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Hybrid Finance Between Related Entities: A Hot Topic

11 May 2011

Spanish profit participation loans (PPL) are hybrid instruments used in business finance, which combine the features of both equity (capital) and borrowing (loans). Their basic civil law form is that of a loan where all or part of the remuneration given to the lender for lending his money is made by reference to the business performance of the borrower. Taxand Spain discusses the widespread use of these hybrid financing instruments and the fact that the requirements they must meet are not always taken into account in their design, resulting in them being considered one of the hottest issues in tax litigation.

According to the legislation in force, PPL qualify as liabilities, but, as provided by Royal Decree 7/1996, are considered net equity for the purposes of capital reduction and company dissolution situation as established in mercantile legislation.

In this regard, a judgment in one such case was recently published by the National Appellate Court (Audiencia Nacional), on 2 February 2011, disallowing the deduction of an expense related to an intragroup profit participation loan on the following grounds:

  • No known maturity date for the PPL. It had actually been stipulated that the PPL would terminate by mutual agreement, subject to approval by the borrower's shareholders' meeting, and that the funds would at all events be converted into the borrower's shares.
  • Interest on the loan was set at a variable rate (tied to 1-day EURIBOR and by reference to the earnings obtained by the lender), with various spreads. In summary: if the borrower did not have any unrestricted earnings, no interest would be paid, and the interest could not go higher than the borrower's unrestricted earnings.
  • The loan specifies that the lender must continue to be the borrower's shareholder, and therefore if the lender transferred all or some of its rights in relation to the transaction under examination, it would have to transfer some of its shares (which would have to be: at the same time, to the same acquirer, and in proportion to the value of the funds being transferred in the transaction). And, in the opposite order, the lender would also have to transfer rights in relation to the transaction if it decided to transfer any of the shares it held in the borrower.

Taxand's Take

The National Appellate Court criticised the fact that the loan could only be terminated by the borrower. It also pointed out that converting the loan into shares is not financially plausible as, although it may later occur that the borrower has no other form of payment and is forced to use this mechanism, an independent party would not have accepted this as the only form of payment. The fact that if there are no earnings at the borrower no interest is paid and that the interest cannot go higher than unrestricted earnings was also heavily criticised by the court. A payment of interest which is linked to the borrower obtaining earnings is far beyond the concept of a "variable interest" and it is in fact a "contingent compensation".

Consequently, a combination of contingency interest compensation, indefinite duration and subordination is quite likely to result in the requalification of the PPL into equity.

Also published in the International Tax Review on 1 May 2011

Your Taxand contact for further queries is:
Javier Montes
T. +34 91 514 5200

Taxand's Take Author