tax impact that must be analyzed in depth before ending the restructuring scheme. We summarize some of the most common tax effects below.

2. Some relevant considerations

Interest capitalization of a debt may generate withholding to the foreign beneficiaries. Depending on how the capitalization occurs, it can be assimilated to a release or generate income for issue of shares at a premium.

In turn, the release can involve an income subject to tax to the beneficiary company and a deduction for the creditor. In releases subject to condition, this income or deduction is postponed.

Refinancing including contingency payments of capital and interests can be assimilated to financial derivatives, so there is a variation in the taxable treatment.

3. Alternatives

3.1 Capitalization of debts

If the credit is capitalized by a foreign creditor, the issue whether such capitalization can generate an Argentine income tax withholding in the interests obtained by the foreign creditor must be reviewed. The party liable for withholding the local company is triggered when a payment is made in the terms provided by the Income Tax Law(LIG).

A “payment” is deemed made if there is:

(a) Availability of funds for the creditor

(b) Tacit and express creditor´s option concerning the funds destination (such as capitalization, reinvestment or deposit in a bank account).

Nevertheless, the term “availability of funds” is a controversial issue in jurisprudence. Some precedents established that in order to have an obligation to withhold there must be an effective delivery of goods, so that the recipient may dispose of it. Lack of funds, delay in payment to the suppliers, extension of terms the local company asked for tax payments and the non distribution of dividends have been considered indicators of the lack of “availability of funds” of the foreign creditor (See: “Cía. Argentina Sydney Ross S.A.”). Nevertheless, in another precedent it was established that “Interest capitalization is deemed as such if the plaintiff included interests accrued in the capital indebted amount arising from a loan contracted overseas at the end of each month, as provided in section 17, subsection b) of Law No. 11,862, which is equivalent to the payment over which the withholding must be made.” (“SA Destilerías y Bodegas y Viñedos El Globo Ltda.”, TFN, 03/11/75, DF. XXVI, 475).

Due to the economic situation that many Argentine companies are experiencing, they capitalize because they cannot pay their debts. This circumstance entails the analysis of the issue whether interest is put at the creditor’s disposition, and whether there is a “payment” in the terms provided in Income Tax Law (LIG).

This analysis must be complemented with the possibility of the local company to deduct interests . Interests are deductible, in general terms, when they are accrued.

Nevertheless, when the creditor is a related party overseas creditor, the Argentine company can deduct the interest only when it pays them to such related party. If the income tax withholding is not be made with respect to the foreign beneficiaries because there is no payment, then interests would not be deductible for the local company.

Cancellation of liabilities through capitalization eliminates the possibility to allocate future negative exchange rate differences. The capitalization has effects in other taxes:

(a) Personal assets tax increases. Taxes of foreign shareholders at a rate of 0.5%, for the shares of Argentine companies held as of December 31 of each year on the increase of the proportional patrimonial value of the local company.

(b) In general terms, the local company must pay 21% or 10.5% to the tax authority upon expiration of the interests. The amount paid is generally allocated by the local company as a tax credit in the following month‘s tax return.

If the capitalization is made at a price lower than the credit, there may be a release. Likewise, if the shares are issued at a higher price than the par value with issuance premium, the issuer is exempt from income tax.

3.2 Release of debts and Interests

In accordance with the Income Tax Law, the release of interest or debts by foreign shareholders are not deemed to be “payments” and, therefore, no withholding must be made to foreign beneficiaries. Since there is no "payment", interests cannot be deducted by the local company (Ruling DAT No. 51/2002).

In some precedents, the tax authority has interpreted that the release of debt implied a gratuitous patrimonial acquisition of welath for the local company. Law No. 25,239 repealed the exemption provided for this kind of enrichment in Income Tax Law and so, in general terms, this kind of earning would be subject to tax.

The release of interest or debts are not always deductible for creditors. The Income Tax Law sets forth some events that must have occurred, for creditors to be entitled to deduct bad debts. Gifts are nondeductible. If the release were partial, it could probably be argued that it is not a gift, but a current cost that allows future taxable income to be obtainable. If the release were total, the possibility of a deduction would be much more uncertain.

3.2.1 Reorganization Proceedings

Net income originated in the definitive releases of liabilities at a judicial approval of a reorganization proceedings set forth in Law No. 24,522, as amended, can be proportionally allocated to the fiscal years in which the agreed reorganization installment payments are due. Net income may be also allocated in the four subsequent fiscal years ending after the definitive judicial approval date, if approval date occurs before.

In accordance with the option explained above, the maximum chargeable net income amount may exceed the difference between the release amount and the accumulated fiscal loss amount as of the beginning of the foregoing approval date (in accordance with Decree No. 2340/2002, applicable for fiscal years ending after November 19, 2002.)

3.3 Payment Deferrals

In principle, payments deferrals do not have tax consequences.

3.4 Debt Restructuring subject to condition

In some debt restructuring processes, the parties have agreed to certain releases of principal and interest subject, for example, to the evolution of the U.S. Dollar quotation. In general, companies determine their earnings and costs by applying the "accrued criterion" and earnings or costs are interpreted as not accrued as long as they are still subject to a condition not verified. Therefore, conditions may be useful to postpone the recognition of earnings and/or deductions derived from such debts releases.

In other schemes, there are contingent payments of principal and interests to be accrued. These circumstances can be regarded as operations similar to the refinancing of a financial derivative, and this event would radically change the applicable tax framework. For example, payments made to foreign countries for derivatives are neither subject to withholdings, nor to Value Added Tax. These payments have special deduction restrictions.