The Spanish Government has asked an experts committee to prepare a report with proposals for the tax reform that the Spanish Government is currently drafting.

One of the proposals of the committee is to establish a new limit to the deductibility of financial expenses. Under current regulations, the deductibility of financial expenses is limited to 30% of the "adjusted" EBITDA of the borrower. This restriction is applicable if annual financial expenses exceed €1 million . The amounts not deducted can be carried forward 18 years with the same limit.

The proposal of the experts committee is to apply a different limit while maintaining the €1 million threshold. The proposed alternative is to reject the deductibility of financial expenses corresponding to "excess debt" (and for this purpose excess debt is considered the amount of financing that exceeds an "equilibrium level" between debt and equity). Put simply, this implies applying a 50/50 debt to equity ratio to the borrower, which is intended to start with a 65/35 ratio and gradually reduced by 3% each year to meet the proposed 50/50 target after five years. It has been published recently in the press that the government intends to implement this recommendation, although the ratio to be applied could be 60/40 instead of 50/50.

Regardless of the final ratio to be established in the tax reform, this measure will imply a serious restriction for the deductibility of financial expenses in Spain that will increase the tax bill of a large number of Spanish business currently struggling with a significant leverage. The debt to equity ratio limit was in force in Spain until 2012, the ratio was 3/1, and was replaced by the current system due to the contradiction of this measure with the EU regulations and Tax Treaties signed by Spain.

The proposed new debt to equity ratio will apply to any financing regarding both related and non-related parties. In the case of intragroup transactions, this measure will be an exception to the application of the arm´s length principle stated in OECD Transfer Pricing guidelines and adopted by the Spanish regulations. Taxpayers should start considering the conversion of intragroup debt into equity to meet with the new limits and avoid tax inefficiencies.