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The Analysis for England and Wales includes articles on Revenue Based Finance – Equity and Revenue Based Finance – Debt
Investment Structure Summary
The regime for equity financing in England and Wales (“E&W”) is a flexible one where the shareholders may decide the rights and obligations adhering to shares in the articles of association or even in a separate shareholders’ agreement.
A company is able to have different classes of shares with different rights attached to them. In this case the investor could benefit from holding preference shares that would guarantee a distribution on a revenue basis (as would need to be set out in the articles of association).
In relation to a liquidation, shareholders shall only be paid after all creditors and debts have been satisfied. This would mean that a company that does not have enough assets to satisfy creditors would then not be able to pay its shareholders. If the shareholder holds preference shares, then the amount due in relation to these would be paid in priority to the ordinary shareholders.
Category
Debt
Category for tax purposes
As a basic matter, the UK tax system treats debt and equity differently. In broad terms, payments on equity are treated as distributions of profit and therefore not deductible in computing the taxable profit of the issuer. By contrast, finance expense incurred on a debt instrument is generally treated as a cost of earning profit, and therefore taken into account to reduce taxable profit. Correspondingly, for the holder the return on an equity instrument is usually exempt from tax whilst the return on a debt instrument is usually taxable.
The UK tax code contains rules designed to police the boundary between debt and equity for these purposes. Pursuant to those rules, loans or debt instruments the return on which varies in line with the performance of the borrower’s business are taxed, in broad terms, as equity instruments rather than debt instruments.
Please see ‘Critical Tax Considerations’ section for the key tax consequences of these rules.
Governance Rights
Governance rights under the law of E&W are flexible and dictated by what is set out in the articles of association or a shareholders’ agreement (if there is one). Investors may be granted any one or more of the rights referred to). However we would not expect revenue based lending to carry with it any particular governance arrangements/ rights.
Any upside or equity linked rights that are linked to the investment (such as warrants) would carry the same governance rights as attaching to the equity once crystalized, and may also benefit from shareholder – like consent rights in particular to protect against dilution.
Investor Qualification Requirements
A shareholder can be based anywhere in the world, they do not need to live in the UK. Foreign controlled companies or owners are treated the same as UK-owned businesses and individuals for the purposes of investment (subject to competition law and regulatory approval for large UK entities and government controlled industries such as transport and energy).
Currency Considerations
Shares in a limited company may be denominated in any currency, and different classes of shares may be denominated in different currencies.
Collateral
Whilst an equity investment may have the right to receive distributions and payments ahead of other shareholders (in particular preference shares) such an investment is not typically secured as no debt claim arises. Collateral can be granted as security for performance obligations as well as debt obligations so it is feasible for an agreement to turn over revenue to be secured in a an asset, but that is certainly not typical.
Priority Payment Rights
As noted above an investment may be made by way of preference shares, with the rights of the preference shareholder rights set out in the borrower’s articles of association. The preference shares’ rights could be paid at a fixed rate if the directors deem there are profits available for distribution.
The articles of association or the relevant shareholders’ agreement may include a liquidation preference. The aim of the liquidation preference is allowing the investor to recover the invested amount (or a multiple of the invested amount) with priority over the rest of the shareholders. However this preferred return will still be subordinated to debt claims.
Distribution and Redemption Limitations
Conditions relating to distributions will be set out in the articles of association and in any case may only be made out of profits for the purpose as verified in the relevant company accounts.
The relevant company accounts are either: (i) the last annual accounts, (ii) interim accounts or (iii) if the company is declaring a distribution during its first accounting reference period then the distribution shall be made in reference to its initial accounts.
There are no restrictions on timing of distributions as these can be paid by decision of the board of directors.
Legal limitations to pricing or total return
N/A
Status in Insolvency Proceedings
In a winding-up scenario, the company’s debts owing to its creditors (preferential, secured and unsecured) must be settled first and then the shareholders of preference shares shall be paid in accordance with the articles of association or shareholders’ agreement.
Limitation of Liability
If the company that the shareholder invests in is a limited liability company then the shareholder’s liability is limited to its committed investment.
That means they are only responsible for company debts up to the value of any shares, (assuming no personal guarantees have been signed).
An investor may be considered a shadow director if it, not being formally appointed a director, directly has authority over how the company is run.
Transfer Restrictions
Transfer restrictions will be dependent on the type of company that is being invested in and the articles of association in force. If the company is a private limited company, there are few restrictions in place
Critical Tax Considerations
We have confined our commentary below to the UK tax considerations relevant to the revenue-linked feature of the lending (as opposed to providing commentary on UK tax considerations that arise on lending transactions generally).
The main UK tax considerations include:
- Non-deductibility for UK corporation tax purposes for corporate borrowers:
- Distribution treatment. In general, any amounts paid on securities where the consideration given by the issuer depends to any extent on the results of the issuer’s business is not deductible when calculating a company’s profits subject to UK corporation tax. There are exceptions to this rule, including where the results dependency is an inverse ratchet or where the payee is subject to UK corporation tax on the return on the debt security.
- Transfer pricing and thin capitalisation rules. To the extent that the results dependency of the return to the holder suggests that the debt fulfils an equity-like function and so the amount invested is not an amount that would at arm’s length have been loaned to the company (i.e., the company is thinly capitalised), it may be that a deduction is denied on that basis under the UK’s transfer pricing rules.
- Anti-hybrid rules The UK’s hybrid mismatch rules target certain arrangements that give rise to tax mismatches, typically on cross border transactions. To the extent that the return on a results dependent loan is characterised as equity in the lender jurisdiction and therefore not subject to tax, that may give rise to a denial of a deduction for the borrower in the UK.
- De-grouping charges:
The revenue-based feature of the loan may cause the borrower to be excluded from a UK tax of which the borrower would otherwise form part, which can in turn lead to de-grouping charges (for example, in circumstances where real estate or other assets have been transferred between group members on a tax neutral basis before the results dependent loan is put in place)
- Stamp duty considerations:
Loan capital is generally exempt from UK stamp duty but there are certain exceptions to this exemption, including where the loan capital carries a return related to profits (that is not an inverse ratchet).