Maria Marta Cancio July 20 2011 Interest deduction for leveraged buy-outs Estudio Garrido Abogados | Corporate Finance/M&A - Argentina Maria Marta Cancio Corporate Finance/M&A IntroductionLimits to interest deduction Exchange controls regulations IntroductionA leveraged buy-out of the target is one of the typical strategies used to push down debt on acquisitions. In this structure, a local company purchases the shares of the local target with third-party financing - usually loans or tax-preferred corporate bonds placed through a public offering.The Argentine tax authority recently audited this type of transaction and decided that the interest deduction must be disallowed, with the effect of eliminating leveraged buy-out transactions from the M&A arena.Limits to interest deduction Under the Income Tax Law, Argentine residents (including branches and other permanent establishments of non-residents) are taxed on their worldwide income. In determining taxable income, Argentine taxpayers can deduct ordinary and necessary business expenses, including - with some restrictions - royalties, technical assistance fees and interest. Interest is a deductible expense for Argentine income tax purposes provided that the financing generating the expense is used to derive taxable income. Likewise, expenses incurred in obtaining, renewing and repaying loans are deductible.The tax authority scrutinised the interest deduction in a leveraged buy-out case and in a case in which there was no merger after the purchase of the shares. In both cases the interest deduction was disallowed because the authority construed the law to allow the deduction of only those expenses that are closely related to the generation of taxable income. In the authority's view, the entry of the loan as a liability in the acquiring company's financial statement was balanced with the entry of the shares as an asset. Consequently, there was no such close relationship to allow the interest deduction, as shares generate dividend income, which is not taxable at present.However, the authority's position can be viewed as a narrow interpretation of the current law. The authority's short-sighted view that shares can generate dividend income only rejects the possibility of capital gains being realised from the sale of shares. That transaction generates taxable income and therefore supports the deductibility of interest accruing on debt incurred to purchase the shares.Exchange controls regulationsThe discussion with the authority on interest deduction in a leveraged buy-out context may not be as effective a deterrent as the exchange controls regulations. Under these regulations, Argentine borrowers must comply with the following requirements: a one-year mandatory reserve requirement equivalent to 30% of the principal amount of the loan received, which must be deposited in an interest-free, US dollar-denominated bank account in Argentina and cannot be pledged as collateral; a minimum term of one year to repay the principal of the loan; and conversion of the foreign currency into Argentine pesos in the Argentine exchange market. The purpose of these regulations is to avoid foreign short-term investment in Argentina. There are certain exceptions to the mandatory reserve, although none apply to financing granted to purchase shares in Argentine companies, whether they involve a controlling stake or not.For further information on this topic please contact Maria Marta Cancio at Estudio Garrido Abogados by telephone (+54 11 4850 4000), fax (+54 11 4850 4001) or email ([email protected]).