Promissory notes and loan notes in corporate reorganisations – uncertain terms in English law?
Published on 4th Dec 2023
Mislabelling a debt instrument as a promissory note can result in unintended consequences
Promissory notes and loan notes are often used in group reorganisations to paper a loan relationship, but because the terms are frequently used interchangeably, there is scope for misuse and misunderstanding.
Many corporate reorganisations involve dealing with new or existing intra-group loans and other debt and credit balances. From a corporation tax perspective, it is often preferable to document new or undocumented loans or balances as part of the reorganisation process. This can be done by the borrower issuing a unilateral instrument.
The terms "promissory note" and "loan note" are often used interchangeably to describe the unilateral instrument, particularly on cross-border reorganisations. While the underlying documents representing promissory notes and loan notes may look similar at a glance – both can be short form instruments executed as a deed by the borrower – under English law, they are distinct legal forms governed by different statutes. It is therefore imperative to correctly identify, label and design the instrument for the relevant circumstances whether it is being created in a group reorganisation or otherwise.
What are some of the differences between promissory notes and loan notes and the significance of the distinction between them from both a company law and tax law perspective?
What is a promissory note?
In English law, a promissory note is defined in section 83(1) of the Bills of Exchange Act 1882 as "an unconditional promise in writing made by one person to another signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money, to, or the other order of, a specified person or the bearer".
A "person" in this context can be a company. Promissory notes are therefore reasonably consistent in their form and content, as they tend to track the requirements (including the phraseology) of the statute.
The process for transferring the right to be paid pursuant to a promissory note is called "negotiation". In a reorganisation context, a promissory note will typically be payable to a specific company. In this case, to transfer the promissory note, the transferor must "endorse" the promissory note (sign it on the back) and deliver it to the transferee in accordance with the requirements of the statute.
As promissory notes are negotiable instruments, they can be treated as analogous to cash, in certain situations.
In the US, promissory notes are also used, but they do not have the same requirements, and a US parent company may unintentionally use a US-style note for a UK subsidiary borrower executing under English law without comprehending what this actually entails under the Bills of Exchange Act.
What is a loan note?
A loan note is a "debenture" as defined in section 738 of the Companies Act 2006. This definition is not exhaustive as it simply states that a debenture includes debenture stock, bond and other securities. HMRC states that a debenture is simply an acknowledgement of a debt, which broadly follows the case law definition.
A debenture has accompanying company law requirements, such as the need for the issuer to register the allotment of debentures. Most commonly, this requirement is satisfied via the issuing company maintaining a loan note register, though if notes are issued for a short period only, this requirement is not always satisfied in practice.
There is no prescribed form of loan note, and in an intragroup reorganisation context they can vary from one page documents to more complex loan note instruments that provide for a series of issuances evidenced via underlying loan note certificates. Loan notes can be listed to take advantage of the quoted Eurobond exemption to withholding tax.
Loan notes are more flexible than promissory notes and substantive actions in respect of the notes are governed by the terms contained in the loan note instrument rather than prescribed by statute. For example, unlike a promissory note, the principal amount does not have to be ascertained up front; an instrument can include "headroom" for additional debt to be issued at a later date.
In relation to transferability, often a loan note instrument will have appended to it a form of loan transfer. In the absence of such a form, many loan notes will constitute "registered securities" under the Stock Transfer Act 1963 and can be transferred utilising a stock transfer form. Where a loan note includes an express assignment provision, an assignment of rights via an assignment agreement or deed is permissible.
From a UK corporation tax perspective, there is a key distinction between debt created by bilateral instruments, such as loan or facility agreements, and debt created by instruments unilaterally executed by one party. This is because the corporation tax loan relationship rules apply to money debts arising from a transaction for the lending of money.
However, where a debt does not arise from such a transaction it can still be deemed to be a loan relationship if an instrument is issued by a person for the purpose of representing security for the debt or the rights of a creditor in respect of the debt. Effectively a money debt which does not arise from a lending transaction – for example, deferred consideration on a supply of goods or services – can still be a loan relationship if a debenture or promissory note is issued in respect of it.
The distinction between debts generally and loan relationships can be important in determining the corporation tax treatment of transactions. For example, connected company waivers of loan relationships can be exempt from corporation tax; the position for debt waivers more generally may be less clear.
Transferring shares or debt for outstanding deferred consideration can have a very different tax treatment to transferring shares or debt for the issue of a debenture or a loan note. In a group context this could be the difference between a tax neutral transaction and a taxable transaction. Treatment as a loan relationship can therefore give rise to positive or negative consequences depending on the situation.
Why does it matter?
Mislabelling the debt instrument as a promissory note, not knowing the impact of that label, can have unintended consequences.
Where companies create promissory notes without a full understanding of what this means, they may fail to adhere to the correct formalities for dealing with those notes, such as endorsement as the means of transfer. The consequence of this is that legal ownership to the promissory notes may not be effectively transferred.
Often, documents are labelled as "promissory notes" but fail to satisfy the requirements of the Bills of Exchange Act 1882: thereby becoming "loan notes". This could mean the documentation utilised to transfer those notes is incorrect, leading to deficient legal implementation of the reorganisation steps.
Such instances risk creating confusion and prompting additional scrutiny on any future review of the documentation either through due diligence, a statutory audit or a further group reorganisation.
What to do
When creating new intra-group debt or papering or amending the terms of any existing debt under English law, it is important to consider the nature of the instrument being transferred, varied, or to be issued – not only whether it should be bilateral or unilateral but also whether it should be a promissory note or a loan note.
Companies should ensure that appropriate documentation and consistent terminology are utilised through the project implementation. As well as corporate law and tax advice, accounting advice is also important when carrying out such transactions.
The issuing entity should be made aware of any processes needed to transfer or deal with the notes in future.
If you would like to discuss any of the issues raised in this Insight, please get in touch with one of the experts listed below. Read more about our CRS team.