Assumption of debt

What it means

Assumption of debt is a contract by which a new debtor takes over a debt in place of the original one. The original debtor leaves the obligation, and the creditor can from then on pursue only the new debtor. The contract is concluded between the old and new debtors, but the creditor’s consent is essential for it to be valid.

The creditor’s consent matters because it is not indifferent who owes it money. The new debtor may be less creditworthy. If the creditor does not agree, the most that can happen is an accession to the obligation, where the new debtor joins alongside the original one and both are jointly and severally liable.

Assumption of debt is the mirror image of an assignment of a receivable. In an assignment the creditor changes and the debtor’s consent is usually not needed; in an assumption of debt the debtor changes and the creditor’s consent is required. Both are often used in group reorganisations and business sales.

How it works in practice

Within groups, assumption of debt is often used to tidy up intercompany liabilities, for example when a parent takes over a subsidiary’s loan. We always examine whether the new debtor receives consideration for this or whether it is a gratuitous transfer with tax consequences.

In the accounts, the assumption must be recorded by all three parties. The original debtor derecognises the liability to the creditor and books either a liability to the new debtor or income if the assumption is gratuitous. The new debtor books a liability to the creditor. The creditor changes the debtor in its subsidiary ledger.

The contract itself and the creditor’s consent serve as the accounting document. Where there are mutual receivables and payables, an assumption of debt can be combined with set-off, reducing cash flows between the companies.

What to watch out for

If the new debtor takes on the debt without adequate consideration, taxable income may arise for the original debtor, and for related parties transfer pricing rules must also be considered. A gratuitous assumption of debt should therefore not be made without a tax review.

Assumption of debt does not automatically release the security backing the debt. A guarantor or pledgor who secured the original debtor’s obligation must agree to the security continuing, otherwise their guarantee may lapse. Creditors therefore usually stipulate this.