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Spanish Tax Agency Attacks Multinationals with Highly Leveraged Spanish Subsidiaries

22 Jul 2011

Five years ago the Spanish Tax Agency started to challenge the tax deductibility of interest on intra-group loans provided to Spanish affiliates, where the financing was raised to acquire non-resident entities already belonging to the same multinational group. They based their attack on general anti-abuse provisions, arguing that those structures were aimed at eroding the corporate income tax base and were not based on valid business reasons.

The Tax Agency initially applied the "fraud upon the law" proceeding, which in Spain cannot trigger penalties (ie the taxpayer followed the literal wording of the law, albeit to achieve an "unfair" tax saving). Since then, there have been isolated cases where the Tax Agency's inspectors have followed a more aggressive approach: "simulation" (which does trigger penalties) and / or "tax offence" (potential imprisonment and very severe penalties). The Tax Agency has recently released an internal report encouraging tax inspectors to carefully consider, on a case-by-case basis, whether the "simulation" or "tax offence" approaches can be used, rather than the more traditional and less aggressive "fraud upon the law". Taxand Spain considers the impact this will have on multinational corporations with a subsidiary in Spain.

Description of the targeted structure:

  1. multinational Group (the Group) with operations in Spain
  2. a Spanish company belonging to the Group acquires stakes in other entities already belonging to the same Group. The Spanish company is normally a holding company but can also be an operating company
  3. the acquisition is financed, totally or partially, through loans provided to the Spanish companies by Group entities located in favourable jurisdictions
  4. the interest expense on the intra-group loans offsets the operating income of the Spanish entities, either directly (if the borrower is an operating entity) or through tax consolidation (if the borrower is a holding company forming a tax group with the Spanish operating entities).

The position of the Tax Agency:

i) the interest expense on the intra-group loan is not tax deductible

ii) the Tax Agency applies general anti-abuse provisions, arguing that the structure was aimed at artificially eroding the Spanish corporate income tax base of the borrower

iii) the Tax Agency issued an internal report on April 6, 2006, informing the tax inspectors that they could apply general anti-abuse provisions to combat this type of structures. Since then, 99% of the tax assessments issued against this type of structures did not include penalties, as the tax inspectors followed the "fraud upon the law" route instead of the "simulation / criminal offence" route

iv) recently, the Tax Agency had a major win in a similar case which was attacked as a "criminal offence". That judgment was part of the front page of a major Spanish newspaper in the Sunday edition

v) the Tax Agency has now posted on its web page an internal report (dated on March 11, 2011), in which it encourages tax inspectors not to assume that all these cases should be challenged using the "fraud upon the law" proceeding (without penalties), but that the "simulation / tax offence" route should be seriously considered as a valid way to attack this type of tax schemes.

Taxand's Take

The Tax Agency appears to be over-applying general anti-abuse provisions to cases in which specific anti-abuse provisions, such as thin-capitalisation or transfer pricing rules, were duly observed by the taxpayers. The first few cases challenged back in 2005 are currently under litigation and we expect that some decisions from the National Appellate Court (Audiencia Nacional or AN) should be made soon, hopefully shedding some light on this "scary" story.

In the meantime, multinational groups under investigation or with a potential to be investigated should design the best strategy possible, based on the specific facts and circumstances of each case, to distance themselves from a "simulation or tax offence" scenario, or even far from a "fraud upon the law" scenario. Although the latter objective may be too ambitious.

The above stories are troublesome and, unfortunately, whether the fraud upon the law, simulation or tax offence route will be followed very much depends not only on each specific case but also on each specific tax inspector. Unless a highly leveraged structure such as those described above is very strongly supported by business reasons, which is rarely the case in the eyes of the Tax Agency, the assessment of the interest expense as non-deductible is a given, but there is a huge difference between a "fraud upon the law" assessment and a "simulation" assessment. Further, once the line between "fraud upon the law" and "simulation" has been crossed, the way to the "tax offence" is paved, and "tax offence" is unaffordable for multinationals.

Handling and monitoring the discussions with the tax inspector in a proper way from the very start becomes crucial and items that normally would be irrelevant become critical (eg whether there was a cash payment for the acquisition of the stakes, or whether interest is paid or built into the principal). Reviewing all the facts and documentation relating to the transaction and preparing in advance the strategy to be followed at the meetings with the tax inspector may make the difference between a "standard" litigation without penalties and a "nightmare" simulation / tax offence litigation, with the directors of the multinational having to testify in front of a Spanish judge for something which, some years ago, seemed to be very legitimate tax planning.

Your Taxand contact for further queries is:
Luis M. Vinuales
T. +34 91 514 5200

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Taxand's Take Author