Cancellation of Debt, Bad Debts, Bond Buy-Back and Debt Restructuring
18 June 2020
Dear Friends and Colleagues,
In view of the recent economic slowdown in Israel as a result of the damages caused by the Coronavirus, we recently have been seeing businesses that need to address questions relating to non-repayment of debts and the resulting tax consequences.
In many cases, a business that is unable to repay its debts may discover that it now owes a new debt to the Israel Tax Authority (the “ITA”), while in other cases businesses that are not aware of their rights fail to claim tax benefits due to debts not repaid to them by costumers or other debtors.
This Client Alert briefly reviews some the relevant legal provisions and presents considerations that should be taken into account in these trying times.
Cancellation of Debt
The Income Tax Ordinance (New Version), 5721-1961 (the “Ordinance”) provides that a person will be subject to tax on cancellation of debt (“COD”), if such debt was recognized as an expense when recorded or was used to generate income.
Israeli case law discussed in length over the years the issues relating to COD income and the circumstances in which a business will be subject to tax for COD. Israeli courts have ruled in several cases that COD, whether explicit or implicit from the behavior of the parties, requires action on part of the creditor. The fact that the debtor is unable to repay its debt is not enough to subject it to tax as COD, as long as the creditor does not forgive the debt.
In many cases, and especially with respect to debts of related parties, the ITA argues that the mere fact that the debt was not repaid constitutes taxable COD. This position was rejected by Israeli courts in several occasions, considering the specific circumstances of each case and the conduct of the parties.
Furthermore, there may be cases in which the creditor recognizes an expense or loss due to bad debt, because it concluded that under the circumstances there is no chance that the debt will be repaid, but the conditions for recognition of COD are still not met, because the creditor never forgave the debt but only reluctantly gave up on collection.
It should be noted that COD may be subject to VAT as well, to the extent it stems from a debt that was not subject to VAT when recorded (suppliers’ debt). However, in many cases involuntary COD, which is the result of the debtor not being able to repay the debt, will not be subject to VAT.
Bonds and Debt Restructuring
In the context of COD taxation, attention should be given to the 2010 ITA’s published position (published on the backdrop of the 2008 financial crisis) with respect to buy-backs of bonds and debt restructuring.
The ITA views a buy-back of bonds as a taxable event for both the issuer company and the bond holders. In this respect, it should be noted that according to the ITA, a portion of the income resulting from the buy-back can be classified as financing income, unless the company explicitly requested to treat it as COD income. This matter may have implications with respect to the company’s ability to utilize business losses to offset income from bonds buy-back, and it is recommended to examine this issue in advance and approach the ITA if it is relevant. In addition, a buy-back of a bond by a subsidiary may, in certain circumstances, allow the tax event to be postponed until the bond repayment date.
With respect to debt restructuring, which allows for a partial or full repayment of bonds, that was approved by an Israeli court, the ITA has confirmed, in light of the need not to overburden a distressed company with tax liability, that companies can apply for a settlement in which carried over losses will be utilized and tax basis in assets will be reduced against a portion of the company’s COD income.
In light of the unique circumstances of the Coronavirus crisis, and the declared policy of the Israeli Government to ease the cash flow of businesses during this difficult time, we believe that there is room to approach the ITA to receive Tax Rulings that reduce the tax liability that results from debt restructuring and COD, in accordance with the principles outlined by the ITA after the 2008 crisis.
Change in Loan Terms
In some cases the debtor and creditor decide to change the terms of an existing loan, in order to allow repayment of the loan without completely forgiving the loan amount (a “haircut”). However, an extensive and material change to the terms of a loan may be considered as a redemption/repayment of the loan and issuance of a new loan.
In this context, we recommend to our clients that are required to change the terms of an existing loan to act with caution and seek preliminary advice with respect to potential tax consequences. In some cases, the parties may have other alternatives that are commercially viable, which will allow relief with respect to the terms of the loan, that does not constitute a taxable material change in the terms of the original loan.
Cross-border financing transaction between related parties are required to be made in arm’s length. The international nature of the Coronavirus crisis, the expansionary monetary policy taken by some countries, the downturn in income of certain economic activities and the depreciation in value of certain assets may create a situation in which certain existing loans do not meet the arm’s length standard, whether because interest rate on the loan is too high or too low.
We recommend to our clients that have cross-border financing schemes with related parties in place to reexamine their transfer pricing policy with respect to these transactions, in order to ensure compliance without paying excess tax.
The Ordinance provides that bad debts generated in the context of business activity be recognized as a deductible expense. Bad debts not generated in the context of business activity (e.g., certain loans to related parties) may be recognized as capital losses. In addition, dealers may reclaim VAT paid when the debt was first recorded.
We recommend to our clients to review the status of their receivables in order to determine whether bad debts should be recognized. It should be made clear that a taxpayer is allowed to deduct an expense for a bad debt even if it did not surrender its claim to collect the debt, and the Ordinance includes explicit provisions with respect to the recognition of income for debt collected after previously been recognized as bad debt.
Our tax department is available and will be happy to advise on the above matters and to assist with applications to or discussions with the ITA. This Client Alert should not be construed as providing tax advice, which depends on the facts and circumstances of each case.
We wish you and your loved ones health and prosperity in these troubling times.
Herzog Fox & Neeman