The decision of funding a company through debt or equity has significant income tax consequences. In many cases, taxpayers elect debt since when the investment is paid back to the lender, deductible interest may result to the entity.

However, frequent disputes arise between taxpayers and tax authorities as to whether the real characterization of an investment in an entity as debt vs. equity. Taxpayers usually desire the “debt” label, while tax authorities often argue that the investment is in reality equity, since this generally generates more overall income tax.

A recent judgment of the Spanish High Court of Appeal (“Audiencia Nacional”) recharacterized as equity a profit participation loan (PPL-subordinated) granted by a Dutch holding company to its Spanish subsidiary, and disallowed the deduction of interest expenses related to the loan. The Court, in application of the “substance over form” principle, considered that the loan did not actually have debt features, and that it was in reality a Shareholders contribution (Equity).

The Court’s arguments to decide the recharacterization of the PPL into equity where, in essence, the following: 

  • The loan agreement did not set the maturity date and should be terminated by mutual agreement.
  • It was expressly stipulated that the loan could be converted into the borrower’s shares. The Court considered that it does not seem realistic that an independent creditor could have any interest in acquiring shares of a borrower that cannot repay the loan. 
  • No interest should be paid if the borrower did not have profits; the amount of interest paid (linked to EURIBOR) was limited to the company’s profits. With this regard, the Court stated that one thing is a "variable interest", and a different thing is linking the payment of interests to the existence of profit. 
  • The loan specifies that the lender must continue to be the borrower's shareholder.

Consequently, a combination of indefinite duration, convertibility and interest payments contingent to the existence of profit, may result in the requalification of a loan into equity.

This development reflects a new trend of the Spanish tax auditors in order to enforce an approach on the implementation of the economic substance doctrine, particularly with regard to international and intragroup transactions.

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