Wednesday, 11 January 2012

More improvements on hybrid financing in Spain

The decision whether to fund a company through debt or equity has significant income tax consequences. Taxpayers usually prefer debt because when the investment is paid back to the lender, the taxpayer may incur deductible interest. The tax authorities, however, often argue that the investment is really equity, because that classification generally generates more overall income tax.
The Spanish High Court of Appeal (Audiencia Nacional) recently re-characterized as equity a profit participation loan (PPL) granted by a Dutch holding company to its Spanish subsidiary and denied the deduction of interest expenses related to the loan. Applying the principle of substance over form, the court found that the loan did not actually have debt features and was, in reality, a shareholder contribution (equity).
The court's arguments for re-characterizing the PPL as equity were as follows:
  • The loan agreement did not set a maturity date and was to be terminated by mutual agreement.
  • It was expressly stipulated that the loan could be converted into the borrower's shares. The court found it unrealistic that an independent creditor would have any interest in acquiring shares of a borrower that cannot repay the loan.
  • The amount of interest paid (linked to the Euro Interbank Offered Rate, or Euribor) was limited to the company's profits (that is, no interest would be paid if the borrower did not realize profits). In that regard, the court stated that variable interest is one thing, but that linking the payment of interest to the existence of profit is something else entirely.
  • The loan specified that the lender must continue to be the borrower's shareholder.
This indicates that a combination of indefinite duration, convertibility, and interest payments contingent on the existence of profit may result in the requalification of a loan into equity.
Despite being a pioneer decision in Spanish case law, this approach follows the general lines of international tax standards on the subject and therefore has a touch of accuracy. However, the characterization of debt versus equity will likely remain a hot topic in disputes between taxpayers and Spanish tax authorities in the coming years.
Therefore, Spanish companies involved in intragroup financing (for example, Spanish subsidiaries of multinationals receiving private equity investments) are advised to review the terms and conditions of their current loan or PPL agreements in order to increase certainty about their correct characterization as debt or equity.
In the same vein, two recent rulings by the Central Tax Administrative Court (rulings of March 17, 2010, and April 18, 2011) upholding the position of the tax administration on the tax treatment of hybrid instruments (Australian preferred shares and Brazilian interest on net equity) are worth noting. The tax authorities rejected the characterization of the hybrid instruments as dividends that are eligible for the participation exemption regime in Spain, characterizing them as interest instead.
Nevertheless, taxpayers received some good news from Supreme Court rulings (Rulings of October 9, 2009, and March 17, 2011) stating that the Spanish thin capitalization antiabuse clause cannot be applied to interest payments made to companies resident in countries that have a tax treaty with Spain that contains a nondiscrimination clause patterned on article 24 of the OECD model tax treaty, unless the Spanish treaty contains a specific clause allowing for the application of the antiabuse clause.
All these developments reflect a new trend among Spanish tax auditors, who are taking a stricter approach to the enforcement of the economic substance doctrine, particularly in international and intragroup transactions. This new administrative approach converges with international standards developed by the OECD in its report on aggressive tax planning. It is therefore highly recommended that taxpayers review and take into account this new approach toward structures and tax planning strategies involving Spanish companies.