Old rules: loan relationships: connection and bad debts: creditor in debt/equity swap
Exchange of debt for equity
This guidance applies to periods of account beginning before 1 January 2005
Where a borrower is in difficulties, a creditor may take shares in the borrower instead of a repayment. This is usually called a debt/equity swap, and may be part of a corporate rescue.
The value of the shares may be less than the amount of debt outstanding, but as part of the arrangement the creditor discharges all liabilities.
For example, JH Ltd lends £100,000 to KF Ltd. KF Ltd gets into difficulties and JH Ltd agrees to accept 500 x £1 shares in full and final settlement of the debt. Because of the poor state of KF Ltd, these shares are only worth £1,000.
The treatment for accounting periods starting before 1 January 2005 was very similar to the current rules. If the companies were not connected, before or after the debt/equity swap, the creditor could have relief for the amount released (£99,000 in the above example) under the authorised arrangements for bad debt. If the companies were connected - including becoming connected simply because of the exchange - FA96/SCH9/PARA6 would have applied to disallow relief. For example, the creditor could acquire a controlling shareholding in the debtor company because of the swap.
This might have discouraged rescues from taking place, so FA96/SCH9/PARA6(4) and FA96/SCH9/PARA6(5) allowed limited bad debt relief where the creditor satisfied certain conditions.
Current guidance in this area can be read at CFM35370 onwards.