In June 2015 the Supreme Administrative Court (NSA) handed down a judgment (case no. II FSK 3272/14) concerning the classification for tax purposes of the part of the remuneration paid by the borrower to the lender calculated as a percentage of the profit achieved by the borrower.
The Company (the Borrower) entered into a loan agreement with a foreign entity (the Lender) for the sole purpose of financing a development project. Under the agreement, the Lender was to receive interest on the principal at an annual rate of 15% and on top of that the Borrower was to pay the Lender 20% of the profit it achieves, if any (a fee known as interest under profit participating loans).
The Borrower applied for a tax ruling to clarify the consequences its payments of interest under profit participating loans will have on the grounds of tax laws, arguing that these amounts shall be qualified as its tax deductible cost.
The Borrower argued that this interest is payable under the loan agreement and is an expense that is reasonable and legitimate in its line of business. In particular, the Borrower explored other financing options, involving other lenders, and proposed that the manner of calculating these particular interest amounts does nothing to alter their status as tax expense given that parties to agreements are free to set interest rates in whatever way they see fit (as fixed or variable rates, or based on more complex instruments).
The Minister of Finance disagreed with the Borrower, finding that the agreement made by the Borrower cannot be deemed an agreement for a loan in the meaning of Article 720 of the Civil Code and that, therefore, the amounts payable thereunder, calculated as a percentage of the Borrower’s profit, if any, cannot be classified as interest.
The competent Provincial Administrative Court (WSA) agreed with the argumentation of the Minister of Finance.
With its June judgement the NSA upheld the positions taken by the Minister of Finance and the WSA, denying the Borrower the option to classify the paid amounts of interest under profit participating loans as its tax deductible costs. These expenditures are directly linked to obtaining the loan and they were incurred in order to obtain this tax-neutral gain rather than to generate some specific revenue. The NSA also found that since the Lender’s rights in this case greatly exceed those it would have under a loan agreement made pursuant to Article 720 of the Civil Code, the agreement considered here is essentially an agreement for the joint implementation of a project serving to jointly benefit the Parties concerned which shoulder the risks that go with the project jointly and severally.
The position taken by the NSA in the judgment considered here is untenable. The business purpose of financing is to pay for business activities geared, by assumption, to generating tax revenue. One must also dispute the Court’s finding that interest under profit participating loans is not classifiable as a tax deductible cost since the Lender incurs an additional business risk by making part of its profit from funding the Borrower’s operations conditional on the business success of the given venture. There can be no doubt that the lender takes on a credit risk whenever it extends a loan, as the risk may materialize if the project financed with it fails. The projections of the severity of the risk involved may have a direct impact on the proposed amount and manner of calculation of the remuneration due to the lender – as was the case here when the higher risk taken on by the Lender (due to the likelihood of the Borrower failing to achieve profit) was compensated for by the Lender’s entitlement to a specific percentage of the Borrower’s profits.
Also, the fact that the interest rate that was calculated based on the Borrower’s profit should not in itself prompt the conclusion that the loan is now no longer a debt instrument and that the interest now becomes a dividend – which is a direct consequence of the Court’s verdict. The Lender’s legal position will at all times definitely differ from that of a shareholder.
This is not the first judgment of this kind coming from the NSA, which suggests that caution must be exercised when entering into participating loan agreements. An important point to make here is that it is possible to come up with an interest formula that will make the interest classifiable as a tax deductible cost even if its amount is indirectly linked to the borrower’s profits – as follows from some of the tax rulings issued by the Minister of Finance.