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Deductibility of Interest Expenses – the EU Crackdown
This article has been republished in Quincena Fiscal, February 2013
As the financial crisis continues and many countries companies across the globe are having a difficult time obtaining finance, it would seem reasonable that legislators should facilitate this financing. In the tax arena the most effective way to do this is simply to allow the deduction of interest. However, we have recently seen numerous jurisdictions imposing new restrictions on the deductibility of interest. The matter is especially relevant for companies involved in capital-intensive sectors, such as energy or infrastructure, as they typically borrow large sums to finance extensive investment projects. Taxand global energy service line investigates the new rules on limitation of interest deductions that have been recently enacted, or proposed, in several jurisdictions across the EU.
Typically, many of these investments rely on project finance, which in turn relies heavily on a financial model where the role of interest deductions is not at all negligible. Changing rules on interest deductibility may require the adjustment of these financial models. New projects are being reconsidered because the limitations on interest deduction risks breaking the delicate financial equilibrium on which they rest. It is important therefore, that new restrictions on interest deduction, if implemented, are accompanied by transitional provisions and specific rules which can address particular situations. In particular, attention should be given to the specific needs of capital-intensive sectors.
On the other hand, tax authorities have a legitimate interest to satisfy themselves that interest borne by a company was incurred for bona fide commercial reasons, and is not the result of an artificial allocation of financial resources within a group of companies. This particular sort of interest is thought of as aimed at reallocating the financial income and expenses within the group in order to benefit from tax arbitrage among jurisdictions with different tax rates and regulations, or between companies with and without tax credits.
In order to meet this aim, so legislators can devise measures directed specifically at potentially abusive situations. It is also possible to assess whether a company?s indebtedness is commercially reasonable. An easy way to do this is to benchmark it against the overall indebtedness of the group as a whole, to unrelated parties. If the company's debt ratio does not exceed that of its group as a whole, then it can be presumed that the individual company is bearing its fair share of the group?s overall debt and financial costs.
We will take a look at how these matters have recently been approached in different countries, with a special focus on whether the enacted measures succeed in aiming at abusive debt structures or may overkill their target and increase the after-tax cost of legitimate borrowing.
The perspective from different EU jurisdictions:
France has traditionally had several limitations on the deductibility of interest, but they have always been designed to tackle abusive structures, whilst intending not to limit the deductibility of interest expense incurred for sound business purposes.
Some of these traditional limitations only apply to related party debt. These include the capping of the deductibility of interest paid to shareholders at an officially published rate, but the taxpayer can still prove that a higher rate is arm?s length, or traditional thin capitalisation rules. Thin capitalisation rules also apply only to debt with related entities, so that they do not impact on "real" third party debt. In a similar fashion, interest that would not be deductible for a company on a standalone basis may become deductible if interest paid to related parties does not exceed 25% of EBITDA at the level of the tax group. To clarify, interest will be deductible if the company can demonstrate its indebtedness is lower than the average indebtedness of the worldwide group it belongs to. In 2011, thin capitalisation rules were extended to debt with unrelated entities, but only when guaranteed by a related party. This rule is therefore aimed at attacking back-to-back debt structures.
Other traditional limitations on the deductibility of interest apply only to specific, potentially abusive transactions. The rule generally known as the Charasse amendment limits the deductibility of interest on debt incurred to acquire related party shares followed by the inclusion of both entities in the same tax group. Following a similar rationale, the tax administration tends, with limited success, to disallow the deduction of interest in "quick mergers" (where a company absorbs a recently acquired target).
A new limitation was introduced in the French tax system in 2012. Interest and other financial expenses incurred by a French company upon the acquisition of a shareholding benefiting from the French participation exemption will not be deductible for eight years following the acquisition. The purpose of the rule is to limit reorganisations of international groups whereby financial leverage is located in France while taking advantage of the French participation exemption, and thereby essentially matching exempt income (dividends) with a deductible expense (interest). But even this limitation will only apply to artificial transactions. The interest incurred will still be deductible if the taxpayer can demonstrate that the decisions relating to the shareholding and the control over the acquired company are effectively exercised in France by itself or by a French resident affiliate. Finally, the traditional safe harbour consisting of the debt to equity ratio of the acquiring company not being higher than the overall ratio of its group of companies is also applicable to these cases.
In summary, while the French legislation has a significant number of rules limiting the deductibility of interest, such rules have so far been designed so as to try to apply only to potentially abusive transactions, while allowing the deductibility of interest on debt incurred for bona fide commercial purposes. Actually it may have been the need to discriminate the good debt and the bad debt that has made the French system complex. As Albert Einstein said: Things should be made as simple as possible, but not simpler. (However, this diagnosis could change shortly, as the new Government could introduce additional restrictions this summer, that would reduce the scope of the "good debt".)
On 4 June 2012 the Dutch government submitted a bill to Parliament introducing a new interest deduction limitation rule. The proposed new rule is intended to address what is known as the "Bosal gap", referring to the case in which the EU court held that a Dutch provision disallowing a deduction for costs in relation to a foreign participation, was in conflict with EU law. To solve this, the new limitation will apply equally with regard to Dutch and foreign participations.
Similarly to the French case, the rule proposed by the government focuses only on the matching of exempt participation income and interest expenses. Based on the new rule, a taxpayer will not be allowed to deduct "excessive participation interest expenses". To determine this, qualifying participations are deemed to be financed first with equity, and any excess of their acquisition cost over the company?s net equity for tax purposes is then treated as financed with debt. Interest is attributed to this excess by pro-rating the company?s total interest and related costs in proportion to the company?s total debt. Interest and related costs so allocated are non-deductible. However, an amount of EUR 1 million of interest expenses per year will not be affected by the new rule. This threshold applies per year and is meant to benefit small and medium sized companies.
Due to an important exemption to the new rule, it does not limit the deduction of interest relating to the so-called "expansion participations". Expansion participations are acquisitions or investments in subsidiaries to expand the business activities of the group by Dutch based multinationals and Dutch holding companies. Most investments in operational companies should qualify, and therefore only investments in passive subsidiaries would fall into the scope of this new rule. Unfortunately, the definition needs further clarification and participations financed through specific, aggressive tax planning structures are also excluded.
The new rule would become effective from 1 January 2013 and no grandfathering rules are currently included.
This new limitation would apply in addition to the current interest deduction limitation rules: anti-base erosion, thin-cap and acquisition holding rules. However, the government has announced its intention to abolish the thin capitalisation regime in the near future (provided that sufficient budget is available).
As can be inferred from the above, the proposed rules are intended to limit aggressive tax planning structures. Considering the current political and economic climate in the Netherlands, the proposed bill is probably the best outcome of a long discussion and should not affect the investment climate in the country.
Germany moved from traditional thin capitalisation rules, based on a maximum debt-equity ratio, to earnings-stripping style rules in 2008. The new rules limit net deductible interest to 30% of EBITDA (as legally defined). Also, while the old thin capitalisation rules were aimed at potentially abusive financing structures (related party debt and back-to-back financing), the new rules have a much broader scope, as they apply to any debt, including genuine third party loans granted by banks.
The limitation only applies if the net deductible interest (including interest brought forward from prior years) meets or exceeds EUR 3 million. Disallowed interest expenses can be carried forward to the following fiscal years, in which they may be deducted, subject to the same ceiling. In cases where the net deductible interest is below the limit, the "excess limitation" can also be carried forward for five years.
The new legislation does not provide for any grandfathering provisions for existing financing, but it provides for several exceptions which moderate its potential impact. First, the limitation does not apply to companies that are not part of a group of companies. This shows that the new rules intend to prevent the use of allocation of debt within a group of companies as a means of shifting taxable income between the companies in a group. Thus, the new rules, even if much broader in scope than the previous ones, are still intended to attack potential abuses. This character is reinforced by the second exception, which safe harbours debt when the equity ratio of the company is equal or higher to the equity ratio of the group as a whole. This would be a sign that the company?s debt level is not the result of an artificial allocation of debt within the group.
Nevertheless, these two exceptions do not apply to companies or groups engaged in "harmful debt financing", which involves related-party debt, or third party debt backed by a related party (intra-group debt is disregarded for these purposes), provided the "harmful interest" exceeds 10% of the total net interest expense incurred by the company or group. Again, the intent is clearly to prevent potentially abusive financing structures. However, the broad scope of the provision may lead to non-abusive cases also being caught by the rule.
The Finish Ministry of Finance has published a draft for a law proposing the restriction of the deductibility of interest expenses in business taxation, which, if approved, would come into force on 1 January 2013.
As in Germany, the net deductible interest would be capped to 30% of EBITDA. The proposed regulation includes a safe haven for net interest expenses up to EUR 500,000. An indefinite carry forward would be available for non-deductible interest.
The most significant exception to the limitation would be that net interest expenses would remain deductible to the extent that they exceed interest paid to related parties. In other words, only interest paid to related entities would be non-deductible (and only if, and to the extent that, the 30% EBITDA ceiling is exceeded). Although this exception moderates the general scope of the limitation, this is still rather wide and will apply irrespective of whether the purpose of the loan arrangement was to minimise the tax burden.
For many years the Canadian Income Tax Act has contained thin capitalisation rules which limit the amount of interest that may be deducted in respect of indebtedness to non-resident related persons. On 29 March the Canadian government introduced its 2012 budget, which included proposed changes to Canada's thin capitalisation rules. Under these proposals the debt to equity ratio for these purposes would be reduced from 2.0 to 1.5. A new rule would also treat any disallowed interest expense as a dividend for non-resident withholding tax purposes. Still, the new rules would continue to apply only to debt with nonresident related entities, thus focusing on potentially abusive structures.
A decree approved by the Spanish government has substituted the traditional Spanish thin capitalisation rules by new restrictions on interest deductions, retroactively effective as of 1 January 2012.
Two different limitations have been set. The first one refers to debt incurred to acquire shareholdings from other group companies or to make capital contributions to other group companies. The rationale for this limitation is similar to the new limitation introduced in France and, also similarly, it allows for the deduction of interest if the taxpayer can substantiate good business reasons for the transaction. However, unlike the French regulation, no exception is provided for the case where the company?s debt ratio does not exceed the group?s overall debt ratio. Also, no grandfathering provisions exist for acquisitions completed in prior years.
The second limitation is similar in many aspects to the German rules, and in fact appears to have been modelled on them: the deduction of net financial expenses is capped at 30% of EBITDA (except for banks); non-deductible interest can be carried forward for 18 years, with the same limitation; excess limitation can be carried forward for 5 years, and no limitation applies to net financial expenses up to EUR 1 million per year.
Also, this limitation does not apply to companies which are not part of a group. However, unlike the German rules, the Spanish regulations do not include an exception based on the fact that the debt ratio of the company does not exceed the debt ratio of its group as a whole.
In summary, the new Spanish rules follow the general lines of the limitations being introduced in other European countries but have failed to incorporate the fundamental indicator used in those jurisdictions to deem that the debt is not abusive, the fact that a company is not more heavily indebted than the group to which it belongs. Thus, the Spanish regulations apply the same simple rule (limitation of deductible interest to 30% of EBITDA) to all taxpayers (except banks), regardless of the specifics of their sector or the group of companies they belong to. This may create additional difficulties for business to obtain finance (especially now that loan facilities are scarce in Spain and EBITDAs tend to be rather low) and for the development of new infrastructure projects. It can also produce inequitable results: a simple limitation rule that applies in the same way to all taxpayers in all circumstances gives the same treatment to different situations, a form of discrimination. In a complex world, tax systems need to have a minimum level of complexity if we want them to have a minimum level of equity.
It should be noted that the above limitations do not apply to companies subject to autonomous Basque regulations, which continue to apply the more traditional thin capitalisation rules, aimed only at debt with related entities not resident in the EU.
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New rules on limitation of interest deductions have been recently enacted or proposed in several jurisdictions. Some of them apply only to potentially abusive situations, such as related party debt or the financing of shareholdings benefitting from a participation exemption. Others are in principle broader in scope but are moderated by exceptions and safe harbours so as to impact mainly on abusive financing structures and respect the deduction of interest accrued on debt incurred for bona fide commercial reasons. In this fashion, the regulations in France and Germany include safe harbour rules based on the principle that a company?s debt should not be considered abusive if it does not exceed the ratio of indebtedness of the group to which it belongs. The exception is Spain, which recently enacted limitations of general scope without a similar safe harbour rule.
However, these exceptions and safe harbours do not ensure that the limitations will not impact bona fide commercial debt. Now is the time for companies to review their financing structures to make sure they comply with local regulations, and that it can be sustained that debt is distributed across the group in line with business needs and rationale.
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