Sometimes businesses cannot bear the weight of debt because the envisaged investment does not pan out as expected. A common occurrence in greenfield investments is that businesses tend to fund themselves through debt, but it often turns out the business case is not solid as expected.
In other cases, the business experiences a long gestation period and a delay on anticipated cashflows that would ideally fund the loan repayment, both principal and interest. In this case, loans must be restructured to enable the business to continue and be in a position to pay its debts.
However, there are situations where the debt is unpayable. This means the only viable option from a reporting perspective is to write off the debt. Whilst this cleans up the balance sheet for both the lender and borrower, there is a possibility of tax consequences.
The income tax law is structured in such a way that any debt obligation that ceases to be an obligation automatically gets realised when it ceases to become a debt obligation.The realisation of such debt obligation, therefore, if not financed by the company’s internal revenues becomes a taxable revenue in the hands of the company that is being ‘forgiven’ the debt. Consequently, it is important to make sure that the written off loan is both structured and timed, in a tax sensitive manner.
If the loan is from a related party, such as a shareholder loan, it is important for the shareholder to consider other options available in order to avoid putting the company in a difficult cashflow situation. An option that may be explored is the conversion of debt into equity, which would not have a negative ‘balance sheet’ implication, given the fact that the loan merely shifts from the debt-to-equity side of the balance, assuming that the minority shareholder agrees to the dilution of their stake.
Companies seeking debt write offs typically do not have excess cashflows to spend on paying taxes. Ideally, a company will avoid a loan write off that creates cash outflow by way of tax payments. Therefore, a company may consider taking a staggered loan write off amount, especially when there are losses to utilise, so that gains triggered by a write off do not negatively impact its cash position.
On the lender’s side, it is important to note that a loan write off is an expense that reduces the profits. More likely, the revenue authority may challenge the deductibility of such expense. This means that there must be credible documentation supporting the basis for the loan write offs. This includes documented resolutions about the write off, their rationalisation as well as why such debt claims are uncollectable.
Of course, one does not want to do write off loans purely as a tax avoidance purposes, but one should consider the tax consequences when it comes to writing off debts. As explained above, any realisation of debt is a gain on the part of the borrower. As such, there will be tax consequences for both the lender and borrower. Businesses should also consider the possibility of converting debts into equity or staggering the write offs.
Finally, all write offs must be documented properly and in a timely manner, with the business rationale for those decisions well-articulated so that there is enough support in case of a query from the revenue authority. Decisions that are made purely due to tax reasons tend to be challenged by the authority. The main focus, therefore, must be getting a struggling business to pay its loans to a healthier position.
Samwel Ndandala is a Senior Manager with Deloitte Consulting. He can be reached at email@example.com The views expressed herein are those of the author and do not necessarily represent the views of Deloitte.