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Economic Substance of Transactions and Tax Fraud Proceedings

7 Dec 2010

September saw the publication of two relevant decisions of the Central Economic-Administrative Tribunal (administrative body made up of prominent public officials in the field of tax, "TEAC"), dated 1 June 2010 and 14 July 2010, in which the TEAC reiterated its view that the economic substance of transactions is a fundamental element of tax fraud proceedings. Taxand Spain reviews the TEACs decisions with respect to taxpayers and benefits to them.

In the first of these decisions, the TEAC analysed a transaction in which a Spanish entity acquired a group company in Portugal from its Swiss parent, for which it needed financing from another EU group company.

The inspectors' view was that the sole aim of the acquisition was to place debt at the Spanish entity so as to decrease its corporate income tax base and reduce the group's taxation in Spain by deducting borrowing costs, without there being any economic, strategic or financial reasons for performing the transaction.

In the benefit of the taxpayer, the TEAC ruled out the existence of tax fraud on this occasion, on the following grounds:

  • The transaction was not artificial (a hallmark of fraud, according to the Supreme Court) because it was the result of a direct purchase, with no detours or strings of transactions, and it was performed by an operating entity.
  • The economic reasons given did not contradict the actual mechanism used.
  • There were genuine legal and financial circumstances that gave economic substance to the structure, as the entity's submissions, establishing that the transaction was performed to create a headquarters in Spain for the Iberian region, were amply proven, and a substantial amount of supporting documents were produced in the proceeding.
  • In short, the TEAC held that it was clear from the proceeding that a number of synergies made the transaction advisable, meaning that there could be no doubt as to the economic

In the second decision, the TEAC analysed a transaction in which a Spanish entity purchased from its parent (also resident in Spain) 70% of the shares in another group entity (for which it obtained a loan from a third group entity, in this case a non-resident) and the remaining 30% through a contribution in kind from the parent.

In this case, the inspectors' reasoning in the tax fraud proceeding was basically the same as in the previous decision, and was primarily based on the argument that the aim sought by the group was to increase the financial burden in Spain, and reduce taxation by deducting the costs associated with the loan from the corporate income tax base, and while doing so, to avoid the thin capitalisation rule in Spanish legislation by making a contribution in kind to increase capital stock.

Based on the facts of this case, and in detriment to the interests of the taxpayer, the TEAC upheld the lawfulness of the finding of tax fraud in this transaction and the resulting reassessment, on the following grounds:

  • Firstly, it considered that the facts proved the transaction's artificial nature as the reorganisation of the structure lacked any genuine financial content and, conversely, seemed to be aimed at proving an apparent need for debt.
  • Secondly, it held that the review procedures carried out in the course of the proceeding had not produced any support for the economic substance underlying the reorganisation, which confirmed that the actual aim was not to acquire something (the reason why the entity took on the debt) but rather to enter into debt, for which it feigned the need for the acquisition, all of which was confirmed by the fact that 3 years later, a new restructuring was carried out to return to the original situation.
  • Lastly, the TEAC focused on the failure to produce proof that the group's aim was to transform the entity into the head of the group in Europe (as the entity had alleged), and the TEAC found to be lacking in the proceeding any analysis or program of objectives, documents evaluating the objectives, or documents evidencing that any actual action was taken to integrate operations, common personnel policies, systems, strategies, etc.

Taxand's Take

These latest decisions confirm the importance that will be placed on the economic and business reasons for transactions in tax fraud proceedings in the future, and even more so, on the availability of proof to sustain it.

Your Taxand contacts for further queries are:
Vicente Bootello
T. +34 91 514 5200

Jos? Ignacio Ripoll
T. +34 91 514 5200

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