Spanish Court Denies Interest Deductions in Cross-Border Financing

A landmark decision following the publication of the OECD's Final Report on Base Erosion and Profit Shifting in 2015 (the Final Report).

The Spanish Central Economic-Administrative Court (the Court) has held that the Spanish Tax Authority was right to deny interest deductions taken on an intra-group financing used to fund share purchases from a third party on the basis that the financing lacked commercial sense and would not have been entered into between independent third parties (Case 05110/2012/00/00). While we hope that the case will be appealed, the decision is, for now, binding. However, there is some doubt about whether any appeal will overturn the decision of the Court, which follows a decision made by the Spanish Supreme Court in 2014.

Key points

• The Spanish court has endorsed the aggressive position of the Spanish Tax Authority when examining cross-border related-party transactions.
• Spanish companies must be actively involved in transactions which impact them and must not have their decision-making powers usurped in order to protect the tax treatment of cross-border intra-group financings.
• Spanish businesses should expect closer scrutiny of cross-border related-party financings and increasing litigation in this area.

Background 

A Spanish holdco in the form of an Entidad de Tenencia de Valores Extranjeros (Spanish Co) was part of an international corporate group (the Group). In October 2002, Spanish Co purchased 100 per cent of the share capital of two Argentine tax resident companies from a third party. Spanish Co’s immediate Dutch parent company (Dutch Co) granted Spanish Co two loans totalling €1,103,505,252 to fund the purchases. The head of the Group was a Brazilian company (Parent Co) and Parent Co exclusively undertook all negotiations with the seller in respect of the share purchases.

Spanish Co’s only income was the receipt of tax-exempt dividends from its subsidiaries.

Details of the loans

The first loan (Loan A) was granted for a term of five years with a fixed interest rate of 4.76 per cent. The second loan (Loan B and together with Loan A the Loans) was granted for a term of six months with a fixed interest rate of 4.8 per cent. Interest payments under the terms of the Loans could not be capitalised and there was no flexibility for Spanish Co to extend the terms of the Loans.

Renegotiation of the loans

On maturity of Loan A, the initial five-year term of Loan A was extended by one year, and then for a further year on expiration of that one-year extension. Loan A was therefore in place from 17 October 2002 to 16 October 2009. The fixed interest rate of 4.76 per cent was increased to 5.65 per cent for the first extension, and then reduced to 4.8 per cent for the second extension.

On maturity of Loan B, the initial six-month term of Loan B was extended for a further six-month period, and thereafter for periods of one year until 16 October 2009. On each extension of Loan B, the interest due on maturity was capitalised with the intention that payments under Loan B would then be made as and when Spanish Co had sufficient liquidity, i.e. when it had received sufficient dividend income from its subsidiaries. It is unknown whether the interest payments under the Loans equalled the dividends received.

Arguments of the parties

The Spanish Tax Authority denied Spanish Co the interest deductions on the basis that under both the Spanish rules on related-party transactions and Article 9 (Associated Enterprises) of the Spain–Netherlands Income and Capital Tax Treaty (1971), related-party transactions must be on an arm’s length basis and no independent third party would have entered into an equivalent financing arrangement in an equivalent situation. Accordingly, the Spanish Tax Authority believed that interest deductions taken in Spanish Co should be added back and taxed accordingly.

Spanish Co argued that the interest deductions should not be denied on the basis that:

• Spanish domestic law on related-party transactions in force at the time of the transaction did not permit the re-characterisation of debt as equity; and
• the interest deductions were not being used to reduce taxable profits in Spanish Co as Spanish Co’s only income was tax-exempt dividend income. Furthermore, the interest payments made to Dutch Co were taxable in the Netherlands.

  As Spanish Co had no taxable income we can only infer that it wanted to use the losses arising from deductible interest payments against another source of income elsewhere in the Group and that the Spanish Tax Authority was concerned about the accumulation of losses in Spanish Co.

Decision of the Court 

The Court, without undertaking any economic or functional analysis of the financing or of the debt leverage assumed by the company, endorsed the approach of the Spanish Tax Authority in denying the interest deductions on the basis that no independent third parties would have entered into an equivalent arrangement. The Court gave the following reasons for reaching this conclusion:

• Spanish Co’s only involvement in the transaction was executing the share purchase documentation: Parent Co undertook all of the negotiations, including in respect of all key terms such as the consideration, and Spanish Co simply purchased the shares in accordance with the overall strategy of the Group. It was also a decision of the Group to fully finance the acquisition by way of an intra-group loan from Dutch Co to Spanish Co rather than an arrangement negotiated between Spanish Co and Dutch Co; and
• as Spanish Co’s only income was dividend income from subsidiaries, no independent third party would have been willing to enter into the financing arrangement and certainly would not have financed the acquisition solely by way of debt financing. Also, no third party would have continually extended the term of the financing or permitted repayments to be dependent upon liquidity in the form of dividend income. Furthermore, the interest deductions resulted in Spanish Co being loss-making.

The Court therefore held that the Loans should be re-characterised as equity and the interest deductions should be denied, without considering any transfer-pricing guidelines or the possibility of a partial disallowance of deductions, an alternative interest rate, the creditworthiness of Spanish Co, or undertaking any economic or functional analysis.

Interestingly, no penalties have been imposed by the Spanish Tax Authority in this instance.