The Judgment of the National High Court (Audiencia Nacional) of 6 March 2014 (appeal 121/2011) rejects the characterization of a profit sharing (participating) loan as a capital contribution (subscription of share capital) pursuant to article 13 of the Spanish General Tax Act.

In summary, in the absence of sufficient evidence regarding the existence of economic substance other than mere tax aims, the NHC gives preference to the form given by the taxpayer to a transaction, basing its Judgment on principles related to the burden of proof applied in connection with the administrative power of standardization, carried out giving priority to substance over form.

Likewise, the NHC establishes a clear distinction between the powers of the Tax Authorities to recast sham and fraudulent transactions under articles 16, 15 and 13 of the General Tax Act and its right to correct the value fixed by the tax payers in their transactions with related parties, under article 16 of the Spanish Consolidated Corporate Income Tax Act, neither being a surrogate for the other.

The background of the case is as follows:

  • A Spanish undertaking involved in the development of real estate, formalized, in the tax years 2004 and 2005, (among others) two profit sharing loans with 50% of its shareholders, for the acquisition of land, deducting the interest paid as financing expenses in the year. The term of the loans could be extended year by year, with a maximum term of ten years. The interest due was fixed according to the company’s profit and loss statement, before Corporate Income Tax and the deductible expense of the loans, so that the interest rate was the result of applying the following calculation: 100/equity (profit sharing loans excluded) + average annual balance of the profit sharing loan.
  • The Spanish Tax Authorities characterized the profit sharing loans as contributions of the shareholders to the company’s share capital, eliminating the deduction of the financing expenses accrued in connection with them. The arguments of the Tax Authorities were: i) absence of a variable interest rate; ii) short term; iii) equivalence in the remuneration, ownership and holding or stake of the share capital and the loans; iv) inexistence of a real necessity of financing, since the undertaking had enough treasury shares for the acquisition of the land that was used for other investments; v) real aim of dividends payment, given the form of interest, since one of the lenders had operating losses that could be offset against the interest expense.
  • The arguments of the undertaking against the Tax Authorities’ reclassification:
    1. The calculation of the variable interest rate was based on the criteria accepted by the Tax Authorities (Directorate-General for Taxation) in its Decisions (V0852-08, y 555-04);
    2. The equivalence in the identity of shareholder and lender is irrelevant for interest deductions, according to the criteria established by the Directorate-General for Taxation in its Decisions (V2158-99, V0548-05, V0055-09);
    3. The short term of a loan cannot prejudice its classification as a loan, as opposed to its long term;
    4. Article 13 of the Spanish General Tax Act (substance over form) cannot be used to recast a transaction where the legal form and the aim and nature are equivalent, due to the sole reason that the lenders are the shareholders.
    5. The Tax Authorities used an incorrect and illegal procedure against the loan, based on its high interest rate, which should have been resolved by correcting the value determined by the parties, under transfer pricing provisions (article 16 of the Consolidated Corporate Income Tax Act);
    6. The reclassification implied unfair enrichment for the Administration, since interest received by the lenders and reclassified as dividends did not benefit from the double taxation deduction, as a result of the application of the statute of limitations given that they were paid in the year 2004.

The NHC found for the tax payer, on the following arguments:

  • The reclassification of a loan with high interests rates, under article 13 of the General Tax Act, “with the aim of achieving a higher taxation of the transaction reviewed” is illegal, since it is contrary to the good faith principle laid down in article 7 of the Civil Code.
  • Article 13 of the General Tax Act does not cover a re-characterization based on the lack of equivalence between the real transaction (remuneration of shareholders) and the instrument used for such purposes (profit sharing loan), since reclassifications of this kind must be construed in accordance with or be based on article 15 of the General Tax Act (or, in our opinion, the simulation/sham provision of article 16 of the General Tax Act). In this sense, it must be noted that the re-characterization power of the Tax Authorities must be limited to the interpretation of legal transactions.
  • The reclassification constitutes a power that can be used by the Tax Authorities to recast the transactions in order to levy the tax according with the real transaction performed, eluding, if necessary, their form or denomination.
  • The regularization cannot affect only the situation of the borrower, excluding the lender, since it would be contrary to public interest, implying high taxation and generating double taxation.
  • Loans formalized in a Public Deed, executed before a Notary Public, comply with the legal requirements set out in Royal Decree Act 7/1996 for profit sharing loans and have been approved by the Notary Public and, therefore, they cannot be disregarded under article 13 of the General Tax Act.
  • The Tax Authorities cannot reclassify under article 13 of the General Tax Law, basing its arguments on hypothesis that do not represent the result achieved, that is, that the transaction performed has a different substance than the form given to it, magnifying, for such purposes, facts that should have lead to the application of transfer pricing.
  • A tax must be imposed according to the legal nature of the transaction due and, thus, when such legal nature is clear and is formalized through a typical transaction, regulated in the applicable Codes and there is no evidence (indirect business /simulation) of discordance between the contractual form and the purpose and substance (real business) carried out by the parties, the reclassification power should be used only in the application of the tax according to the legal nature and effects of the transaction concluded.
  • The Tax Authorities are not allowed to use the reclassification power to reshape the clear terms of an agreement, exceeding its grammatical interpretation and reaching a tax interpretation which is contrary to the purpose of the parties, being subject to other acts performed prior and after the transaction due.
  • Loan agreements cannot be reclassified only owing to the fact that it would lead to higher taxation, nor because the loan is concluded between a company and its shareholder; or because it has a short term or a “high” interest subject to the fact that the company obtains a profit.

This ruling of the NHC follows the criteria adopted by the Supreme Court in its Judgment of 12 December 2013, which held that profit sharing loans are a valid and legal option, regardless of its higher or lower cost, which does not affect to the deduction of the interest generated by them.