The Japanese Ministry for Economics and Industry (keizai sangyousho/経済産業省) has sponsored a private research group (the ‘DES Research Group’) to look at the taxation of debt equity swaps (DES). One issue which they focus on is the uncertainty around the valuations used in the transactions concerned.
The DES Research Group published their report in January. Below are notes on the report written by the author of this post. The report which includes a useful summary of the history of tax reform in the area and the group’s proposals. Future postings will look in more detail at the taxation of DES and other corporate reconstruction transactions.
DES – definition and comparison with debt abandonment
A DES is the exchange by a creditor of debt issued by a debtor for shares issued by the debtor. From the point of view of the debtor, its debt is converted to equity capital. The report notes the fairly obvious benefits of a DES compared to an abandonment of debt (saikenhouki/債権放棄): Involvement in management as a shareholder, maintaining a relationship with the debtor company, possiblity to earn income and capital gain and through the existence of voting rights the reduction in moral hazard. However valuations in the transaction for tax purposes are uncertain and the use of DES has, along with a temporary economic recovery, decreased.
History of DES transactions in Japanese tax reform
Japanese tax has seen a range of modernising reforms in recent years, including reform in the area of taxtion of corporate recovery as well as in the more well known areas of corporate reorganisation and tax consolidation. These are noted in the report as below:
2005 – establishment of the tax system for corporate recovery
A key Japanese tax issue in corporate recovery transactions is mitigating taxation on gain arising from the release of debt (saimu menjo eki/債務免除益) in the relevant corporate reorganisation plan by offset against either the realisation of embedded losses on assets (hyoukason/評価損), the (indirect) use of expired tax losses (kigenkire kessonkinn/期限切れ欠損金) or the use of carried forwared unexpired tax losses (aoiro kessonkinn/青色欠損金/Blue Form Tax Losses or NOLs). Tax reforms in this year established the system that allowed the offset of exipred tax losses ahead of current NOLs and the recognition of embedded losses on assets provided certain conditions were met, as noted below:
- The corporate reconstruction plan is prepared in accordance with general, publically issued procedures for dealing with debts (see below)
- Appropriate asset valuation is carried out and a balance sheet produced in accordance with those valuations
- the amount of gain from debt exemption is determined based on the asset valuation under (2) above
- Two or more financial institutions abandon debts (or the RCC (seirikaishuukikoutou/整理回収機構等) alone abandons its debts)
Items (1) to (3) above require the approval of a third party institution (e.g. the court approving the balance sheet or an appropriate institution approving the corporate recovery procedures).
The above rules will clearly limit the scope of application of the tax reliefs to cases involving ‘real’ bankruptcy and exclude many intergroup reorganisations (unless a group is able and wants to go to the trouble of putting its subsidiaries through the above procedures). The reform also left a few gaps which were gradually filled as noted below.
2006 – DES related reform
Tax reform in 2006 recognised that the conversion of debt in DES transactions is in substance the same as debt abandonment. The reform accordingly recognised income from debt abandonment in debt equity swaps but also allowed its inclusion in the above framework allowing the offset of unrealised, expired and carry forward losses.
2009 – DES related reform and remaining issues
In the 2009 tax reform DES transactions were included in the scope of debt exemption transactions requiring two or more financial institutions – thus increasing flexibility in structuring transactions qualifying under those conditions. However, the problem remaining on which the DES Study Group focuses on is clarity around establishing the market value of debts in the DES transactions.
Scope of DES covered by the DES Research Group
Sensibly the DES Research Group has looked at both DES transasctions under court supervision and un-supervised “private” DES transactions that resemble court supervised transactions and are carried out under appropriate regulations. There seem to be a large number of “privately regulated” corporate reconstruction transactions to make one worried that economic decline is practically institutionalised in Japan. The Japanese Association of Turnaround Professionals would likely have a view on this. The main ones are:
- Reconstuction plans based on the guidelines for private resolution and related Q&A
- Reconstruction plans based on the procedures for corporate reconstruction with the support of the co-operative supporting the reconstruction of small and medium sized business
- Reconstruction plans based on RCC business reconstruction scheme
- Reconstruction plans following the procedures for alternative dispute resolution in corporate reconstruction
- Corporate reconstruction with the support of the institution for support of corporate reconstruction
Valuations for tax purposes in DES transactions
This is the main part of the DES Research Group’s deliberations. In outline the process for valuing debt and equity in a DES transaction within the scope of the report is as follows:
- make a logical estimate of the amount that can be recovered from the business under reconstruction
- based on the above calculation, split debts into those that will be retained and those that will be subject to the DES transaction
- decide on the market value of the debts that are part of the DES transaction
The shares that are acquired by the creditor in the DES transaction should be valued using the market value of the debts that are subject to the DES transaction. The results of the discussion of the DES Research Group around valuation are as follows:
Valuation of debts contributed in a DES
(1) A logical estimate of the amount of recoverable debts
For corporate reconstructions to which the special tax rules around corporate reconstruction apply then the normal practice is as follows. Ahead of the creditors meeting each asset and liability is valued according to prescribed valuation standards and a balance sheet reflecting the businesses actual position is produced. Adjustment to amounts owed to creditors is then made based on the excess liabilities shown and then looking at the expected gains or losses in the reconstruction plan the amount of debt exemption gain determined. Given that approach is based on the agreement between the business and the creditors this is seen as a logical approach for estimating the debts recoverable and the amount of debt forgiveness and hence CLTEO 24-2-1 with conditions for the application of the special tax rules for corporate rrecovery are based on this approach.
(2) Market value of debts subject to the DES transaction
A condition in the tax system for application of the special tax system for corporate recovery is that even when a DES is involved, the amount recoverable from the business is calculated in the same manner as if there was no DES but only debt forgiveness. Given this, the valuation of the debts subject to a DES is logically estimated based on the amount recoverable from the business and given the above process from the excess liabilities shown on the reorganisation balance sheet and considering future potential gains and losses from the business.
The report notes here that in cases where there is a transaction price for debts in the DES or for shares issued in the exchange (perhaps because there is still a secondary market for the debt) then from the point of view of the business the transaction is seen as a contribution of the debts (as an asset to be netted against itself as a liability) in exchange for the shares and accordingly there is a view that the debts should be valued with respect to the transaction value. However the DES Research Group does not accept this is always an objective and logical approach, especially in the rare circumstances of a corporate reorganisation to which the special tax rules apply. The report goes on to discuss other valuation problems arising from relying on market values or overall (DCF, income etc) ways of valuing the business including the fact that such valuations may include expectation of profits after the reconstruction period is over or may be influenced by rumours around the success or failure of the plan.
(3) Valuation of shares received in the DES for tax purposes
The report notes the very logical rule in CTLEO 119-1-2 that where marketable securities are acquired from the provision of assets other then monetary assets, then such acquisition value is based on the value of the assets provided. The report takes the position that the assets should be valued using the same principles as outlined above for the debts in the DES, this giving rise to a symetrical treatment. Reasons for not using a transaction value for the shares are noted as similar to the above.
Examples illustrating the DES Research Group proposed approach
DES without an expected recoverable amount
Where a DES is carried out for a transaction where in the valuation process described above a DES is used for the debt where there is no possibility of recovery, the value of the debt treated as contributed in exchange for the share is zero. The face value of such debt is still treated as extinguishing the liability of the debtor and zero is also used as the value for the gain on disposal of the debt on the side of the creditor.
For example, suppose the actual balance sheet of the business used in the reconstruction plan shows assets, expected gains of 600 compared with liabilities of 1000, 300 of such debt is exempted and 100 is used in a DES. In this case 600 debts will remain, 400 of gain will be realised from debt exemption and debt cancellation but no value is given to the debts or shares exchanged.
DES with an expected recoverable amount
In DES that includes an amount of debt that may be recoverable then the value of the debts contributed in the DES is taken to be the amount of that may be recovered. In this case there will be a difference between the amount of debt extinguished and related gain on the debtor side but such gain will still be recognised as debt exemption gain on the debtor side.
Looking at similar figures to the above suppose the actual balance sheet of the business used in the reconstruction plan shows assets, expected gains of 600 compared with liabilities of 1000, 300 of such debt is exempted and 200 is used in a DES. In this case 500 debts will remain, 400 of gain will be realised from debt exemption and debt cancellation but no value is given to the debts or shares exchanged. The creditor side loss on disposal of the debt in exchange for the shares is based on a value of 100, which is taken as the value of the shares acquired.
DES involving shares with varied rights
The DES Research Group proposes that the same method also be used without adaption for shares issued with varied rights (shurui kabushiki/種類株式). This is the case regardless of the rights to repayment or similar or subordination of the shares.
The above valuation approach has the advantage of being straightforward as well as removing a great deal of uncertainty around valuation according to transactions in the market or applying valuation methods in circumstances – i.e. company reconstruction – that are inherently uncertain. Losses unused on the debtor side even after set off against debt exemption give rise to tax inefficiency either as a temporary or permanent difference if they remain unused so any valuation approach that tends to use up such losses while allowing an earlier write down and tax relief for losses on the debt on the creditor side would tend to benefit the tax payer.