Debt relief, bad debts, bond buybacks and debt rescheduling
With the recent economic slowdown in Israel as a result of the damage caused by the coronavirus, we have recently seen companies grappling with debt default issues and the resulting tax consequences.
In many cases, a company unable to repay its debts may find that it now owes new debt to the Israeli tax authorities (the “ITA”), while in other cases, companies that are unaware of their rights do not claim taxes perform services based on debts that customers or other debtors have not repaid to them.
This Client Alert gives a brief overview of some relevant legal provisions and offers considerations that should be considered during these difficult times.
Income Tax Ordinance (Revised), 5721-1961 (the “Ordinance”) provides that an individual is liable to tax on debt relief (“COD”) if that debt was recognized as an expense when recognized or used to generate income .
Israeli jurisprudence over the years has discussed at length issues related to cash on delivery receipts and the circumstances in which a company is subject to cash on delivery tax. Israeli courts have ruled in several cases that COD, whether explicitly or implicitly from the behavior of the parties, requires action by the creditor. The fact that the debtor cannot repay his debt is not enough to tax it as cash on delivery as long as the obligee does not remit the debt.
In many cases, and particularly with regard to related party debts, the ITA argues that the mere fact that the debt has not been paid off constitutes a chargeable cash on delivery. This position has been rejected several times by Israeli courts, taking into account the specific circumstances of each case and the conduct of the parties.
In addition, there may be cases in which the obligee recognizes an expense or loss due to a bad debt loss because he comes to the conclusion that under the given circumstances there is no chance of repayment of the claim, but the requirements for the recognition of cash on delivery still exist are not fulfilled, because the creditor never forgave the debt, only reluctantly gave up.
It should be noted that cash on delivery can also be subject to VAT, provided it originates from a claim that is not subject to VAT when it is recorded (supplier’s debt). However, in many cases, involuntary cash on delivery due to the debtor being unable to repay the debt is not subject to VAT.
Bonds and Debt Rescheduling
In connection with the COD taxation, the published position of the ITA 2010 (published against the background of the 2008 financial crisis) on repurchases of bonds and debt rescheduling should be noted.
The ITA regards a bond buyback as a chargeable event for both the issuing company and the bondholders. It should be noted that, according to the ITA, part of the income resulting from the repurchase is to be classified as finance income, unless the company expressly requested that it be treated as cash on delivery income. This matter may affect the company’s ability to use business losses to offset proceeds from bond repurchases, and it is recommended that you review this matter in advance and contact the ITA if necessary. In addition, the repurchase of a bond by a subsidiary may allow the tax event to be postponed until the bond repayment date.
Regarding a debt rescheduling that allows partial or full repayment of bonds that has been approved by an Israeli court, given the need not to overburden a troubled company with tax debt, the ITA has confirmed that companies can file an application a comparison that uses carried-over losses and reduces the tax base on assets from a portion of the company’s cash on delivery income.
Given the unique circumstances surrounding the coronavirus crisis and the Israeli government’s stated policy to facilitate corporate cash flow during this troubled time, we believe there is leeway to turn to the ITA for tax notices that are tax liability reduce resulting from the rescheduling and the estate, in accordance with the principles outlined by the ITA after the 2008 crisis.
Change in credit terms
In some cases, debtors and creditors decide to change the terms of an existing loan to allow repayment of the loan without waiving the loan amount in full (a “haircut”). However, a large and substantial change in the terms of the loan can be viewed as the repayment / repayment of the loan and the issuance of a new loan.
In this context, we recommend our customers who need to change the terms of an existing loan to act cautiously and seek advice in advance with regard to possible tax consequences. In some cases, the parties may have other commercially viable alternatives that allow for loan terms relief that are not a taxable material change in the terms of the original loan.
Cross-border financing transactions between related parties must be conducted on market terms. The international nature of the coronavirus crisis, the expansionary monetary policy of some countries, the decline in income in certain sectors of the economy and the depreciation of certain assets can mean that certain existing loans do not meet the arm’s length standards, be it because the lending rate is too high or too low.
We encourage our clients who have cross-border financing programs with related parties to review their transfer pricing policies in relation to these transactions to ensure compliance without undue taxes.
The ordinance stipulates that bad debts incurred in the course of business activities are recorded as deductible expenses. Bad debt losses not incurred in the course of business activities (e.g. certain loans to related parties) can be recorded as capital losses. In addition, traders can claim back the VAT paid when the debt was first recorded.
We recommend our clients to check the status of their claims to determine whether bad debts should be recognized. It should be clarified that a taxpayer may deduct an expense for a bad debt even if he has not assigned his claim to collect the claim, and the regulation contains explicit rules on the recognition of income for claims that have been collected after previous recovery recognized as bad debt.