Since late January 2021, the price action on shares of video
games retailer GameStop Inc (“GME“) and
other heavily shorted companies like AMC Entertainment
(“AMC“) has attracted the attention of
the finance world. The story is presented as a group of individual
investors betting against short sellers and hedge funds and trying
to provoke a short squeeze, which many believe would mark financial
history. Online brokers, US congress members, financial news
outlets and online discussion boards have all been featured in this
fascinating, still unfolding, chain of events.
But this particular angle of the story is not the only one worth
looking at. The dramatic increase in GME share price from $4 to
more than $400 and from $3 to $19 a share for AMC in only a few
weeks has also created opportunities for certain investors holding
other securities of the companies.
For example, it was reported that Silver Lake, a US buyout firm,
was able to cash in on a convertible bond issued by AMC, which it
converted into shares of the company at a conversion price of
approx. $13, generating a huge and likely unexpectedly short-term
profit, which some fellow hedge fund managers and commentators
referred to as a “trade of a lifetime”. No specific
disclosure was made on the potential income tax impact of such
trade, however, and that is now the subject of the below
discussion.
What would a similar trade mean for European investors?
In Europe, while these kinds of securities and transactions may
be directly held and performed by tax-exempt institutional entities
like investment funds, a lot of global credit and special
situations managers structure such investments through the use of
one or several SPVs, which are often taxable corporate subsidiaries
holding a diversified portfolio of credit securities.
These SPVs are typically financed with debt, and interest
charges on such debt are, in principle, deductible from the taxable
basis of the SPV under certain conditions. However, as a
consequence of the EU-wide implementation of the Anti-Tax Avoidance
Directive (Directive (EU) 2016/1164 of 12 July 2016 –
“ATAD“), Luxembourg has introduced
specific rules to limit the interest deductibility for tax purposes
(the “IDLR“). The limitation applies to
so-called “exceeding borrowing costs” (i.e. the amount by
which the borrowing costs exceed the interest income in a given
year) and corresponds to the higher of EUR 3mio or 30% of the tax
EBITDA per fiscal year.
In this context, the definition of what constitutes borrowing
costs is of paramount importance. On 8 January 2021, the Luxembourg
tax authorities issued a new Circular n° 168bis/1 (the
“Circular“) in order to provide guidance
on the interpretation of the IDLR. Under the Circular, borrowing
costs may only concern deductible interest expenses, i.e.
non-deductible interest expenses, regardless of the reason for the
non-deductibility (e.g. anti-hybrid rules), do not qualify as
borrowing costs. Therefore, to apply the IDLR, one should first
consider whether the relevant expenses are deductible under the
other provisions of Luxembourg tax law. As a second step, the
nature of the expenses has to be checked to determine whether or
not they fall into the scope of borrowing costs within the meaning
of the IDLR. Where such limitations to the tax deduction apply, the
resulting potential tax charge may have a huge impact on the
fund’s returns.
While not all bonds or receivables are convertible, the impact
of additional equity contributed to issuers of plain-vanilla debt
may directly impact the valuation and recovery value of such debt.
Under the IDLR in Luxembourg, a deduction for impairment of
(presumably) irrecoverable receivables does not give rise to
borrowing costs on the part of the creditor. Hence, the reversal of
such impairment should likewise not constitute interest income.
This in turn means that gains on impaired or discounted debt
holdings may be offset by tax deductible interest charges only up
to a certain limit, thereby resulting in a potential increased tax
charge for their holders.
The conversion of debt into equity is more complex to analyse.
On the one hand, an exchange of assets is normally characterised
for Luxembourg tax purposes as a sale of the asset followed by the
acquisition of the other asset obtained in exchange, and therefore
a difference in value between the two should be a gain (or a loss).
However, under the Circular and the symmetry principle it laid
down, the characterisation of income and gains in the hands of the
holder of a security should in principle replicate that at the
level of the issuer. Therefore, if redemption premiums on
convertible bonds are considered as borrowing costs for the issuer,
the premiums should also be considered as
“interest-equivalent” for the lender.
Any income realised following the subsequent sale of the shares
or new equity received in exchange for the conversion of the debt
will, however, almost always be considered as non-interest income
(i.e. “bad income” for the purposes of the IDLR). In
these situations, the exact sequence of transactions will therefore
be extremely important to understand and monitor to determine the
applicable tax treatment and whether or not a portion of the
interest charges will be non-deductible for tax purposes.
Asset managers which finance discounted or convertible debt with
profit participating instruments or other loan instruments (e.g.
debt funds) may therefore need to review their current structure
setup to identify potential tax exposures and take the necessary
steps, if needed, to prevent potential “trades of a
lifetime” from turning sour once an unexpected tax burden
ruins the party.
And… oh yes, for Luxembourg individual investors, short-term
capital gains (less than 6 months), as well as short-selling gains,
are considered speculative and therefore subject to individual
taxation at the maximum tax rate.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.