Covid-19 and Taxation – Financing needs: in search of lost cash flow

01/05/20
Covid-19 and Taxation – Financing needs: in search of lost cash flow

Or how funding is undeniably the weakest link…

  The funding channels are impenetrable or almost ...   In the context of the COVID-19 pandemic, a systemic financial crisis has developed. Businesses are, to a greater or lesser extent, faced with insufficient liquidity to meet incompressible current expenses, payment of suppliers, etc. In order to compensate for declining business, sluggish turnover and collections, companies have no choice but to resort to massive cash injections. They will then have to fall back on a substitute cash flow, as the "natural" cash flow resulting from economic activity at cruising speed proves to be lacking.   While recourse to external financing from banks appears at first sight to be the most obvious and attractive option in that it provides rapid and certain access to the necessary liquidity, this alternative is far from being a panacea in that it may prove extremely costly in the long term, even if the interest paid will escape the rules limiting the deductibility of financial charges and will therefore be fully tax deductible.   As a good father, any company could be tempted, given the future economic uncertainty, to apply for a PGE (State Guaranteed Loan) in order to provide itself with a pocket of comfort and security and to protect itself against possible bankruptcy. However, this source of financial oxygen must not become a preferred method of financing for the company, by artificially and in the long term dangerously replacing its natural cash flow. It should only be activated as a last resort, because here again it can prove costly:  
  • (i) First of all, with a "cash" effect in the event that the State aid repayable “in fine” extends beyond the 12-month "grace period" with a zero rate resulting from a negative EURIBOR: the risk linked to the cost of financing for the banks could weigh negatively on the company;
  • (ii) Then, over and above the abovementioned actual cost, there is a potential cost in the event that the entities benefiting from a PGE were to be members of a group subject to a distribution ban that contravened that ban, obliging the beneficiary entities to return the State aid and then placing them in a possibly irremediable financial situation.
  Thus, although the bank infusion may seem reassuring by giving direct and almost instant access to the necessary cash, it is nonetheless a reflex solution in a climate tinged with financial tension and uncertainty. However, it is neither the only solution nor necessarily the most appropriate one.   Financing solutions are in fact very diffuse and some may prove to be much more relevant in that, for example, they will not generate any additional costs.   The situations of companies and groups are also very diffuse and will therefore have to be assessed on a case-by-case basis.  

1- Tax levers: tax savings at the service of cash flows

Taxation to help the treasury is not a myth but a reality. It will be a question of studying and then implementing certain tax measures that will make it possible to generate tax savings and thus free up fresh and available cash.   Several avenues could be explored for this purpose, based on four main points:
  • Improving the effective tax rate;
  • Reducing the tax burden by "crushing" the taxable base by maximizing tax-deductible expenses;
  • The attraction for consolidation;
  • The reduction of financial costs.
This is not an exhaustive review of all the possible measures, but simply a sample of what could be implemented.

1-1 Improving the effective tax rate

By way of illustration, an enterprise with numerous intangible assets such as patents or software protected by copyright may restructure its economic chain, in particular by relocating research and development expenditure relating to an asset or a line of assets in order to improve its effective tax rate according to the Nexus ratio approach.   It may also opt for the tax consolidation regime, which offers a favorable tax rate on cash inflows (see below - attraction for consolidation).  

1-2 Maximizing tax-deductible expenses

The expense necessarily reflects an upstream financial commitment. It will therefore be necessary either to reduce the charge where possible, which will symmetrically result in a reduction of the financial commitment, or, where the charge is unavoidable, to maximize as far as possible its deductibility for tax purposes in order to reduce the tax base.  
  • Thus, first of all, in the case of interco-financing likely to limit the deductibility of financial charges, one solution could be to improve the firm's equity capital on which the determination of its thin-capitalization situation is based by using shareholders' current account debts to carry out a capital increase by way of incorporation, mechanically increasing the firm's equity capital and potentially cancelling out the thin-capitalization situation.
 
  • In a very deteriorated economic context, the firm may also choose to maximize or even systematize provisions for risks and charges and for depreciation of certain assets, since demonstrating that the loss is likely to be incurred should not pose any major difficulties, since depreciation of trade receivables is almost inherent in the current situation.
  The deductible nature of the provision for tax purposes, which since the decision of the Supreme Court (French Conseil d'Etat) dated 23 December 2013 "SAS Foncière du Rond-Point" (No. 346018) has become the principle, will allow a reduction in the tax base.  
  • Particular attention will also have to be paid to mechanisms for intra-group aid and even beyond. In this period, it would not be surprising to see certain companies helping other client companies or subsidiaries to alleviate their cash flow difficulties.
At first sight, this is a type of aid which is similar to gifts in kind or debt write-offs, and which remains subject to the principles of ordinary law, i.e. unfavorable tax treatment, since the aid cannot be deducted for tax purposes at the level of the company which granted it and will remain fully taxable at the level of the recipient company.   Nevertheless, such private initiatives could escape this disadvantageous tax treatment if the "granting" company manages to demonstrate that the aid granted is of undeniable commercial interest, i.e. is part of normal management. In such a case, the company would have to be able to demonstrate that the aid granted has enabled it, for example, to maintain its commercial outlets or to increase its activity. This demonstration, which is fairly complicated to provide in normal times, should benefit from the unprecedented economic context, which will undeniably favor proof of the commercial causal link.   Conversely, the recipient enterprise, which is normally taxable, may in certain cases benefit from derogatory measures by the Government, which would decide, for example, by decree, to exempt cash donations from taxation. This was the case, for example, with regards to donations made to support enterprises exposed to the Erika shipwreck, the Prestige or the AZF explosion, the forest fires in the South of France in the summer of 2003, or the Xynthia storm.   In the same vein, in the context of the amending finance law for 2020 which was adopted on 23 April 2020, incorporating the consequences of the COVID 19 crisis, one of the measures provides for lessor companies which grant rent waivers to their lessees to be able to deduct the cost of waiving rent from their tax bill in the same way as for waivers of commercial debts. Proof of this is that in times of crisis, the exception can become the rule even if tax law is impervious to the concept of force majeure  

1-3 The attraction for consolidation !

  Strength in numbers!   There are many mechanisms aimed at a more or less complete consolidation of companies.  
  • First and foremost, of course, there is tax consolidation, which can not only allow profits and losses to be pooled in groups with, for example, very heterogeneous business units and therefore unequally impacted by the crisis, but also allow the financial consolidation of the parent company through the reporting of cash flows taxed at 1%, i.e. less heavily than in the absence of any tax consolidation, thus generating de facto substantial tax savings. The question of overhauling a pre-existing group to change its scope or, for example, to move from "vertical" to "horizontal" consolidation may also arise, particularly in an international context.
All the more so as the deadlines for opting for the establishment of a consolidated tax group or for reviewing its tax consolidation scope have already been extended until 30 June 2020. We will therefore have to take a serious look at the issue by assessing the stakes.  
  • Consolidation will necessarily push the debate towards the advisability of setting up a central cash pooling system, which, in addition to making cash requirements more fluid by balancing the member companies' surpluses and cash needs:
  • facilitates accounting and administrative management by grouping balances in a single account,
  • provides an overall view of the performance of each member subsidiary and,
  • above all, constitutes financial leverage with a significant impact on the company's financial position.
  By centralizing the balances of the subsidiaries, the "pivot" entity that manages the centralization will record a single charge for all the accounts that it will be able to trade down and, symmetrically, will be able to obtain a higher return on the investment of the mechanically larger consolidated balances.   This centralized management will also make it possible to achieve economies of scale in day-to-day cash management (in terms of liquidity and risk management, etc.) and reduce liquidity risk.   Finally, centralized cash management will enable the Group to have a greater weighting on the financial markets and access to advantageous financing conditions.  
  • The Leverage Buy-Out (“LBO”) can be a remarkable fiscal and financial lever when used properly
  In financial terms, it improves the company's equity capital under LBO and should normally allow the target's acquisition loan to be amortized quickly and thus to benefit from the profits.   From a tax point of view, the transaction will make it possible to maximize the deduction of loan interest at the holding company level, to benefit from the parent-subsidiary regime allowing a virtually tax-free distribution of dividends between the holding company and the target and, above all, from the tax consolidation regime (see above).    

1-4 Reducing financial costs

Reducing certain costs does not necessarily involve magic, but simply the implementation of efficient mechanisms, particularly those based on consolidation.   The tax consolidation referred to above is a perfect illustration of this.   The implementation of a "cash pooling" system, also detailed above, which is an essential lever of financial performance by making it possible in particular to optimize financial expenses, may prove to be more than judicious.   Beware, however, of the perverse risk of vases-communicators. Artificially reducing costs in an intra-group context, by means of waivers of management fees, variations in margins, or reductions in rates on intra-group loans, may not only lead to the problem being shifted from one group entity to another, but above all, in the long term, may generate serious tax risks (abnormal management actions, transfer pricing issues, etc.).  

2- Self-financing: monetizing balance sheet assets!

The balance sheet is full of assets that are sources of cash in the making. Today, it is possible to monetize all types of assets (databases, patents, goodwill, real estate assets, equity interests, receivables, etc.) and to generate cash by selling or leasing tangible or intangible assets. Moreover, a number of Fintechs have developed in recent years to replace banks and financial institutions playing a real role as an Internet marketplace.   The monetization of assets, whether fixed or current, is therefore a fundamental issue in financing in that it allows to generate cash in the very short term.   Depending on the assets selected, the company will then have several mechanisms at its disposal to transform the trial. The terms of the monetization can take a wide variety of financial circuits and the choice is not insignificant since, depending on the operating method chosen, the business may completely transfer its assets, intend to give them up or not completely dispose of its assets while continuing to benefit from them, intend to use them and even earn income from them. In order to opt for the most suitable solution, the logistical and financial needs of the company will have to be weighed against the tax costs associated with the chosen model, to avoid the immediate cash inflow being partially or too heavily absorbed by the tax authorities.   Disposal, which is the most extreme form of monetization, in that it involves a transfer of ownership from a legal point of view and the removal of assets from the balance sheet from an accounting point of view, can generate significant tax costs:  
  • In terms of taxation of the proceeds of disposal: capital gains taxed at the standard rate of 28% or at a reduced rate of 12% of the standard rate for equity interests held for more than two years, Nexus rate for proceeds from the sale of software protected by copyright or patents, etc.
  • In terms of registration duties: in case of transfer of an on-going concern, for example (registration fees of 3% up to €23,000 and 5% above).
  • In terms of VAT: in case of transfers of isolated assets or real estate assets completed less than 5 years ago, VAT at the rate of 20% will be applicable.
It will therefore be necessary to delve into the tax system applicable to each operation concerned according to the asset in question in order to visualize the tax treatment applicable to the said operation and to evaluate the tax costs incurred.    

2-1 The time has come for liquidation: everything that can be monetized must be monetizable!

  By way of illustration, a company that has investment securities, i.e. financial securities, shares or bonds corresponding to the invested excess cash, should be able to sell them quickly since they very often correspond to short-term investments. It will simply be necessary to ensure the liquidity of the financial securities and the anniversary date of their liquidation with the managing financial institution.  

2-2 As regards monetization of fixed assets

  Many fixed assets can be monetized. Examples include real estate assets and shareholdings.  
  • a) The lease-back: "a war treasure"?
A company that no longer has the means to assume its assets may first of all prefer the leaseback solution, this type of operation essentially aims for the company to obtain capital in order to improve its cash flow, make investments or finance its development projects. By doing so, the company will be able to build up available cash almost instantaneously.   Lease-back is the operation whereby a company that owns a professional property sells it to a property leasing company (the lessor) and simultaneously takes it on as a property lease and becomes a lessee (the lessee).   The primary interest of this financing technique is to enable the transferor who has become a lessee to retain the use of his former property by continuing to use it.   Unlike a sale of a building followed by a lease, the leasing contract must include a purchase option that guarantees the former owner who has become a lessee that he can buy back his building at a contractually defined price, either during the contract (early exercise of the option) or, more often than not, at the end of the contract.   The price of the purchase option will be fixed as soon as the contract is signed for a symbolic amount (often 1€ or in relation to the value of the property's land base, or in the event of early exercise of the purchase option, depending on the contractual terms). This method of financing also guarantees the lessee a rent that will not fluctuate according to the evolution of the real estate market.   Finally, this method of monetization of real estate assets is supported by an advantageous tax regime, with the result that the transaction is subject to the property advertising tax or to registration duty at the reduced rate, provided that the transaction has been published if this formality is mandatory pursuant to the provisions of Article 28 of Decree No. 55-22 of 4 January 1955 as amended, reforming the property advertising law, i.e. when the real estate leasing contract entails the creation of a lease with a term of more than 12 years.   The rents paid under the lease-back will be deductible from the company's results (excluding the share of the land). In short, the operation will make it possible to obtain full refinancing of the amount of the property sold, thus giving the company strong financial leverage with reasonable tax costs.    
  • b) The monetization of interest: on the “equity swaps” side
In the same vein, it is possible to monetize treasury stock or minority interests. “Equity swaps" are precisely the kind of investment monetization transactions that make it possible to buy back treasury stock or minority interests in listed or unlisted companies. The effect of these agreements will be to facilitate and smooth the transfer of minority or treasury shares, which is far from obvious a priori, by hedging - often with a bank - against the risk of loss of value of the investment sold. Indeed, the transferee will be guaranteed to obtain an amount equal to the difference between the price of the holding at the time of its subsequent sale and the price of the holding at the time of its acquisition - this difference is negative. In this way, the equity swap agreement, by protecting the assignee against any depreciation of the participation sold and consequently contributing to social losses, will greatly favor the purchase of treasury or minority interests and consequently, access to immediate cash for the assignor.  

2-3 As regards current assets

  Businesses became aware, long before the pandemic, of the importance of their trade receivables as money "sleeping" in their accounts.   It is clear that a company that sells its trade receivables recovers cash, improves its cash flow and its working capital requirements. In an increasingly competitive economic environment, it has become important to make trade receivables an effective management tool.  
  • Factoring: a professionalization of the assignment of trade receivables
  To raise the issue of rapid financing needs for companies with a large number of trade receivables inevitably leads to the factoring route. In essence, this is a financing technique enabling a company (the creditor) to assign its receivables from one or more customers (the debtors) to a financial institution specializing in factoring (called the factor).   Factoring has, moreover, supplanted the Dailly assignment technique, appearing to be a model that is both more modern and more radical. The main advantage of factoring is twofold: it gives the firm very rapid access to cash and transfers the risk of non-payment to the factor (unlike the Dailly assignment, where the bank merely finances the unpaid invoices passed on to it, leaving the firm to manage the customer item and hence the accompanying risk of non-payment), in return for payment of a commission equal to a percentage of the firm's turnover.  

2-4 Transversal operating modes

  While the monetization of certain assets requires the implementation of dedicated mechanisms (e.g. factoring is a technique specific to trade receivables), there are transversal operating methods that can be implemented regardless of the nature of the monetized asset. Such is the case with the trust: a secure solution for the lender and attractive from a tax point of view. The trust is a mechanism whereby the trustee receives ownership of the property under trust, i.e., that which is vested in him or her, and must carry out the mission entrusted to him or her by the settlor, the fruit of this mission accruing to a beneficiary for whose benefit the purpose of the trust is carried out (the beneficiary may be the settlor or the trustee). The trust is a cross-cutting mechanism in that it may be used for any type of asset: movable or immovable property, whether personal rights (receivables, securities, intellectual property rights) or real rights (usufruct, bare ownership) or security rights. The trust is governed by a principle of tax neutrality. Consequently, even if the beneficiary is the owner of the trust assets, all taxes owed in respect of those assets must be paid by the grantor. This mechanism will allow the business to raise debt using its own assets, even highly depreciated assets, at a very low tax cost while securing the lender (very strong fiduciary security) and allowing the borrower to maintain the availability of the assets placed in trust and to access very rapid financing, to avoid certain tax friction (e.g. in the case of a direct disposal or even a leaseback) and to continue to benefit from the accounting and tax treatment inherent in the asset (e.g. depreciation expense, income from the asset, from contracts relating to the asset, holding period, etc.).  

2-5 Securitization: a method of assigning receivables that dilutes risk

Securitization is a mechanism for issuing securities backed by a pool of assets, most often receivables, to enable the original holder of the underlying assets to refinance them. In doing so, the underlying assets are "converted" into securities, so to speak. Since the security is backed by a basket of assets that existed prior to the origination, the issuer's ability to meet the scheduled payments will therefore depend on the quality of the underlying assets. Unlike factoring, which involves receivables that are certain to be liquid and due, securitization can be applied to typically illiquid assets, such as, for example, receivables from individuals (receivables relating to consumer loans that individually generate low income but which together make up an overall basket of assets of sufficient value). Securitization will therefore make it possible to transform "unsaleable" assets into marketable assets. A wide variety of assets will therefore be securitized, and in the case of companies, this may concern their bank loans, trade receivables, leasing activities, royalties, etc.). In short, any asset that generates cash flows can be securitized. In essence, securitization will have the advantage of allowing the seller to get rid of its receivables and symmetrically to bring in cash. Given the chain of actors involved in the securitization transaction, the transaction will allow a dilution of risk.  

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Companies therefore have a considerable toolbox to (auto) generate cash very quickly at a lower tax cost. The legal technique, together with its financial and tax counterparts, is full of procedures to be studied, which will prove more or less relevant depending on the asset in question, the company in question, its balance sheet structure, etc. This study is not intended to provide an exhaustive approach to all the possible mechanisms, as they are numerous and diversified (forward sales, repurchase agreements, etc.). In any event, a strategic financial approach will have to be adopted:
  • Incorporating regulatory constraints such as those imposed by the executive which, in response to the pandemic, issued a FAQ (updated version of 2 April 2020) imposing a ban on large companies (meaning companies with at least 5,000 employees or with a consolidated turnover in excess of €1.5 billion, including groups) from making dividend distributions in 2020. This would mean that intra-group lending rates, forgiveness of debts, etc. should not be used as a reason to distribute dividends in 2020. Concentrating cash at the level of a national entity that falls under the ban, creating either a "cash trap" by freezing cash in the entity so as not to contravene the ban on distributions, or [in the event that the ban is ignored], calling into question the State financial aid allocated to other entities in the group, placing them in an inextricable financial situation (the aid granted, such as EMPs, deferred charges, etc., would then have to be repaid);
  • Weighing the benefit of the immediate cash inflow against the financial and/or tax costs incurred;
  • Measuring the magnitude of the risks incurred (tax risks, risk of unavailability of a monetized asset, etc.).
 

Our attorneys are at your service to help you better understand the way out of the crisis and to set up these lines of thought: contact@dgfla.com.

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