Financing options: Debt versus equity A country overview

www.pwc.nl Contents

Introduction 3

Background and aim of this book 3 ʞʞ Historical context 3 ʞʞ Development of financing structures 3

Tax environment of financing 4 ʞʞ General treaty/directive implications on financing 5 ʞʞ Anti-avoidance and substance requirements 10 ʞʞ Recent developments: OECD and EU 10

Country input ʞʞ Egypt 12 ʞʞ Germany 19 ʞʞ Italy 28 ʞʞ Malaysia 39 ʞʞ Switzerland 43 ʞʞ The Netherlands 56 ʞʞ Turkey 63 ʞʞ United Kingdom 71 ʞʞ United States 79

Contact 89

Financing options: Debt versus equity 2 Introduction

Background and aim of this book

This book provides an overview of the tax treatment of the provision of capital to a legal entity in the following countries: Egypt, Germany, Italy, Malaysia, Switzerland, The Netherlands, Turkey, United Kingdom, and United States. Separate chapters are dedicated to these countries.

Each country has its own set of rules to determine whether the capital provided to a legal entity takes the form of equity capital or takes the form of debt capital. The country chapters in this book describe the approach that each country adopts. The outcome is relevant for tax purposes as the expense may or may not be tax deductible for the payer, whereas the income may or may not be taxed in the hand of the recipient.

Historical context For tax law purposes the question whether Development of financing a provision of capital to a legal entity structures In order to invest through a legal entity, represents either equity capital or debt such as a company, capital is needed. capital usually starts with following the This tax treatment provides for a Generally, capital can take the form of civil law of the country under which law consistent system within one legal system: either equity capital or debt capital. the legal entity is established. The tax law the provision of equity leads to a non- Both types of capital have different thus follows another more general branch deductible expense but will not lead characteristics from a civil law point of of law. In a cross-border context, however, to taxable income either, whereas the view. Broadly speaking a shareholder will countries may not share the same view. provision of debt leads to a deductible provide equity capital in return for shares expense but also leads to taxable income. (stock) which usually will incorporate The compensation for providing equity In a purely domestic context, the overall voting rights. The shareholder is the owner capital is dividend. The compensation for tax burden should not create a preference of the legal entity and is not entitled to providing debt capital is interest. From for one of the two sorts of capital. However, redemption of the capital provided to the a tax point of view, the treatment most in a cross-border context the person entity. Debt capital will be provided by a countries adopt is that the payment of providing the capital may have a bias to lender. The lender is not an owner of the dividend constitutes a non-deductible cost choose to provide debt capital instead of legal entity by virtue of the provision of for the legal entity whereas the recipient equity capital, specifically if parties are a loan. Other than the shareholder, the will most likely not be taxed in order to related parties. It may for instance be lender is entitled to repayment of the prevent economic double taxation. As advantageous to provide debt capital from capital provided to the entity as well as a such, the shareholder may invoke a kind a country that has a lower tax rate than remuneration during this provision of debt of a domestic exemption for dividends the country of the debtor. For example, capital (interest). One could say in general received, as a result of which he will not an interest expense may be offset against terms that the lender takes less risk than be taxed with (corporate) income tax for taxable income of country A at a rate of a shareholder as in case of a liquidation of the dividend income. Within the EU, for 30%, where the interest income is taxed the legal entity, the liquidation proceeds instance, the EU Parent Subsidiary will in country B at 15%. In this financing will be distributed to the lender first, and generally make sure that the recipient structure, related parties arbitrage between then to the shareholder. The position of of the dividend payment will not suffer the tax rates of countries. the shareholder is subordinated to that economic double taxation. Conversely, of the lender. Losses suffered by the legal most countries treat interest expenses, the entity will be at the expense of the equity compensation for providing debt capital, provided by the shareholders. as a tax deductible expense at the level of the payer. In the hands of the payee, the interest income will be taxed.

Financing options: Debt versus equity 3 Another example is where a disparity exists company A from a third party, which in longer be a disparity in the cross-border between two countries with respect to the its turn would receive debt capital from a context: two countries now take the same classification of the provision of capital as related party of company A. In this case, view. Another suggestion of the OECD is either debt or equity capital: mismatch. If company A is indirectly leveraged with to limit interest expenses to the group’s country A treats the provision of capital related party debt. Later, countries extended total external interest cost (BEPS Action to a legal entity established in country A the scope of their thin-capitalisation rules Plan 4): group-wide rules. Under the latter as debt under its laws, any remuneration to domestic lenders. Countries also started approach a group cannot deduct more paid will constitute an interest expense introducing both targeted anti-avoidance interest expenses than interest expenses in country A. Absent specific rules, the rules that disallow interest expense on paid to third parties. The aim is to align interest expense will be tax deductible in certain transactions and arm’s length the interest expense of individual entities country A. If country B, where the provider tests. The first set of rules are for instance with the interest expense of a group of the capital is established, would treat the aimed at intragroup transactions. Under of companies. A group entity’s interest provision of this capital as equity capital, the latter set of rules the level of debt of expense is limited with reference to the it may well be that the income is exempt. an entity is compared to that of unrelated actual position of the worldwide group. In this example, the disparity leads to a parties. More recently countries have deduction of interest in country A where chosen another approach than the thin- the income is not taxed in country B. The capitalisation approach: interest capping reason that this disparity can exist is that rules have been introduced. Under an Tax environment of each country follows its own domestic interest capping approach, the deduction of financing rules to determine whether the capital interest expenses is limited to a percentage provided to a legal entity constitutes equity of the income of the entity that is provided capital or debt capital. In this financing with debt capital. The EBITDA (Earnings The international tax environment of structure, related parties arbitrage before Interest, Tax, Depreciation and financing is complex. Currently, there is between the tax laws of countries. Within Amortisation) is commonly used in this no internally accepted uniform standard the EU, harmonization is taking place respect as a reference to the level of interest for determining whether an instrument in this area (see the last two paragraphs expenses. For instance, interest expenses are constitutes debt capital or equity capital. EU: amendments to the Parent-Subsidiary deductible to the point where these reach As discussed in the previous chapter, Directive and EU: Anti-Tax Avoidance 30% of EBITDA of the entity at hand. states use different criteria for the Package including the Anti-Tax Avoidance characterization of financial instruments. Directive and CCCTB). Both the OECD and the EU have taken Moreover, they may put emphasis on up the glove in the battle against excess different factors in this respect. A particular Countries have adopted anti-abuse rules shareholder financing. The EU Parent instrument employed in a cross-border to combat financing structures. Initially, Subsidiary has been amended such that no context may consequently be qualified countries restricted non-resident related exemption is granted for income received differently by the states involved. Such a party financing. More recently, countries that has led to a deduction at the level conflict of qualification may result in both limit interest expense more generally. We of the payer per 1 January 2016. The double taxation and double non-taxation. see the following trend. First, countries mismatch between the tax treatment in The possibility of divergent qualifications introduced thin-capitalisation rules for the payer country and the tax treatment especially exists with respect to hybrid foreign related parties. The U.S. introduced in the recipient country has now been financial instruments having some earnings stripping rules already in 1989. taken away. Furthermore, the European characteristics usually associated with debt Other countries followed by introducing Commission has proposed introducing and some characteristics usually associated their own thin-capitalisation rules. These an interest capping approach in EU with equity. And, even if states do agree on rules essentially require an entity to be countries (see EU: Anti-Tax Avoidance the classification of the income, they may funded with a minimum amount of equity. Package including the Anti-Tax Avoidance nevertheless treat the yield differently for A debt to equity ratio of 3:1 for instance Directive and CCCTB). The OECD under tax purposes. applies. If the debt capital is insufficiently its Action Plan against Base Erosion and covered by equity capital, the interest Profit Shifting (BEPS) proposes several There are two basic cross-border situations expense related to the excess debt is not tax rules. In order to abolish mismatches, in which a state has to deal with the deductible. Then, countries extended the the OECD introduces so-called linking qualification of a capital investment and scope of their thin-capitalisation rules for rules (BEPS Action Plan 2). As a result, with the tax treatment of the return related parties to back-to-back financing one country should follow the other thereon. First, a state may have to deal with structures and to unrelated party debt. A country’s determination of capital as either inbound capital investment from investors back-to-back structure would for instance equity or debt instead of using its own resident abroad. In this scenario, the state entail the provision of debt capital to determination. By doing so, there can no is characterized as ‘state of source’ and

Financing options: Debt versus equity 4 has to qualify the instrument to determine their commercial activities can turn to 1 As opposite to the internal source of whether the outbound payment must be the external1 sources of finance of ‘debt’ finance, the retained profits. classified as either dividend or interest. and ‘equity’. Instruments of debt, e.g. Second, in case of an outbound capital loans, are generally characterized by the investment of a resident investor in another unconditional liability requiring repayment state. In that case, the state is considered to and interest, while instruments of equity, be the ‘state of residence’ and has to qualify e.g. shares, generally represent ownership the instrument to determine whether the in and control over an asset. The return on inbound payment must be classified as debt is usually fixed in advance while the either dividend or interest. return on equity is variable and depends on the performance of the business. And The variety of financial instruments that while debt is associated with credit risks, incorporate elements of both equity and equity is associated with business risks. debt continues to grow. Differences in Even within one jurisdiction, differences qualification thereof within and between can often be found between tax, regulatory tax jurisdictions create both risks and and accounting definitions. In addition to opportunities for tax payers. But above all, the more traditional instruments, there it makes it difficult to ascertain the right is a large and growing variety of hybrid qualification of a specific instrument and financial instruments with features of both the consequences for tax law purposes in debt and equity. the respective states. In addition questions arise as to qualification of financial Despite the different definitions and instruments for bilateral tax treaty qualification methods within and among purposes. It must be established whether national systems, there are some general the remuneration on an investment should characteristics of debt and equity that can be classified as either ‘interest’ or ‘dividend’ be identified and used to distinguish one for treaty purposes. The treaty qualification from another. Equity capital is usually is of relevance because it may influence associated with: the allocation of taxing rights between the contracting states. In an EU context, • ‘corporate rights’; questions concerning the applicability of • ‘ownership’; the EU directives comes into play. • ‘control by means of voting rights’; • ‘uncertain return on investment’; This chapter provides an overview of some • ‘return dependent on business results’; general approaches in international tax • ‘business risks’ and law practice towards the qualification of • ‘subordination in payment’. financing instruments as either ‘debt’ or ‘equity’ for tax treaty purposes. It also The characteristics of debt capital include: describes the main consequences of the qualification of income as ‘interest’ or • the ‘obligation to repayment of the ‘dividend’. In addition, some of the main principal sum’; features in this respect of the EU Parent- • ‘a predetermined and fixed return Subsidiary Directive and the EU Interest related to the principal amount’; and Royalty Directive are briefly discussed. • ‘credit risks’ and • ‘preference in payment’.

General treaty/directive Qualification for tax treaty purposes implications on financing In a cross-border context, provided the states involved have conducted a bilateral Qualification of financing instruments tax treaty, a financial instrument must also be classified for treaty purposes. The Financial instruments and factors for the tax treaty qualification is of relevance for demarcation the determination of the allocation rule Businesses requiring capital to fund applicable to the income, that is the return

Financing options: Debt versus equity 5 on the debt capital (‘interest’) and the in profits’ but with the exclusion of debt- 2 Commentary on Article 10 OECD MTC, return on equity capital (‘dividends’). Most claims, broadening the scope. The third part paragraph 23, Commentary on Article 10 bilateral treaties are based on either the refers to the ‘income from other corporate UN MTC, paragraph 14. OECD Model Tax Convention (MTC), and rights’ and the classification of the income, 3 Article 10(3) OECD MTC: “The term in case of a developing state as contracting more precisely the tax treatment, by the “dividends” as used in this Article means state on the UN MTC. state of source. The qualification by the income from shares, “jouissance” shares or state of residence seems of no importance “jouissance” rights, mining shares, founders’ Tax treaty and the classification of income in this respect. The allocation rule applies, shares or other rights, not being debt-claims, as ‘dividends’ in principle, to all payments regarded as participating in profits, as well as income from other corporate rights which is subjected Essentially all bilateral tax treaties dividends by the state of source. Such to the same taxation treatment as income contain an allocation rule for cross-border payments may also include disguised from shares by the laws of the State of which dividends. So do the OECD MTC and the distributions of profits in cash or money’s the company making the distribution is a UN MTC. But because of the differences worth and interest on loans insofar the resident.” between the laws of states in this respect, lender effectively takes on business risks 4 Article 10(3) UN MTC, “The term the MTCs do not provide an autonomous of the company. The reference to the “dividends” as used in this Article means and exhaustive definition of the term national tax treatment of the income for the income from shares, “jouissance” shares or ‘dividends’. Both the OECD and the UN classification of the income for tax treaty “jouissance” rights, mining shares, founders’ have found it impossible to draft such a purposes may cause some uncertainty for shares or other rights, not being debt claims, clause.2 They do however describe the the taxpayer in the other state if unfamiliar participating in profits, as well as income from other corporate rights which is subjected kind of income that in any case falls within with the various national tax laws. It should to the same taxation treatment as income the scope. The description of ‘dividends’ be noted that the definition as provided from shares by the laws of the State of which in the MTCs refers to a variety of forms seems to be limited to the application of the company making the distribution is a in which states may recognize ‘return on the allocation rule because it clarifies the resident.” equity’ for tax law purposes and leaves interpretation of the term ‘as used in this 5 Article 11 (3) OECD MTC: “The term room for adaption in bilateral tax treaties. Article’ instead of ‘for the purposes of this “interest” as used in this Article means income In essence, the underlying common notion Convention’. But the implications of this from debt-claims of every kind, whether or is the distribution of profits, where the seem to be somewhat undefined. not secured by mortgage and whether or entitlement to such profits is constituted by not carrying a right to participate in the corporate shares or rights. Tax treaty and the classification of income debtor’s profits, and in particular, income from government securities and income from as ‘interest’ bonds or debentures, including premiums and The OECD MTC3 nor the UN MTC4 provide Essentially all bilateral tax treaties contain prizes attaching to such securities, bonds or a classification method to identify ‘return on an allocation rule for cross-border interest. debentures. Penalty charges for late payment equity’, nor do they contain an autonomous So do the OECD MTC and the UN MTC. shall not be regarded as interest for the definition of the term ‘dividends’. Both Both the OECD MTC5 and the UN MTC6 purpose of this Article.” MTCs do however provide an enumeration provide an autonomous and closed 6 Article 11(3) UN MTC: “The term “interest” of payments regarded as dividend. The definition of the term ‘interest’, but the as used in this Article means income from definition clarifies that for the purpose of scope appears to be limited to the interest debt claims of every kind, whether or not the allocation article ‘dividends’ means income allocation rules. And although no secured by mortgage and whether or not ‘income from shares, “jouissance” shares or reference is made to the classification of carrying a right to participate in the debtor’s profits, and in particular, income from “jouissance” rights, mining shares, founders’ the income in the source or residence state, government securities and income from bonds shares or other rights, not being debt-claims, states may agree on including a reference or debentures, including premiums and participating in profits, as well as income to the national laws of one or both of them prizes attaching to such securities, bonds or from other corporate rights which is subjected in their bilateral treaties.7 debentures. Penalty charges for late payment to the same taxation treatment as income shall not be regarded as interest for the purpose of this Article.” from shares by the laws of the State of which The definition states that ‘interest’ means the company making the distribution is a ‘term “interest” as used in this Article 7 Commentary on Article 11 OECD MTC, resident.’ means income from debt-claims of every paragraphs 21 and 21.1. kind, whether or not secured by mortgage The definition appears to be three-parted. and whether or not carrying a right to The first part consists of examples of income participate in the debtor’s profits, and considered as the return on equity capital in particular, income from government found commonly in states. This phrase securities and income from bonds or seems to be an closed definition. The second debentures, including premiums and part refers to ‘other rights participating prizes attaching to such securities, bonds

Financing options: Debt versus equity 6 or debentures. Penalty charges for late residence. A tax treaty seldom prescribes 8 Commentary on Article 11 OECD MTC, payment shall not be regarded as interest for exclusive taxation of dividend or interest. paragraph 19. the purpose of this Article.’ In essence, all This holds true for tax treaties based on the kinds of debt in every form fall within the OECD MTC as well as those based on the 9 Commentary on Article 11 OECD MTC, paragraph 19 and Commentary on Article scope. The term ‘interest’ does not include UN MTC. A generally accepted rule for the 10 OECD MTC, paragraph 25. items of income which are dealt with under exclusive taxation of dividends or interest the article concerning the allocation rule in either the source state or residence 10 Commentary on Articles 23a and 23b with respect to dividends.8 Remuneration is also not likely to be agreed on in the OECD MTC, paragraph 32.1 – 32.7. on participating bonds and convertible foreseeable future. States take opposite 11 For example, the Netherlands. bonds is considered interest for tax treaty views as to which of the contracting states purposes, unless the loan effectively shares should be granted exclusive taxing rights of 12 Article 10(1) and (2) OECD MTC and the business risks of the debtor.9 such income under a tax treaty. Article 10(1) and (2) UN MTC. Conflicts in qualification With respect to dividends, the Commentary 13 Commentary to Article 10 OECD MTC, paragraph 5. According to the Commentary on OECD to the OECD MTC states that exclusive MTC, conflicts of qualification of an taxation in the state of source is not 14 Commentary to Article 10 OECD MTC, financial instrument and the classification acceptable as a general rule13 and exclusive paragraph 6. of income between the two contracting taxation in the state of residence not states should be resolved by binding the feasible.14 The Commentary does observe 15 Commentary to Article 11 OECD MTC, paragraph 3. state of residence to the classification that taxation by the state of residence of the state of source for the purpose of would be appropriate for investment 16 Commentary to Article 11 UN MTC, the method for elimination of double income such as dividends, but it also states paragraph 5. taxation.10 But not all states agree on that that it seems unrealistic to expect source position.11 states to give up their right to tax. A similar compromise is reached with respect to Withholding taxation under OECD MTC the allocation of taxing rights on interest and UN MTC income.15 Interest may be taxed in the state of source and the state of residence, but the Allocation of taxing rights taxing rights of the source state are limited In most cases, dividends paid by a by prescribing maximum tax rates. corporation in one state to a shareholder in another state falls within the tax Also tax treaties based on the UN MTC jurisdiction of both states. The same holds grant by way of compromise both the state true for interest paid by a debtor in one of source and the state of residence the state to a creditor in another state. If both right to tax. But in contrast to the OECD states impose tax on the same income, MTC, the underlying preference is that juridical double taxation arises. To avoid dividends are taxed exclusively by the state international double taxation, MTCs of source. Nevertheless, current practice provide for the allocation of taxing rights largely follows the OECD MTC approach. between the state of source and the state of The taxing rights of the source state are residence. If the right to tax is exclusively even limited by prescribing maximum tax attributed to one state, viz. ‘shall be taxable rates. A similar compromise is reached with only’, usually the state of residence, the respect to the allocation of taxing rights on other state is precluded from taxing the interest income.16 income. If taxing rights are allocated to both states, viz. ‘may be taxed’12, the state Withholding taxation of residence must provide relief to avoid The state of source often executes its double taxation by the exemption or credit taxing rights by means of a withholding method. Most bilateral tax treaties are tax. Under a tax treaty, the tax rate to be based on either the allocation rules as applied is limited. Both the OECD MTC included in the OECD MTC or the UN MTC. and the UN MTCs effectively prescribe maximum tax rates to be applied by Taxing rights are usually allocated to the state of source. Usually, a different both the state of source and the state of maximum rate applies to dividends arising

Financing options: Debt versus equity 7 from direct investment and portfolio compared to the OECD MTC. The threshold 17 Commentary to Article 10 OECD MTC, investment. The maximum tax rate for for direct investment is a 10% holding. paragraph 9. interest is usually lower compared to The lower maximum rate applies if the dividends. beneficial owner is a company which holds 18 Article 3(1)(b) OECD MTC. directly at least 10 per cent of the capital 19 Commentary to Article 10 OECD MTC, Maximum tax rates on dividends of the company making the dividend paragraph 13. Tax treaties based on the OECD MTC payment. According to UN Commentary, generally provide for different maximum this threshold is chosen because in some 20 Commentary to Article 10 UN MTC, tax rates to be applied by the state of developing countries non-residents are paragraph 10. source depending on the nature of equity limited to a 50 per cent share ownership. 21 Commentary to Article 10 UN MTC, investment. On portfolio investment In such case, a 10 per cent holding is paragraph 10. dividends, the rate of tax in the state of considered a significant portion of such source is as a rule limited to 15 per cent permitted ownership.22 22 Commentary to Article 6 UN MTC, under the OECD MTC. According to the paragraph 6. Commentary, this percentage appears to be Maximum tax rates on interest 23 Commentary to Article 11 OECD MTC, reasonable since the underling corporate The taxing rights of the state of source with paragraph 7. profits are also taxable in that state.17 A respect to interest are usually limited by lower maximum is provided for eligible treaties based on the OECD MTC by means 24 Commentary to Article 11 OECD MTC, direct investment dividends. A maximum of a maximum rate to be applied of 10 per paragraph 7. of 5 per cent applies if the beneficial cent. According to the Commentary, this 25 Commentary to Article 11 UN MTC, owner is a company, meaning any body percentage appears to be reasonable since paragraph 10. corporate or any entity that is treated as the underling corporate profits financed a body corporate for tax purposes,18 that out of the debt instrument are also taxable 26 Commentary to Article 11 UN MTC, meet the threshold. For this, the company in that state.23 Contracting states may paragraph 8. must hold directly at least 25 per cent of agree upon a lower tax rate or on exclusive 27 Commentary to Article 11 UN MTC, the capital of the company making the taxation in the state of residence.24 paragraph 9. dividend payment. The contracting states may agree on lower maximum tax rates Tax treaties based on the UN MTC also limit 28 Commentary to Article 11 UN MTC, and even on exclusive taxation in the state the taxing rights of the state of source, but paragraph 10. of residence.19 Also, they may agree on a with an mutual larger variety in maximum lower holding percentage. percentages. The maximum tax rates for interest range from nil to 25 per cent.25 Tax treaties based on the UN MTC also The UN MTC does prescribe to apply a generally provide for maximum tax maximum tax rate on interest in the source rates on portfolio and direct investment state, but leaves the actual percentage to be dividends to be applied by the state of established through bilateral negotiation. source, but there are no maxima included Traditionally, some states would rather in the UN MTC itself. These percentages prefer to grant the state of source an are left to be set by the contracting states exclusive right to tax interest, based on the through bilateral negotiation. According reasoning that interest is earned where to the Commentary, the Double Tax the capital is used. In contrast, other states Convention (DTC) rates traditionally range would prefer an exclusive right to tax to between 15 and 25 percent for portfolio the state of residence to, among other, investment dividends and between 5 per promote the mobility of capital.26 Although cent and 15 per cent for direct investment in the end an agreement was reached dividends.20 To attract investment in on joined taxation, it was not possible developing countries, some of the current to reach a consensus on a maximum DTCs based on the UN MTC provide for percentage. According to the commentary, lower rates.21 And, some DTC include the maximum rate as adopted in the OECD special features as lower maximum tax MTC was considered to be too low.27 rates for the contracting developed state Nevertheless, in current tax treaty practice, compared to the contracting developing contracting states do agree on maximum state. The demarcation between direct rates at or below the OECD MTC rate of 10 investment and portfolio investment differs per cent to attract investment.28

Financing options: Debt versus equity 8 EU: Interest and Royalty Directive and The Interest and Royalty Directive applies 29 The OECD’s Action Plan on Base Erosion Parent-Subsidiary Directive to ‘interest’. For the purposes of the and Profit Shifting. See OECD (2013), directive the term ‘interest’ means ‘income Addressing Base Erosion and Profit Shifting, The qualification of financial instruments from debt-claims of every kind, whether OECD Publishing, Paris, OECD (2013), Action Plan on Base Erosion and Profit and the classification of the yield thereon or not secured by mortgage and whether Shifting, OECD Publishing, Paris, and the for both national tax purposes and bilateral or not carrying a right to participate in the resulting reports, especially OECD (2014), tax treaties, falls within the competence debtor’s profits, and in particular, income Neutralising the Effects of Hybrid Mismatch of the EU Member States. In principle, EU from securities and income from bonds Arrangements, OECD/G20 Base Erosion and law does not interfere. There is however or debentures, including premiums and Profit Shifting Project, OECD Publishing, Paris. secondary EU-law on the tax treatment of prizes attaching to such securities, bonds certain intra-EU dividend payments and or debentures; penalty charges for late interest payments. Several directives are payment shall not be regarded as interest.’. issued for the approximation of national The source state is not obliged to apply the tax law systems of the Member States of directive to payments from debt-claims the EU. With respect to corporate income with certain characteristics of equity, taxation and financial instruments, the i.e. ‘payments from debt-claims which Parent-Subsidiary Directive and the carry a right to participate in the debtor’s Interest and Royalty Directive are the most profits’, ‘payments from debt-claims which relevant because they may cover the return entitle the creditor to exchange his right on financial instruments. The EU Parent- to interest for a right to participate in Subsidiary directive aims to eliminate the debtor’s profits’ and ‘payments from juridical and economical double taxation debt-claims which contain no provision on profit distributions made by a subsidiary for repayment of the principal amount or company resident in an EU Member State where the repayment is due more than 50 to a parent company resident in another years after the date of issue’. EU Member State. The state of source may not levy a withholding tax and the state Although this appears to be a closed of residence must apply an exemption or definition, the national qualification of the credit method. But conditions apply. The state of source is relevant. An EU Member EU Interest and Royalty Directive exempts State – in its capacity as state of source – is interest payments from tax in the EU not obliged to grant the benefits of the Member State of source if the conditions directive to payments which are treated as are met. a distribution of profits or as a repayment of capital under its laws. Qualification for EU directive purposes The Parent-Subsidiary Directive applies to WHT under EU directives ‘distributions of profits’. The actual term An EU Member State may not levy a ‘dividends’ is not employed in the provisions withholding tax on profit distributions containing the obligations of the EU falling within the scope of the Parent- Member States. It appears to be generally Subsidiary Directive. agreed on that the objective of the directive requires the notion of ‘profit distribution’ An EU Member State may also not levy to be understood in a broad meaning. a withholding tax on interest payments But the qualification of an instrument for falling within the scope of the Interest and directive purposes is left to the EU Member Royalty Directive. States. Both the state of source and the state of residence autonomously qualify the Mismatches in tax effects instrument and payment according their The OECD and G20 states aim achieve national tax laws. Obviously this may result international consensus on rules to in conflicts of qualification and possibly neutralize the effect of mismatch mismatches in tax outcomes. As of January arrangements. This as part of addressing 2016, the Parent-Subsidiary Directive has the current possibilities to ‘Base Erosion been amended to avoid double non-taxation and Profit Shifting’ (‘BEPS’).29 Most of the in this respect. suggestions take form of ‘linking rules’,

Financing options: Debt versus equity 9 rules that align the tax treatment payments relies primarily on the legal form of the jurisdictions, limits the interest deduction on a financial instrument in one state with transaction in determining the existence by reference to the earnings of the issuer treatment in the other state to arrive at a and relevance of payment obligations. In (“earnings stripping rules”). Under these balanced outcome. Payments are either tax other jurisdictions however, the concept rules, interest deductions are limited a to deductible and taxed or tax non-deductible of debt and equity for tax purposes may certain percentage of EBITDA (earnings and eligible for a relief for double taxation. differ from the concept of debt and equity before interest, taxes, depreciation and that can be found in the jurisdiction’s amortization). For instance, under the commercial law or accounting principles. German “earnings stripping rules”, interest Anti-avoidance and substance deductions are limited to 30 per cent of requirements Under an “economic substance” or EBITDA, while under Italian rules, interest “substance over form” approach, all the expenses are fully deductible to the extent As discussed in the previous chapters, many facts and circumstances are considered to of interest income. Interest expenses that jurisdictions apply a basic distinction by determine whether a financial instrument exceed interest income, however, are which interest payments are deductible in more closely resembles debt or equity. deductible up to 30 per cent of EBITDA. computing the taxable profits of the issuer, These rules may not only be used to while dividend payments are not deductible. characterize a financial instrument as debt General anti-abuse rules (“GAAR”) This tax benefit may create a bias towards or equity, but may also be used as well to Finally, excessive interest deductions could debt financing, especially when the parties recharacterize or reclassify a transaction in be attacked through the application of a are related parties. Internationally, a accordance with its substance. country’s general anti-abuse rule (“GAAR”) country may also be concerned about the in order to recharacterize debt as equity potential for erosion of its tax base. Anti-abuse rules when the arrangement was entered into with the (main or principle) objective of Therefore, jurisdictions may adopt Many countries require that the rate of obtaining a tax advantage. The anti-abuse rules with the purpose of reducing or interest paid with respect to loans from rule may as well be applied in attacking even eliminating the bias toward debt related parties is an at arm’s length rate. specific transactions in which the capital financing. This bias may become even In some cases, the interest that would be structure of an entity is modified to replace more pronounced when payments cross non-deductible as a result of the interest outstanding equity instruments with debt borders, and the source jurisdiction treats not being at an arm’s length rate could be instruments, especially with respect to loan a payment as a deductible interest while recharacterized as a dividend. A number transactions between the entity and its the jurisdiction in which the investor is a of countries also require that the amount shareholder(s). resident provides a participation exemption of debt cannot exceed an arm’s length for what it considers to be a dividend amount. (“hybrid mismatch”). Recent developments: OECD and Thin capitalization rules EU In general, rules with the purpose of A common approach in a number of reducing or even eliminating the bias jurisdictions is the adoption of rules that OECD: the BEPS Project toward debt financing may be divided into establish a maximum debt to equity ratio, two categories: usually referred to as “thin capitalization In 2013, the OECD announced its project 1. “reclassification” rules; rules”. Under these rules, interest on debt against Base Erosion and Profit Shifting 2. “anti-abuse” rules, such as the more that exceeds the maximum ratio would (BEPS). This project consists of 15 separate targeted “thin capitalization” rules and not be deductible in computing the taxable Action Plans with a view to addressing “earnings stripping” rules, or general profit of the issuer of the loan. In practice, perceived flaws in international tax anti-abuse rules (“GAAR”). the allowable debt-equity ratio may vary rules. After the publication of several considerably. Many jurisdictions have discussion drafts in 2014 and 2015, the Reclassification rules adopted a 3:1 ratio, but a 5:1 ratio can be OECD published its final reports of the found as well. BEPS project on 5 October 2015. Of these A number of countries attempt to reclassify reports, more specifically Action Plan financial instruments through the use In some cases, the interest that would be 2 (“Neutralizing the Effects of Hybrid of “economic substance”, or through non-deductible as a result of the maximum Mismatch Arrangements”) and Action “substance over form” principles. debt-equity ratio could be recharacterized Plan 4 (“Limiting Base Erosion Involving as a dividend. Interest Deductions and Other Financial In some jurisdictions, the concept of debt Payments”) are addressing the equity versus equity for tax purposes follows the Earnings stripping rules versus debt discussion. legal form of the transaction. This test Another approach applied by a number of

Financing options: Debt versus equity 10 Action Plan 2 sets out a number of EU: Anti-Tax Avoidance Package the EU. On 25 October 2016 however, as recommendations to neutralize the effect including the Anti-Tax Avoidance part of the October package – see below, of hybrid mismatch arrangements. These Directive and CCCTB the EC presented a proposal to complement recommendations are aimed at neutralizing these rules by broadening their scope to the effect of cross-border hybrid mismatch On 28 January 2016, the European include EU corporate taxpayers engaged arrangements, e.g. with respect to payments Commission presented its EU “Anti-Tax in a cross-border hybrid mismatch made under a hybrid financial instrument Avoidance Package” (ATAP). One of the 7 arrangement involving a third country. that produce multiple deductions for parts of this package was a proposed “Anti- a single expense or a deduction in one Tax Avoidance Directive” (ATAD). On 21 On 25 October 2016, the EC announced jurisdiction with no corresponding taxation June 2016, the EU-28 Finance Ministers plans for a corporate tax reform for the in the other jurisdiction. reached political agreement on the ATAD. EU; the ‘October-package’. As part of One of the key provisions in the ATAD that package, the EC re-launched the The mobility and fungibility of money is concerned with the deductibility of proposal for a single set of uniform rules makes it possible for multinational groups interest. for the calculation of the taxable profits of to achieve favorable tax results by adjusting multinationals active within the EU. The the amount of debt in a group entity. ATAD will introduce a rule restricting plans also include a tax base consolidation Therefore, Action Plan 4’s recommended net borrowing costs to 30% of the system and a tax base apportionment approach ensures that an entity’s net taxpayer’s EBITDA, optionally with a mechanism. This will be introduced in a interest deductions are directly linked to its EUR 3m threshold. Standalone entities staged approach. The first step will be a level of economic activity, based on taxable may be excluded from the scope. Within Common Corporate Tax Base (CCTB), i.e. earnings before deducting net interest consolidated groups, Member States rules on the common tax base. The second expense, depreciation and amortization may allow full or partial deduction of step will be the adoption of the Common (EBITDA). This approach includes three exceeding borrowing costs under ‘group Consolidated Corporate Tax Base (CCCTB), parts: (i) a fixed ratio rule based on a ratio’ conditions. Member States may i.e. the rules on the consolidation. The benchmark net interest/EBITDA ratio; (ii) exclude loans concluded before 17 June tax rates to be applied will remain at the a group ratio rule which allows an entity 2016, loans used to fund long-term EU competence of the Member States. The to deduct more interest expense in certain public infrastructure projects, and financial CCCTB will be mandatory for groups with circumstances based on the position of its undertakings. Carry-forward of non- a consolidated annual revenue of EUR 750 worldwide group; and (iii) targeted rules deductible exceeding borrowing costs may million. to address specific risks. be allowed without time limit (with an option also to include carry-back for up to The CCTB/CCCTB plans include an interest EU: amendments to the Parent- 3 years or carry-forward of unused interest deduction rule akin to the above described Subsidiary Directive capacity for up to 5 years). A grand- ATAD rule. In addition, the plans partially fathering clause that will end at the latest address the debt-equity bias by offering an In 2014, the European Union’s Economic on 1 January 2024 was agreed for national allowance for growth and investment. The and Financial Affairs Council proposed targeted rules which are “as effective as amount of a defined yield calculated on the an amendment to the EU Parent- the fixed ratio rules” to be applied for a mutation of the equity base will be added Subsidiary Directive. This amendment full fiscal year following the publication to the taxable base. I.e. an increase of was targeted at cross-border hybrid date of an OECD agreement on a minimum equity results in an amount to be deducted loan arrangements, and was aimed at standard. Member States that wish to opt from the taxable base, a decrease will lead neutralizing international mismatches that for this derogation will need to notify this to an amount to be included in the taxable may arise due to international qualification before 1 July 2017 to the EC which will base. differences of such loan arrangements. assess the effectiveness of the national Following the amendment, hybrid loan targeted rules. arrangements are dealt with a linking rule; under this linking rule, the Member The ATAD also includes rules on State where the parent company is located hybrid mismatches to tackle ‘double will no longer be allowed to exempt deduction’/‘deduction no inclusion’ distributed profits to the extent that such outcomes caused by differences in the legal profits are deductible by the subsidiary of characterisation of a financial instrument. the parent company. The Member States Application of those rules may result in the were to implement the amendment in their non-deductibility of the remuneration paid domestic tax laws by 31 December 2015 at on a financial instrument. The ATAD, as it the latest. currently stands, targets mismatches within

Financing options: Debt versus equity 11 Egypt

In this article, we will be providing an overview of the forms of financing in Egypt. We will discuss the general economic aspects as well as the financial environment, the definition of a debt and equity and the tax consequences related to each form of financing. We will also provide an example of calculation for the Egyptian tax burden resulting from equity financing in comparison with the tax burden resulting from debt financing.

General Economic and • Despite the above, the Egyptian Nourhan Elitriby Investment Environment economy is a highly diverse economy [email protected] and Egypt has strong financial and regulatory systems, all of which helped Soha Mazen • A number of rigorous changes have to reduce the effect of the crisis. Egypt [email protected] occurred in Egypt’s political scene, is currently restructuring its political President Mohamed Morsi was ousted system to build stronger economic and Passant ElTabei from power and the constitution was investment environments. The Egyptian [email protected] suspended, Mr. Adly Mansour was government has launched a strategy appointed to act as Egypt’s president which focuses on 3 aspects; business during the transitional period until reform, foreign direct investment elections. The presidential elections attraction and investor care. This is were held in May 2014, which saw the aimed to reduce the business costs election of Abdel Fattah el-Sisi, who is and to enhance the processes related now the Egyptian president. to foreign investors by reducing the amount of licensing needed. • The Egyptian economy faced an extreme downturn due to the circumstances that • However, investors are facing a number occurred and the Egyptian government of challenges where the Egyptian faced a number of challenges regarding companies have to comply with the reviving growth, economic and political Foreign Corrupt Practices Act and the stability. Currently, the political and UK Bribery Act 2010. economic situation have become much more stable and growing than the past • Investments and business startup couple of years. The government along processes and requirements are with the president focus mainly on expected to be less bureaucratic and less expanding and stabilizing the economy, corrupted. In 2015, Egypt was the 88th through encouraging investments as country on the Corruption Perception well as engaging in huge infrastructure Index. projects. • Obtaining credit and financing is not • The GDP growth rate in July/September an easy process in Egypt, this is due to 2014/2015 was 6.8%. the high risk associated with lending. According to the World Bank’s doing • In addition, Egypt’s budget deficit fell to business guide, Egypt ranked the 71st 11.5% of its GDP in the fiscal year 2014- in the ease of getting credit, however; 2015, ending in June 2015, as compared Egypt’s rank deteriorated to become to the 12.2% recorded in the previous the 79th at the beginning of 2016. fiscal year. It is worth mentioning that, Financing through equity in Egypt is the budget deficit for FY14/15 was possible through a number of ways, the initially set at 10.8% of GDP. first option is through an IPO, where the

Egypt Financing options: Debt versus equity 12 company can issue shares in the stock • Equity includes paid up capital (“PUC”), Capital gains market (partially or entirely) in case the in addition all reserves and dividends company is listed in the stock market. reduced by retained losses should serve • A tax on capital gains was first imposed Alternatively, the company can sell as the basis for computing equity. The as of July 2014. Before that, there was unlisted shares to normal individuals below formulas are provided by the no withholding tax imposed on capital seeking to invest their savings. law for the purpose of calculating the gains in Egypt. average equity and debt amounts: • Existing projects can finance their • Taxable capital gains are calculated as projects through increasing their capital • Equity = Equity at the beginning of the difference between the acquisition and issuing shares, and they can sell the financial year and equity at the cost and the fair market value / selling the majority or minority of shares to the end of the financial year, divided by 2. price. investors. • However, if equity per the above Sale of listed shares by resident and • Equity providers can be individuals, equation is less than zero, then equity non-resident shareholders which are mainly known families that is equivalent to PUC for purposes of desire to invest their savings in shares, computing the debt to equity ratio in • A 10% capital gains tax is imposed on or through private equities and foreign the context of thin capitalization. the capital gains realized upon the sale direct investors. of listed Egyptian shares, by resident or • Debt = Loans and advances at the non-resident shareholders (Companies • Grants are another mean of financing beginning of the period and loans and individuals). However, this tax has in Egypt, grants in the form of loans and advances at the end of the been put on hold for 2 years as of 17 or equity financing are provided by a period, divided by 2. May 2015, based on the amendments number of entities such as EBRD, IFC introduced by law no. 96 of 2015. and USDA, such grants are usually provided to developmental projects or to Sale of unlisted shares by resident start ups and small businesses. Equity Financing shareholders

• Debt is available in its conventional • Capital gains realised upon the sale of forms (loans and bonds) and in the Contribution of equity unlisted shares by resident individuals Islamic finance forms. Leasing is also are subject to the personal income tax another form of financing, operating Stamp duty or similar taxes rates, at the relevant brackets. Please leases specifically is a common form find below the personal income tax of financing in Egypt. Factoring (with • On the 29th of April 2013, a new law brackets, as per the provisions of the recourse or without recourse) is was issued to amend some articles of Egyptian income tax law. available in Egypt, where the owner of the existing stamp duty law, and add the receivables can sell the receivables new articles. • EGP 0 - 6,500 0% to a third party. • EGP 6,500 - 30,000 10% • The stamp tax on the transfer of shares • EGP 30,000 - 45,000 15% (0.1% on both the buyer and the seller) • EGP 45,00 - 200,000 20% Definition of terms “equity” and has been abolished by virtue of law no. • More than EGP 200,000 22.5% “debt” for tax purposes 53 of 2014. • However, in case the capital gains were • Misr for Central clearing, Depository realized by resident companies, these • Debt includes all amounts related to and Registry “MCDR” is a governmental gains would be subject to a tax, at the loans and advances, and the debit agency that applies the central rate of 22.5%. interest includes all amounts chargeable depository system, effects central by the creditor in return for the loans - registry of securities traded in the Sale of unlisted shares by non-resident advances of any kind obtained thereby, Egyptian capital market and undertakes shareholders bonds and bills. The loans and advances clearing and settlement on securities include, for purposes of this item, bonds traded in the capital market. • On the other hand, the capital gains and any form of financing by debts realized upon the sale of unlisted through securities with a fixed or a • The Egyptian Stock Exchange” is a Egyptian shares by non-residents would variable interest rate. governmental agency that operates and be subject to a capital gains tax at the develops the market. rate of 22.5%. However; a relevant DTT

Egypt Financing options: Debt versus equity 13 (if any) can further reduce this rate or • Starting the 1st of July 2014, a 10% a foreign tax credit allowed for any even eliminate it. withholding tax has become imposed foreign taxes paid to the extent of the on the dividends paid by Egyptian local tax payable. Tax imposed on the capital gains companies to resident and non-resident realised from the revaluation of assets shareholders. • Moreover, in case an Egyptian entity holds at least 25% of another Egyptian • Based on the Egyptian income tax law, • In case the recipients of the dividends company’s shares, for at least 2 years, the following shall be considered as a are resident / non-resident companies then the participation exemption rule change in the legal form: or individuals, the 10% WHT can should apply where 90% of the dividend be reduced to 5%, if the following income received by the Egyptian entity • Merger of two or more resident conditions were met together would be exempted from corporate companies. “qualifying dividends”: income tax (i.e. only 10% of the dividend • Spin off of a resident company to two income would be subject to corporate or more resident companies. • The shareholder holds more than income tax). Thus, the effective tax rate • Conversion of a partnership to 25% of the share capital or the voting applicable in this case would be 2.25%. a corporation or conversion of a rights of the subsidiary company; and corporation to another. • The shares are held for at least 2 • Purchase or acquisition of 33% or years. more of shares or voting rights either Debt Financing from the perspective of the number • Dividends received by a resident or value in a resident company, company / individual from another against shares in the acquiring resident company would not be subject Granting of debt company. to CIT / personal income tax purposes • Purchase or acquisition of 33% or at the level of the recipient company / Stamp duty more of the assets and liabilities individual, provided that all associated of a resident company by another costs are not deductible. • A proportional tax at the rate of 0.4% resident company. annually (i.e. 0.1% per quarter) is • Conversion of partnership into a • According to article 32 (BIS) of the imposed on the beginning balance of corporation. executive regulations, the associated each quarter of credit facilities and loans costs is the costs accrued or payable and advances provided by Egyptian • Based on the Egyptian income tax law, in the financial statements including banks or branches of foreign banks the tax applied on the capital gains interest accrued/payable on funds, during the financial year. In addition to realized from re-evaluation, upon loans or any other financing instruments the amounts utilized within this quarter. changing the legal form of a company as well as general and administrative The bank and the customer each may be deferred, provided that: costs that the investor bears due to bear half of the tax. Loans from other carrying out the investment. It is worth establishments are not subject to this • The company recognizes the assets noting that, in the context of this article, tax. Banks will be obliged to settle the and liabilities at book value, for tax the depreciation and amortization fees stamp duty due during the first 7 days calculation purpose. are not included within the general and following the end of each quarter. • The company calculates the tax administrative costs. depreciation on assets and carries Withholding taxes forward the provisions and reserves • It is worth noting that, individuals are based on their values before their only taxed on the dividends income • An Egyptian entity making interest valuation. exceeding EGP 10,000. payments to a non-resident person, • The company does not dispose the natural or juridical, must withhold shares within three years. • However, dividend income received tax at the rate of 20%, at the time of • The parties related to the by resident individuals whose annual payment, however in case a double tax transactions must all be tax resident investment portfolio does not exceed treaty exists between Egypt and the in Egypt. EGP 10,000, are not subject to tax. country of the non-resident person, this rate might be reduced. In addition, Payments of equity • Dividends received by resident interest on loans with more than three individuals from shares invested abroad years maturity are exempt from the • Payments of equity is possible to take are subject to the normal personal 20% withholding tax according to the the form of dividends distribution. income tax rates (stated above), with Egyptian income tax law.

Egypt Financing options: Debt versus equity 14 • The interests on loans and credit • Equity = Equity at the beginning of the • There has to be at least three facilities obtained by the government, financial year and equity at the end of shareholders and they can all be local government units, or other the financial year, divided by 2. foreigners. And, the capital of a JSC public juridical persons, from sources should be at least 250,000 EGP or its abroad shall be exempted from the tax • The following types of loans should be equivalent in foreign currencies. prescribed. Companies of the public excluded from the calculation: interest sector, the public business sector, and free loans, loans with non-taxable • Joint stock companies can be registered the private sector shall also be exempted interest, and loans with a grace period on the Egyptian stock exchange, and from this tax providing the loan or for settling the interest payments solely 10% of the company’s annual net profits facility period shall be more than three until the end of the loan period. must be distributed among employees. years. • Determining the equity, the following Deductibility items represent the basis for calculation: Limited Liability companies the paid up capital in addition to (“LLC”): • The thin capitalization rule that applies all reserves, dividends and retained in Egypt is a 4:1, debt to equity ratio. earnings (reduced by retained losses • Under the limited liability company This means that companies cannot if any), providing the revaluation form, all activities are permitted, deduct the interest payments of debts differences carried forward to the foreigners owning limited liability that are more than 4 times their equity. reserves shall be eliminated in case they companies are not allowed to import, for The excess in debt over this ratio will are non-taxable. In case of retained or the purpose of trading in Egypt. not be accepted by the Egyptian tax carry-forward losses, they must be used authority and so the associated interest to reduce retained profits and reserves • There has to be at least two partners and will not be treated as a tax deductible solely, the percentage is calculated they can all be foreigners. As for capital expense. on basis of total loans and advances requirements, there are no minimum in proportion to the remaining equity capital requirements. • The second requirement for interest amount, after deducting the retained payments to be considered a deductible losses with a minimum of the paid up • It is necessary to appoint one Egyptian expense, is that the interest rate should capital. manager where foreign managers will not be more than 2 times the discount be employed by the company. Limited rate declared by the Central Bank of liability companies can’t be registered Egypt which is currently 9.75%. in the Egyptian stock exchange. In case Typical Generic Structures the capital exceeds 250,000 EGP, 10% • In case the debt would be acquired of the company’s annual net profits must through a related party, transfer be distributed among employees. pricing rules should also be taken into In Egypt, there are four typical forms of consideration in order for the interest to legal entities; be considered a deductible expense. Branch 1. Joint stock company • It is worth mentioning that, one of 2. Limited Liability company • The purpose of a Branch is to implement the conditions required to allow the 3. Branch a specific contract in Egypt, and there deductibility of interest payments is 4. Representative office. are no capital requirements, it is only that the loan should be related to the required to a deposit of 5,000 EGP. business activities of the debtor and The manager of the branch can be an should be supported by documents. Joint stock companies (“JSC”) Egyptian or a foreigner.

Determining the debt and equity for thin • Under the joint stock company form, • A branch may deduct a head office cap calculation purposes all activities are permitted, foreigners charge of an amount up to 10% of its net owning joint stock companies are not annual taxable income. • Debt = Loans and advances at the allowed to import, for the purpose of beginning of the period and loans and trading in Egypt. advances at the end of the period, divided by 2.

Egypt Financing options: Debt versus equity 15 Representative office companies Calculations and Matrix for General Decision • Representative office companies are established for the limited purpose of studying the markets without practicing Information a commercial activity. Description Rate • No partners are required and no Corporate tax rate 22.5% capital is required, however the parent Withholding tax rate 20% company should transfer a minimum Stamp tax imposed on loans 0.4% of 1,000 USD to be deposited in the Capital gains tax imposed on the gains 10% for listed shares (on hold for two years representative office’s account under realized from selling securities, whether listed starting 17 May 2015), and 22.5% / personal foundation. or not or whether disposed by residents or income tax brackets for unlisted. non-residents. • All representative office expenses The credit and deduction rate declared by the 9.75% should be transferred from the head Central Bank of Egypt on the 01 January 2016 office abroad. The manager of the representative office can be an Egyptian or a foreigner.

Assumption one: Revenue 200 Paid up capital: We assumed in this example that the loan COGS 50 Number of shares 500 is provided by a resident entity, that the Equity: 1,000 Value of share 2 interest is within the thin capitalization Loan: 500 Total value of shares 1000 ratio and that the interest rate is not more Interest rate: 10% than 2 times the credit and deduction rate Interest expense 50 declared by the Central Bank of Egypt.

Effect on revenue in case of debt/equity financing:

Description Debt Equity Revenue 200 200 Less: COGS 50 50 Gross profit 150 150 Less: Interest expense 50 0 Earnings before tax 100 150 Corporate tax 22.5 33.75 Stamp tax Imposed on the selling of shares 0 0 transaction. Capital gains tax imposed on the gains 0 10% for listed shares realized from selling securities, whether (on hold for two years listed or not or whether disposed by starting 17 May 2015), residents or non-residents. and 22.5% / personal income tax brackets for unlisted. Stamp tax imposed on loans 1 0

Egypt Financing options: Debt versus equity 16 Assumption two: Revenue 700 Paid up capital: COGS 100 Number of shares 500 We assumed in this example that the Equity: 1,000 Value of share 2 debt to equity ratio exceeds the thin Loan: 4,500 Total value of shares 1000 capitalization ratio (4:1), and that the loan is provided by a local resident. Interest rate: 10% Interest expense 450

Description Debt Equity Revenue 700 700 Less: COGS 100 100 Gross profit 600 600 Less: Interest expense 450 0 Add: Interest adjustment 50 0 Earnings before tax 200 600 Corporate tax 45 135 Interest adjustment explanation: Stamp tax Imposed on the selling of shares 0 0 transaction Equity average: 1000 Capital gains tax imposed on the gains 10% for listed shares realized from selling securities, whether listed (on hold for two Loans average: 4500 or not or whether disposed by residents or years starting 17 May non-residents. 2015), and 22.5% / personal Debt to Equity ratio: 4.5 to 1 income tax brackets Adjustment: 4.5-4/4.5 for unlisted. Adjustment percentage: 11% Stamp tax imposed on loans 9 0

Assumption three: Revenue 700 Paid up capital: COGS 100 Number of shares 500 We assumed in this example that the Equity: 1,000 Value of share 2 interest rate is more than 2 times the credit Loan: 500 Total value of shares 1000 and deduction rate announced by the Central bank of Egypt which is currently Interest rate: 20% 9.75%. Interest expense 100

Egypt Financing options: Debt versus equity 17 Interest adjustment explanation: Description Debt Equity Revenue 700 700 The credit and deduction rate declared Less: by the Central Bank of Egypt is 9.75%, COGS 100 100 the interest rate used in the calculation of Gross profit 600 600 interest cannot exceed the double of the interest rate declared by the Central Bank Less: of Egypt which is 19.5% (9.75%*2).The Interest expense 100 0 Interest rate in this example is 20%, so Add: accordingly the interest adjustment is 0.5% Interest adjustment 2.5 0 (20% - 19.5%). Earnings before tax 502.5 600 Corporate tax 113.06 135 Stamp tax Imposed on the selling of shares 0 0 transaction Stamp tax imposed on loans 1 0

Assumption 4: Revenue 700 Paid up capital: COGS 100 Number of shares 500 We assumed in this example that the loan Equity: 1,000 Value of share 2 is provided by a non-resident entity, please Loan: 500 Total value of shares 1000 note that the Withholding tax will be borne by the loan provider. Interest rate: 15% Interest expense 75

Description Debt Equity Revenue 700 700 Less: COGS 100 100 Gross profit 600 600 Less: Interest expense 75 0 Earnings before tax 525 600 Corporate tax 118.12 135 Stamp tax Imposed on the selling of shares 0 0 transactions Capital gains tax imposed on the gains 10% for listed realized from selling securities, whether listed shares (on hold for or not or whether disposed by residents or two starting 17 May non-residents. 2015), and 22.5% / personal income tax brackets for unlisted. Withholding tax imposed on the interest 15 0 payments ( borne by the provider of the loan)

Note: In case a double tax treaty exists between Egypt and the non-resident’s country, the Withholding tax imposed on interest payments may be reduced.

Egypt Financing options: Debt versus equity 18 Germany

The following article provides an overview of possible forms of financing in Germany.

After a short presentation of general economic aspects as well as the financial environment, related to the selection of the financing, the decisive criteria for the qualification of a financial instrument as equity or as a liability are addressed. The focus is then on the presentation of the tax consequences associated with the selected form of financing, but partly on the legal consequences as well. Finally, on basis of an example calculation the German tax burden resulting from equity financing is compared with that resulting from debt financing.

Financing environment in is not inappropriate for tax purposes. Of Arne Schnitger Germany course, various limitations exist regarding [email protected] financing for tax purposes (in particular the so-called “interest barrier” – see below). Christoph Bildstein In Germany, debt is an important factor in [email protected] connection with the financing of companies. Definition of equity versus debt As a general rule, debt outweighs equity. Considering all German companies, the In connection with the financing of equity ratio has continuously increased a company, equity and debt can be from 2008 (appr. 22%) through 2014 distinguished based on the legal status of (appr. 29%).1 the investor. Furthermore, there are hybrid financing forms which exhibit elements of It is interesting on the one hand that the both equity and debt. equity ratio of larger companies – especially the listed companies – is substantially higher Legal classification of financing than that of smaller companies. On the other instruments hand, the equity ratio also strongly depends on the industry. While in 2013 the average Under commercial law and company law equity ratio in the chemistry and synthetics the classification of financing instruments industry exceeded 34%, the equity ration is dependent upon the liability criterion. in the transportation and logistics industry Forms of financing which – from the did not even reach 18%.2 In contrast, creditor’s point of view –are available as considering the low inflation and interest recoverable assets in the case of a loss, are rates of the last years, indication is given that normally classified as equity.3 In contrast, the financing requirements of companies financing instruments that are independent are not significantly influenced by economic of results are usually classified as debt.4 measures of inflation or the interest rate Hybrid financing instruments (also so- 1 Source: Creditreform market analysis as of level but instead develop more from a called quasi-equity), such as jouissance November 2015 business point of view. rights (Genussrechte) or shareholder loans, can be treated as equity or debt, depending 2 Source: Creditreform market analysis as of 5 November 2015 Thus, it is also relevant that in Germany on their arrangement. – derived from basic constitutional rights 3 See Fischer/Lohbeck, IStR 2012, 678, 679. –the principle of financing freedom exists. Classification of financing Based on this, a person is principally free to instruments for tax purposes 4 See Michalski, Kommentar zum GmbHG, finance an investment with equity or debt. 2. Auflage, Band I, Systematische Darstellung 5, C II Rn. 92ff. This principle is especially relevant in the The starting point for the tax classification context of intra-group financing flows and of financing instruments as equity or debt 5 See Michalski (Footnote 2), C II Rn. 98f. leads to the fact that debt financing per se is principally the classification under

Germany Financing options: Debt versus equity 19 commercial law and company law. There case of capital companies, however, the 6 Also in the Outbound case not further can be deviations especially in two cases:6 procurement of nominal capital is subject investigated here, the above-mentioned authority with respect to the foreign to formal requirements (i.e., certification accounting basically does not apply; see • On the one hand, a legal relationship by a notary and entry in the commercial Fischer/Lohbeck, IStR 2012, 678, 679. under the law of obligations due to register) and capital maintenance rules. In the case of a cross-border dimension, special agreements can lead to the In the case of a GmbH, the minimum the Bundesfinanzhof [federal fiscal court] creation of a so-called partnership capital amounts to EUR 25,000 and for a has developed basic principles for the tax- related differentiation between equity and between the lender and borrower. This is stock corporation (AG) to EUR 50,000. A debt in connection with the investment in a the case if borrower carries on a trade and contribution exceeding these amounts into foreign capital company for purposes of Art. the lender carries out entrepreneurial free capital reserves is possible at any time 1 of the Foreign Transaction Tax Law; see initiative and bares the risk related to the without the issuance of new shares. BFH judgment of May 30, 1990, I R 97/88, commercial activity.7 Entrepreneurial BStBl. II 1990, 875; more or less confirmed by BFH, decision of November 29, 2000, I initiative means that the lender develops If, in connection with the raising of cash R 85/99, BStBl. II 2002, 720.The German control rights which are at least at a capital, a capital company, for example, tax authorities regularly apply principles set level of control that a limited partner repays loans to its shareholders or out in the case law; Sec. 1 AEAStG May 14, has in a German limited partnership purchases assets from its shareholders, 2004; decree of October 17, 2002, IV B 4-S (KG). Entrepreneurial risk means that the principles of disguised contributions 1341 -14/02. the lender carries a risk beyond the pure in kind or investments in kind must be 7 See H 15.8 (1) EStH. risk of granting a loan; for example, this observed. This means that the share would be the case if the lender also – at capital is considered to be insufficient to 8 For more detailed information see BFH v. least on a limited basis – participates in the extent that the disguised contribution 14.6.2005, VIII R 73/03, BStBl. II 2005, income and losses of the borrower as well made in kind is not recoverable, i.e., 861. as in the hidden reserves of the business does not reach the nominal amount of 9 Assets that cannot be recognized in the assets of the borrower. the cash contribution. The result is that financial statements cannot be contributed the shareholders are obligated to make according to the resolution of the Grand • On the other hand, in the case of the another contribution in the amount of Senate of the BFH of August 28, 1987, issuance of a so-called jouissance the difference, and the general managers BStBl. II 1988, 348. right, German tax law provides for a of the company are liable as joint debtors differentiated treatment of the legal in addition to the shareholders. As a relationship (Art. 8 (3) Sent. 1 German consequence, in connection with the Corporation Tax Act – KStG). According formation of or increase in capital of a to this, for tax purposes a relationship capital company, caution should be taken similar to equity is assumed if the holder that no transactions are triggered that of the jouissance right participates in could qualify as a disguised non-cash the income and the liquidation proceeds contribution or capital increase. of the capital company.8 In the case of partnerships, in principle no rules exist regarding the raising of capital or capital increases due to the fact that at Equity financing least one partner has personal liability. However, to the extent that limited partners of a limited partnership have In connection with equity financing, the not actually paid up their contribution, company obtains new capital through an these individuals have unlimited liability increase in the existing contributions from pursuant to Sec. 171 of the German outside or through a self-financing by Commercial Code (HGB). The raising and converting retained earnings. use of capital is overall only mandatorily regulated to a limited extent. For example, contrary to tax law9, equity can also be Contribution of equity raised through the performance of services or transfer of right of use. Legal aspects With respect to the transfer of equity there are in principle no legal restrictions. In the

Germany Financing options: Debt versus equity 20 Tax-related aspects the contribution12. This only applies, 10 See R 40 KStR. For tax purposes, first open contributions however, to the extent that the profit of the 10 11 See for example § 6 Abs. 6 EStG. and hidden contributions must be contributing shareholder has not decreased distinguished. The latter exists if a (so-called correspondence principle).13 12 § 4 (1) Sent. 1 EStG (where applicable, in domestic company provides a monetary conjunction with § 8 (1) Sent. 1 KStG) and bookable advantage for a contribution Stamp taxes or similar taxes are not assessed and the company does not receive a in Germany. The last of such taxes that was 13 § 8 (3) Sent. 4 KStG. corresponding consideration and also if comparable to these, the so-called exchange such a contribution would not have been tax, was eliminated from January 1, 1992 carried out by a non-shareholder. Open pursuant to the Financial Markets Promotion contributions are all contributions that Act of February 22, 1990. are in connection with the formation or capital increase of a company; they generally require a connection with the Payments out of equity issuance of shares in a capital company or the justification/strengthening of the Legal aspects status of the partner in a partnership. The With respect to capital companies, distinction between an open and hidden payments out of equity are principally contribution is relevant for the application possible in the form of distributions. of various German tax rules.11 This requires a formal resolution of the shareholders; however, management/ Under these rules the open contribution the management board can submit an of capital into the equity of a company appropriate proposal. A distribution is is carried out basically without tax only possible if a corresponding adequate consequences: retained profit is available; this can be created through the release of non- • With respect to contributions into restricted capital reserves (§ 272 (2) No. capital reserves, the acquisition cost 4 HGB). For a distribution, there doesn’t of the investment is increased for the necessarily have to be a reference to a year- contributing company. At the level of end balance sheet; advance distributions the company there is an increase in of the expected retained profits are the equity (respectively the capital conceivable. If these are ultimately reserve) as well as in the tax-specific not adequate for the distribution, a contribution account in the amount of reimbursement claim arises against the the contribution made to the capital shareholders. reserve. According to the legal provisions for the • Contributions of capital into maintenance of the nominal share capital partnerships which qualify as pursuant to Art. 30 of the Law on Limited partnerships for tax purposes basically Liability Companies (GmbHG) respectively increase the capital account of the Art. 57 of the Stock Corporation Act contributing partner. This capital (AktG), other disbursements from equity account represents – taking into are principally not allowed for a GmbH consideration any adjustments from or an AG/KGaA. These rules pertaining so-called supplementary and special- to capital maintenance aim to achieve purpose balance sheets – the acquisition creditor protection. However, there are cost of the partner (so-called capital exceptions to the disbursement prohibition mirroring approach). pursuant to Art. 30 (1) Sent. 2 and 3 GmbHG, respectively Art. 57 (1) Sent Hidden contributions in principal also 2 to 4 AktG. According to these rules, have no tax effect; increases in business repayments to the shareholders from assets resulting from contributions are equity are allowed even if not covered by to be neutralized for tax purposes at disributable profits, if they are a) made the level of the company that received in connection with the existence of a

Germany Financing options: Debt versus equity 21 control or profit transfer agreement or b) free, provided the receiving company 14 Different for example from Brazil with the counter guaranteed with a fully valuable held at least a participation of 10% in so-called “Interest on Net Equity” regime. consideration claim or claim of restitution the nominal capital of the payor at the 15 Different for example from Belgium or against the shareholder. beginning of the calendar year in which the recently Italy. dividend is received.16 The repurchase of treasury shares by the 16 Exceptions to this are especially named in GmbH or AG also represents a form of Notwithstanding the above, to the extent § 8b (7) and (8) KStG and exist in particular for financial insti-tutions and repayment of equity to the shareholders. dividends are funded from the tax-specific financial holdings. Furthermore, for The repurchase of treasury shares by the contribution account of a company, they German trade tax purposes the 95% company basically requires a resolution, are to be offset against the acquisition cost, exemption is only applicable if further respectively the approval, of the general without tax effect, both by the distributing requirements are met. shareholder meeting. Depending upon the company and the recipient; accordingly, no 17 See § 8b (2), (3) Sent. 1 KStG. situation, the repurchase of shares can be withholding tax is due. If the distribution connected to a withdrawal of the affected from the tax-specific contribution account 18 See especially § 15a EStG. shares. From an accounting perspective, is in excess of the acquisition cost, a capital the repurchase of shares requires the ability gain results (normally 95 per cent tax of the company to establish a reserve in free).17 the amount of the acquisition cost for the share repurchase. The instrument of the With respect to the question of when purchase of treasury shares can be utilized a distribution from the tax-specific in many constellations, for example in contribution account occurs, an assumed connection with larger changes at the application is applied: first, it is assumed shareholder level, in order to make it easier that the so-called neutral asset is for individual investors to withdraw from distributed, i.e. the amount by which the company through the collection of the the tax-specific equity account exceeds shares. Please note thatthe repurchase of the nominal capital and the separately treasury shares is subject to the fulfillment determined and assesed tax-specific of several conditions which vary depending contribution account. To the extent that on the legal form of the entity (particularly this neutral asset is distributed, the tax- Art. 71 AktG and Art. 33 GmbHG). specific contribution account is deemed to be used. If this is fully depleted, it is In connection with partnerships, there are assumed in turn that a distribution is made basically no corresponding restrictions. from the neutral asset, also if the equity Here, a disbursement from capital is for tax purposes is negative or will become essentially possible without restriction; negative. Decisive in each case is the last however, for limited partners, under determined tax-basis equity and the tax- certain circumstances, there is personal specific contribution account prior to the and direct liability up to the amount of the distribution. guaranteed liability pursuant to Sec. 172 HGB as entered in the commercial register. With respect to partnerships, profits are first recorded to the capital account of Tax-related aspects the partner. Distributions then qualify as Payments out of equity are not tax withdrawals, which reduce the capital deductible.14 German tax law also grants account accordingly. No withholding tax no deemed interest deduction on equity.15 is due on this. In the case of withdrawals that are in excess of the profit (“excess As a matter of principle, dividends paid by withdrawals”), special rules are to be a German capital company are generally observed. Also in the case of limited-liability subject to a German withholding tax in owners (for example, limited-liability the amount of 26,375 per cent including partners of a KG), there are additional rules solidarity surcharge. to be observed if the withdrawal leads to a negative capital account or increases the For capital companies receiving a dividend, negative account.18 the dividend is generally 95 per cent tax

Germany Financing options: Debt versus equity 22 Reduction of equity The fund becoming available from a 19 See § 7 (8) ErbStG. simplified capital reduction is only allowed Legal aspects to be applied in accordance with Art. 58b In the case of capital companies, capital GmbHG, respectively Art. § 230 AktG reductions are utilized in practice mostly for loss compensation and in the case of to eliminate an existing adverse balance in a stock corporation for the formation of the commercial financial statements and a capital reserve in a limited amount. In are suitable only to a limited extent for particular, a repayment of such funds the repayment of nominal capital of the to the shareholders is not permitted. In company in the form of successive profit connection with corporate restructurings, distributions from uncommitted funds that the simplified capital reduction is often become available. The pre-conditions for connected to a simultaneous cash capital and effects of a capital reduction depend increase, so that fresh capital can be on the nature of the reduction. One injected at the same time that the losses distinguishes between an ordinary and arise on the balance sheet. simplified capital reduction. Tax-related aspects The repayment of equity according to an In connection with a capital reduction ordinary capital reduction is subject to of a capital company it is necessary to a number of restrictions to protect the distinguish the following two scenarios. creditors. Equity in principle can only be made available in connection with • If there is only a reduction in share an ordinary capital reduction when the capital which does not originate from nominal capital remaining after the a conversion of capital reserves or reduction is covered by assets, i.e., there revenue reserves, the distribution is is no adverse balance. The remaining initially without tax consequences nominal capital must at least equal the (offset with the acquisition cost of statutory minimum capital. A condition for the shareholder, no withholding tax). an ordinary capital reduction is a notarized On the other hand, to the extent that resolution of the shareholders which – capital reserves or share capital arising unless otherwise governed by the articles of from the conversion of reserves are incorporation – represents a three-fourth’s distributed, the order of appropriation majority. For every GmbH the reduction described above is applicable. resolution is to be published in the electronic Federal Gazette and is to be first • Capital reductions of a partnership entered in the commercial register at least basically reduce – initially without one year after the announcement; for stock tax effect – the capital account of companies not only the capital reduction the respective partner and thereby but also its implementation is to be entered his acquisition cost in the same in the commercial register. For GmbHs, amount. Apart from that, the above during the one-year blocking period, comments regarding reductions apply creditors of the company can make a claim correspondingly. against the company for collateral security or settlement of their receivables. The application, respectively the disbursement, Additional considerations - tax- to the shareholders of the equity becoming related aspects free as a result of the reduction, is only possible after the expiration of the blocking Disproportionate contributions of capital period. For stock companies, creditors of the can establish hidden profit distributions. company have a period of six months after Moreover, disproportionate contributions the capital reduction is published to make of capital can meet the conditions for a a claim against the company for collateral gift tax.19 In the case of distributions of security or settlement of their receivables. non-cash assets of capital companies or This is not a blocking period. partnerships, the so-called partial value

Germany Financing options: Debt versus equity 23 is applied. The application of the partial Also in other respects there are basically 20 In particular, the Thin-Cap-Rule of § 8a value has the consequence that hidden no limitations for tax purposes of KStG in the old version was eliminated by 20 UntStRefG. reserves in the distributed goods and issuing debt. However, if a partner values become visible and are subjected to of a partnership grants a loan to the 21 This conclusion can also result if the debt taxation. In many cases the partial value partnership, it is treated in a second is transferred through an intermediated equals the fair market value. Still the stage of profit determination as so-called company. In order to insure the partial value also considers the use of the separate business asset similar to equity.21 deductibility of interest in the case of a partnership, a careful planning review asset for the specific business of the seller This has consequences for the effective and planning of the financing should on the basis of a going concern prognosis. deductibility of the payments on this debt accordingly be carried out. for German tax purposes.

22 See E I. 1. above Debt financing Payments on debt

Legal aspects Issuance of debt In connection with the payment of interest on shareholder loans which qualify as debt, Legal aspects the principles already described above In contrast to equity, debt fundamentally regarding contestability of such payments establishes an obligation for repayment must be considered.22 to the creditor. In connection with the issuance of debt it primarily needs to be Tax-related aspects ensured that at the level of the company Withholding tax no over-indebtedness is incurred under In principle, Germany does not levy insolvency law or commercial law. withholding tax (capital gains tax) on interest payments to domestic and foreign In connection with the granting of lenders. shareholder payments which initially qualified as debt, the rules regarding equity However, there are exceptions to this substitution needed to be observed, before principle. For example, a capital gains the law was changed; under these old tax is levied if the borrower is a domestic rules, the issuance of a shareholder loan, in credit institution, if the interest pertains to particular in times of crisis of the company, a loan that is dependent on profits or if it led to the prohibition of repayment. After relates to interest on loans and receivables the German Act to Modernize the Law on that are entered in a public debt register Private Limited Companies and Combat or a foreign register. The respective Abuses (MoMiG) went into effect on withholding tax can be reduced (where November 1, 2008, the repatriation of applicable, to 0 per cent) by meeting such shareholder loan is allowed also in certain requirements according to the times of crisis. Pursuant to Art. 135 of the European Interest and Royalties Directive German Statute on Insolvency (InsO) any or in connection with a double tax treaty. repayments made by the company within For this, a timely application prior to one year prior to the filing of insolvency of the payment is necessary; alternatively the company can be contested; the same a subsequent refund upon application is applies to any security granted by the possible. company for any shareholder loan within ten years prior to the filing of insolvency of Deductibility the company. As business expenses or income-related expenses, interest payments on debt in Tax-related aspects principle reduce the tax assessment base Stamp taxes or similar taxes are not levied as long as they are business related. Such in Germany; in particular there is no tax on a business relationship, for example, can the conclusion of loan contracts. also be given with respect to debt-financed

Germany Financing options: Debt versus equity 24 share purchases within a group or debt- interest barrier.24 Controlling companies 23 See § 8 No. 1 GewStG. financed dividend distributions. and consolidated tax group companies are 24 According to, among others, Köhler, DStR considered as one operation for purposes 2007, 597; Hahne, DStR 2007, 1947, 1949; For trade tax purposes, debt financing costs of the interest barrier.25 Wagner/Fischer, BB 2007, 1811. are to be partially added to the assessment basis and as a result are generally not The interest barrier contains 3 levels: 25 § 15 Sent. 1 No. 3 Sent. 2 KStG. fully deductible.23 Furthermore, the so- 26 Hahne, DStR 2007, 1947, 1948. called net principle is to be considered. 1. Interest expenses are deductible under This means that if earnings components the interest barrier if the operation in of the trade tax assessment basis are to be the related business year generates reduced, this also applies to the directly- interest income in at least the same related financing costs; therefore, for amount. trade tax purposes such costs are not fully deductible. 2. To the extent that the interest expense in excess of the interest income (net Exceptions exist to the principle of the interest expense) does not exceed 30 general deductibility of debt financing per cent of the taxable income before costs, however, in the form of the arm’s interest, taxes and depreciation and length principle and in the form of the amortization (taxable EBITDA), the interest barrier, which are described below. interest expenses are deductible.

Arm’s length principle 3. If the interest expense is in excess of If loans do not carry interest rates that the limit described above, it is not are in compliance with the arm’s length deductible in the related assessment principle, this can lead to a hidden period, and it increases the taxable dividend distribution, respectively this can income; the non-deductible interest entail a correction of the income. expense, however, as an “interest carryforward”, can be deducted in a Interest barrier later assessment period – within the In connection with the 2008 Business limitations mentioned above pursuant Tax Reform Act, the previous rules for to Art. 4h EstG.26 shareholder debt financing pursuant to Art. 8a of the Corporation Tax Act (KStG) were In certain cases the interest barrier is replaced by the so-called interest barrier not applicable, with the result that all (Art. 4h of the Income Tax Act (EStG)) interest expenses of an operation are tax and in the meantime have been partially deductible. In particular, the interest modified. barrier is not applicable if:

The interest barrier, which is of a highly • the net interest expense of an operation complex design, provides for a limitation is less than EUR 3 million, of the deductibility of interest expenses • the operation does not belong to or of an operation. Interest expenses are belongs only proportionately to a expenses from the temporary transfer of consolidated group, or (monetary) capital, thus, among others, • the equity ratio (relationship of equity all interest expenses that result from loans to the balance sheet total) of the made by shareholders, related parties and operation is not below 2 per cent of the third parties, loans with fixed, variable or equity ratio of the consolidated group income-dependent interest rates and/or (so-called ratio comparison). loans with shorter or longer terms. The exceptions 2 and 3 are not applicable The term “operation” is not defined by due to a reverse exception if a detrimental law. In principle, however, every capital shareholder debt financing exists, the rules company and commercial partnership for which are not further presented here. qualifies as an operation in terms of the

Germany Financing options: Debt versus equity 25 Loans in the case of partnerships Additional considerations - legal 27 See especially § 3c EStG. As discussed above, a loan issued by aspects 28 Vgl. insbesondere § 4 Abs. 4a EStG. a partner to its partnership generally represents a special business asset In connection with debt financing, there 29 Vgl. insbesondere § 8b Abs. 3 S. 4 ff. KStG. (Sonderbetriebsvermögen). As a result of are often further specific special issues this classification, the interest payments that result from the observance of the 30 Siehe oben Ziffer E I. 1. on the loan are added back to second insolvency law. In the event that over- 31 See especially § 5 (2a) EStG. With respect level of income determination of the indebtedness exists for a company under to the transfer of such liabilities, Germany income generated by the partnership. insolvency law from the issuance of debt, introduced new legis-lation in 2015 which Furthermore, the payments then represent in practice a (partial) waiver of receivables is not further presented here. withdrawals of the partner. with or without a compensation agreement, respectively a subordination, could come Additional limitations of deductibility into question. The statutory rules in connection with the deductibility of operating expenses, The subordination serves pursuant to Art. respectively income-related expenses, 39 (2) of the Insolvency Statute (InsO) to in connection with debt are diverse avoid over-indebtedness under insolvency under German tax law. For example, law of the company and exists if, pursuant the following (partial) limitations on to Art. 19 (2) InsO it is agreed, that the deductibility exist: creditor with his receivable accepts a lower position than the receivables designated in • limitation of deductibility if the Art. 39 (1) No. 1 to 5 InsO of other creditors. operating expenses are in connection In contrast to a subordination, a waiver of with (partially) tax free income,27 a receivable results in a cancelation of the • limitation of deductibility in connection receivable. However, if in connection with with over-withdrawals of partnerships, an improvement of economic situation of and28 the borrower such a receivable is revived, • limitation of deductibility in connection the receivable waiver can be agreed to by a with impairment to the lower realizable so-called compensation agreement. value of certain shareholder loans.29 Furthermore, in connection with the granting of loans, the other conditions, Reduction of debt such as provisions regarding repayment and interest, are of particular importance. Legal aspects The repayment of shareholder loans classified as equity is subject to the Additional considerations - tax- principles already described above related aspects regarding the contestability of such payments.30 From a tax point of view, there is still a requirement to recognize the liability in the Tax-related aspects case of both a simple and also a qualified The repayment of debt, as redemption, in subordination. principle has no tax effect. Solely in the case of differences between receivable If loans provide for conditions, it should and according payable (for example, in be carefully analyzed what the conditions the form of write-downs made to the relate to (for example, the arising of the realizable value) there are significant tax liability, the arising of the obligation to implications. repay). The German tax law contains a special rule in this respect. Thus, liabilities in particular that are only to be redeemed if future revenues or income are achieved are first to be recognized when the revenues or income are achieved.31

Germany Financing options: Debt versus equity 26 In contrast, in the case of a waiver of a The German tax law provides a special rule 32 See especially § 6 (1) No. 3 EStG. receivable, the liability is derecognized with respect to the tax base for interest-free by the borrower with profit or loss loans.32 This specifies that liabilities from effect. However, regarding shareholder interest-free loans are to be recognized on relationships, a hidden contribution exists in a discounted basis and thereby basically the amount of the recoverable value of the establishes a taxable income amount receivable (see above regarding the effects). which results in successive expenses in the On the part of the creditor, the expense subsequent years. resulting from the derecognition of the receivable is generally not tax deductible.

Example calculation and overview

Assumptions m EUR In particular due to the fact that – in general – no withholding taxes are levied on interest Earnings before taxes 40 payments, a debt financing of German Net interest expense 60 operations is usually advantageous from a Depreciations/amortizations 80 pure German tax perspective. The overall EBITDA 180 tax efficiency then depends on the taxation of the interest income at the level of the Corporate tax rate (standard) 15% of corporate tax base creditor/shareholder. Solidarity surcharge (standard) 5,50% of corporate tax amount Trade tax (applying trade factor of 400%) 14% of trade tax base

Computation of taxable income Equity Debt m EUR m EUR

Corporate tax EBITDA 180 180 Depreciations/amortizations -80 -80 Net interest expense n/a -60 Adjustments due to interest capping rule n/a 6 Corporate tax base 100 46

Corporate tax 15,000 6,900 Solidarity surcharge 0,825 0,380

Trade tax Corporate tax base 100 46 Add-back (simplified) 13,5 Trade tax base 100 59,5

Trade tax 14,000 8,330

Summary of taxes Corporate tax 15,000 6,900 Solidarity surcharge 0,825 0,380 Trade tax 14,000 8,330 Withholding tax on interest n/a n/a Total 29,825 15,610

Germany Financing options: Debt versus equity 27 Italy

The following article provides an overview of the main distinctions between equity and debt financing from an Italian legal and tax point of view. The consequences deriving from the two forms of financing have been considered from the point of view of the Italian company/borrower; the taxation associated to the outbound payments deriving from the financing (i.e. dividend and/ or interest) have also been commented. At the end of the article, the Italian tax consequences deriving from the equity and debt financing are compared and explained with an example.

Financing environment in Definition of terms “equity” and Franco Boga Italy “debt” +39 02 91605400 [email protected] Legal perspective In principle, Italian companies are free to From a purely legal perspective, the Matteo Calizzi finance the investments either via debt distinction between “equity” and “debt” can [email protected] financing or via equity or through a mixture be found in the fact that the contributing of both. There are several variables that may party - upon contribution of equity - drive the final decision including the tax becomes a shareholder (with all associated consequences associated to each alternative. rights and obligations), whilst the lending party – upon granting of financial means The vast majority of Italian enterprises make to the borrowing company – only acquires systematic use of third party debt financing. the role of creditor, but is not in principle Most of these resources are lent by banking vested with rights usually reserved to a institutions. In fact, analysis evidenced shareholder. that the financial model of most Italian companies is greatly banks dependent. This According to the 2003 reform of Italian is particularly true for small/medium size company law (i.e. Legislative Decree companies. 6/2013), Italian companies are now Analysts put in evidence that the way entitled to issue a wide range of financial forward to strengthen the financial model of instruments that impacts such a traditional Italian companies is to encourage a greater distinction. capitalization and to replace banks debt with a greater use of other forms of financial From a broader perspective, therefore, instruments. the significant innovation introduced by the reform was the creation of an entire Some relatively recent law provisions category of financial instruments which have gone in this direction, namely (i) stand between shares and bonds. the Notional Interest Deduction (NID) provision, (ii) allowing more companies A key consideration regarding hybrid to issue financial instruments (bond and instruments – such as those under Article subordinate participative loan) and (iii) a 2411(3) and Article 2346(6) Italian Civil less restrictive taxation associated to those Code (ICC) – is the fact that although the types of loan financing. subscriber can exercise economic rights (which means that the relevant holder is granted with a remuneration for having subscribed relevant hybrid instruments) and also has limited administrative powers [such as: (i) an option right in case of

Italy Financing options: Debt versus equity 28 issuance of new hybrid instruments and payment of a periodic remuneration, which Equity Financing (ii) the right to vote on specific matters, do not confer upon the holder any direct being expressly excluded a right to vote in or indirect management rights relating to the general shareholders’ meeting], the the issuer or the deal relating to which the Contribution of equity instruments never involve a share in the security was issued, and do not give any equity of the company. In fact, central to control over the management itself. Stamp duty or similar taxes their identification is that the new hybrid No material tax is due on capital increase: instruments never give a subscriber the In short, the definition of securities similar only 200 € registration tax applies to equity status of shareholder in the issuer. to bonds is defined by a double negative contributions. requirement: Moreover, non-listed companies (other Legal constraints (e.g., limits to than banks and micro enterprises) have • the absence of contractual risk of transfer cash inbound, timing, formal been recently entitled to issue subordinate loss (as the principal must be always requirements, etc.) participative bonds (Law decree repaid); and In general terms, a company can be equity N.83/2012). financed either through new capital • the absence of control powers. injections or through conversion of existing Tax perspective equity reserves, including those composed The classification of financial instruments as Borderline areas of retained earnings. Capital can be debt or equity for tax purposes is provided The system is not a black-or-white one. increased also by means of contribution in by art 44 of the Income Tax Code (ITC), As a result, there can be (a) situations in kind of assets. which provides for a definition of the which a security may qualify as similar to securities that are to be considered “similar both shares and bonds and (b) situations Under Article 2342 and Article 2464 of to shares” and for a definition of securities in which a security qualifies as similar to the ICC, contribution into equity has to be that are to be considered “similar to bonds”. neither shares nor bonds. done in cash if the incorporation deed of the company does not provide differently. Securities similar to shares Under the first scenario, a security could The minimum capital amount requested Article 44(2)(a) of the ITC defines be built with both (i) the requirements by the ICC is respectively Euro 50,000 as “similar to shares” the securities to be considered “similar to shares” for a Joint Stock Company (Società per and financial instruments issued by (remuneration entirely linked to the Azioni) and Euro 10,000 for a Limited corporations, other business entities and all economic results of the company) and (ii) Liability Company (Società a Responsabilità nonresident entities, whose remuneration those to be considered “similar to bonds” Limitata), even though it is also possible is entirely made up by a participation to (no risk of loss and no control powers). to incorporate a Società a Responsabilità the economic results of the issuer, of other In such a case, the assimilation to a share Limitata with a corporate capital lower than companies in the same group, or of the prevails. Euro 10,000, being it understood that in single deal relating to which the securities such case the company shall comply with and financial instruments were issued. Under the second scenario, there may be certain requirements provided for by the Participation in the capital or equity, as securities which pass neither the test to be law. Increase of the share capital has usually well as securities and financial instruments defined as (i) “similar to shares” nor that to to be resolved by either the extraordinary mentioned in the preceding sentence, issued be defined as (ii) “similar to bonds”. Until shareholders’/quotaholders’ meeting, by non-resident entities are considered 2016, this implied that the holder could to be held before the Notary Public and similar to shares on condition that the not treat the remuneration according to the whose minutes shall be then filed with the related remuneration is fully nondeductible dividend exemption regime and the issuer competent Register of Companies. Within for the non-resident issuer in determining could not deduct the portion of the hybrid certain limits, also the board of directors can the taxable income in the foreign country of security linked to the economic result of the be delegated with the power to implement residence. company. Following a recent amendment, a previously resolved increase of the the holder is now allowed to apply the corporate capital. Securities similar to bonds dividend exemption regime, inasmuch as On the other hand, article 44(2)(c)(2) of the remuneration of the hybrid security is Other forms of financing the ITC defines as “similar to bonds” mass not deductible in the hands of the issuer. Apart from capital increase, the grant from securities containing the unconditional An example of these hybrid securities could the shareholders/quotaholders is one of obligation to pay, at maturity, a sum be reverse convertibles and mandatory the most commonly-used means through corresponding to not less than the nominal convertible bonds. which a company may increase its financial value indicated in them, with or without the capability. Unlike loans, grants do not bear

Italy Financing options: Debt versus equity 29 interest and are not usually reimbursed as The notion of payments on equity is not capacity. In essence: long as the company exists. limited to dividends distributed as such. • Dividends received by individual Grants can be essentially divided into 3 As a general rule, capital reserves shareholders in a business capacity main categories, depending on the specific distributed as such are not taxable as are partially (50.28% ) exempt from reasons for which the same are made: dividends: they reduce the base cost tax; the remaining portion (49.72%) is of the shares and only once such base included in the taxable income subject i. non-repayable grants (versamenti a cost is zeroed also for tax purposes, is to the progressive rates of personal fondo perduto); the excess taxable (as dividend outside income tax (IRPEF); assuming an business income, or as a capital gain individual top marginal rate of 43%, this ii. grants on capital account (versamenti within a business income framework). means an effective tax rate of 21-22%. in conto capitale); However, there is a presumption under which, irrespective of the shareholders’ • The taxation of individual shareholders iii. grants for future capital increase meeting resolution, any profit reserves not holding the participation in a (versamenti in conto futuro aumento (available for distribution) are deemed to business capacity depends on whether di capitale). be distributed before capital reserves. or not some qualification thresholds are exceeded. A participation is considered Non repayable grants (versamenti a Capital distributions work likewise: qualifying if exceeding 2% of voting fondo perduto) and grants on capital ordinarily they are not taxable as rights in the ordinary shareholders’ account (versamenti in conto capitale) dividends, but reduce the base cost meeting or 5% of capital in a listed are made on a voluntary basis by one or (also for tax purposes) of the shares; company; for unlisted companies, the more shareholders (not necessarily in however, to the extent profit reserves were percentages are 20% of voting rights proportion to their respective shareholding previously imputed to capital, these take in the ordinary shareholders’ meeting and without altering the percentage of precedence in any distribution, which is or 25% of capital. A participation shareholding of the granting party) with correspondingly taxable as dividend. is considered non-qualifying if the specific purpose of increasing the not exceeding either of the above financial capability of the company. Liquidation and redemption proceeds thresholds. are always taxable (generally as dividend Grants for future capital increase outside business income, or as a capital • Dividends received by individual (versamenti in conto futuro aumento di gain or dividend within a business income shareholders (no business) from a capitale) are explicitly destined to increase framework, depending from the nature of qualifying participation are taxed like the corporate capital within the agreed the items distributed): the taxable base is those received in a business capacity. time period. Should this condition not be the amount exceeding the tax base cost of • Dividends received by individual met, then the company has the obligation the participation. When a WHT is provided shareholders (no business) from to reimburse to the lending shareholders for, the taxpayer must provide the WHT a non-qualifying participation are the grants. agent with the base cost for tax purposes: subject to a final withholding tax at otherwise this latter may apply the WHT a rate of 26%; there is no tax return For tax purposes, the cash contribution into on the gross amount. filing requirement. new capital is considered as increasing the base cost of the shareholders’ participation. In the event of a distribution in kind, In both cases, dividends derived from capital gains tax may be triggered for the participations in tax haven companies company paying the dividend, for the (other than those from a non-qualifying difference between the fair market value of participation in a listed company, which Payments on equity the goods distributed and their base cost are still taxable at 26%) are fully included for tax purposes. in the taxable income for individual income tax purposes and taxable at progressive Withholding taxes Dividend taxation for resident individual rates unless a ruling is granted, accepting shareholders that the participation does not result in General remarks The dividends derived by individual sheltering the profits in a tax haven. This paragraph addresses the taxation of shareholders are subject to the individual payments on equity, distinguishing if the progressive income tax (43% top rate Dividend taxation for resident corporate recipient is individual or corporate and – plus 3% surcharge) and the relevant tax shareholders in the latter case – if it is resident or not treatment depends on whether or not the Dividends derived by resident companies resident in Italy. relevant participation is held in a business from other resident companies are exempt

Italy Financing options: Debt versus equity 30 from the 27.5% corporate income tax Nonresidents: primary EU regime, the Nonresidents: double tax treaties (IRES) for 95% of their amount; effective 1.375% rate When the EU Parent-Subsidiary Directive’s tax rate is 27,5% * 5% = 1,375% as long A special rate is provided for companies in requirements are not met, and for as some requirements are met. According the EU and white-listed EEA Countries (i.e. payments destined to entities resident in to the 2016 Budget Law, the corporate tax Norway and Iceland): these companies are non-EU countries, the network of 80+ rate will be decreased to 24% from 2017, entitled to a 1.375% dividend WHT rate. Double Tax Conventions(DTCs) which Italy thus the effective tax rate will be The 2016 Budget Law lowers this rate to has in force comes into play. Where the 24% * 5% = 1,2%. 1,2%, taking effect from 2017. income is classified as dividend income, the WHT levied may vary from 5% to 15% Dividends derived by resident companies The requirements are pretty much the same depending from the applicable DTC. from non-resident companies are subject as those to the Parent-Subsidiary Directive to the same tax treatment, provided that regime, but there is (i) no minimum The application of the minimum WHT rate (i) the dividends are not deductible on the participation threshold and (ii) no minimum provided for in the treaties is generally distributing company’s side and (ii) the holding period. There is no specific anti- subject to the condition that the recipient is distributing company is not resident in a abuse rule, but circular letters held that the the beneficial owner of the income. tax haven. European Court of Justice “wholly artificial arrangement” standard applies. Dividends derived – directly or indirectly – (Fictitious) deductions on from participations in tax haven companies Nonresidents: secondary EU regime, the equity (INE, NID, similar are fully taxable at the 27,5% (24% from Parent-Subsidiary Directive considerations) 2017) corporate income tax rate. However, Dividends paid to an EU company may this does not apply if a ruling is granted, benefit from the EU Parent–Subsidiary From tax year 2011, resident companies accepting that the participation does not Directive: they are not subject to any WHT and Italian branches of non-resident result in sheltering the profits in a tax in Italy if the EU parent company receiving companies are entitled to benefit from haven. the dividends from its Italian subsidiary Notional Interest Deduction (“NID”), i.e. (both having one of the legal forms listed a deduction from their corporate income A special tax regime applies to shares by the Parent–Subsidiary Directive) has tax base computed as a percentage of and similar financial instruments held held, without interruption, for at least one “new equity” generated after 2010. The by companies preparing their financial year, a participation representing at least deduction is equal to the notional yield of statements according to the IAS or the IFRS 10 per cent of the capital of the subsidiary qualifying equity increase (net of qualifying and accounting for the shares as “held for (provided that the residence country does decrease) which must be realized in trading”. In this case, dividends are fully not allow for any special regime exempting comparison to the equity resulting from the taxed and realized and unrealized gains the subsidiary from corporate tax). balance sheet as of 31 December 2010. The and losses resulting from the mark-to- qualifying increase must derive from cash market valuation of the shares are fully There used to be a specific anti-abuse rule, contributions or from undistributed profits relevant for IRES purposes. which reversed the burden of proof: the destined to reserves (except for the sum set directive could apply also if the EU parent aside as non-available reserves). Dividends received by commercial and (of the Italian subsidiary) was controlled, manufacturing enterprises are not subject directly or indirectly, from a non-EU The notional yield rate was fixed at 3% for to local trade tax (IRAP). Different rules company, as long as the taxpayer proved to FY 2011 though FY 2013; the rate was: apply to banks and financial companies. the tax administration that the structure (i) 4% for the 2014 fiscal year, (ii) 4,5% was not merely a way to benefit from the for the 2015 fiscal year and (iii) 4,75% for Nonresidents: domestic law directive with no economic substance the 2016 fiscal year. From 2017 onwards, 26% dividend WHT applies to dividends whatsoever. a Ministry of Finance decree will establish paid to all nonresidents (irrespective the notional yield rate on a yearly basis, of whether or not they exceed the In order to cope with the common de based on the remuneration of Government qualification threshold). minimis general anti-abuse rule in the bonds plus a premium risk. Companies revised PSD, the above-mentioned specific listed on an EU - or EEA - regulated stock As an alternative to other reductions (i.e. anti-abuse rule was repealed and reference exchange market after June 25, 2014 may treaty or EU regimes), a refund of foreign is now made to the Italian GAAR (general increase their new equity qualifying for taxes (if any) is granted to the nonresident anti-avoidance rule). As a result of this NID by 40% in the first three tax years after shareholder, up to 11/26 of the WHT (i.e. recent amendment, the burden of proof first being so listed. up to a maximum of 11%). should now be with the Tax Authority, rather than reversed on the taxpayer.

Italy Financing options: Debt versus equity 31 In the relevant tax year the contribution in the board of directors). Distribution of the however, to the extent profit reserves were cash is computed from the date on which it annual results is ordinarily resolved when previously imputed to capital, these take is made. approving the yearly financial statements. precedence in any distribution, which is correspondingly taxable as dividend. The amount of notional yield exceeding the Dividends cannot be paid unless from profits net taxable income of the relevant fiscal year effectively attained and resulting from the Liquidation and redemption proceeds may be carried forward and used to offset duly approved financial statements and, are always taxable (generally as dividend the net taxable income of a following fiscal moreover, in the event that a loss affecting outside business income, or as a capital year or to be offset against IRAP liabilities the corporate capital occurred, dividends gain or dividend within a business income according to certain mechanics. may not be distributed until the corporate framework depending from the nature of capital is restored or reduced accordingly. the items distributed): the taxable base is The regulation includes an anti-avoidance the amount exceeding the base cost of the provision that reduces the new equity after Distribution of interim dividends is participation. When a WHT is provided for, transactions that may create an undue allowed to those companies whose the taxpayer must provide the WHT agent duplication (or multiplication) of qualifying financial statements shall – pursuant to with the base cost: otherwise this latter may equity. In this context, there are specific law – be audited (and have obtained a apply the WHT on the gross amount. transactions, listed by NID Law, which entail positive assessment by the auditor(s)) an a priori reduction in the new equity. and whose by-laws permits the payment In the event of a distribution in kind, capital of interim dividends. If dividend is not gains tax may be triggered for the company Anti avoidance instructions have been cashed by a shareholder / quotaholder, the reducing the equity, for the difference provided for also by the Revenue Agency; corresponding credit right is subject to a between the fair market value of the goods essentially the guidelines require to apply a 5-year statute of limitation. distributed and their base cost. “look through” approach in case of capital contribution coming from nonresident For dividends taxation, reference is made to shareholders to see if there are either the “payments on equity” paragraph. ultimate Italian resident contributor(s) that Reduction of equity could benefit from the NID (thus creating a In the following, an outline is provided for duplication of the benefit) or contributors the taxation of capital gains. resident in black listed countries. In such Stamp duty or similar taxes cases the capital contribution would affect Capital gains taxation for resident the benefit associated to the NID allowance. A 200 € fixed amount registration tax individual shareholders applies to reductions of the statutory equity Capital gains derived by individual Though no longer mandatory, a tax ruling paid in cash. shareholders are subject to the progressive can be filed in order to disregard this anti- individual income tax (43% top rate plus avoidance provision. 3% surcharge) and the tax treatment of Withholding taxes capital gains depends on whether or not the relevant participation is held in a business Legal constraints (e.g., limits General remarks capacity. to transfer of cash outbound, As a general rule, capital reserves timing, formal requirements, distributed as such are not taxable as • Provided the “participation exemption” etc.) dividends: they reduce the base cost of requirements are met (see below for the shares and only once such base cost is corporations), capital gains derived by From a legal perspective, payments out zeroed, is the excess taxable (as dividend individual shareholders in a business of equity can be represented by either the outside business income, or as a capital capacity are partially (50,28%) exempt distribution of profits or by the redemption gain within a business income framework). from tax with the remaining portion of prior contributions made by shareholders However, there is a presumption under (49.72%) included in the taxable / quotaholders. The reimbursement of which, irrespective of the shareholders’ income subject to the progressive rates contributions is examined under following meeting resolution, any profit reserves of IRPEF; assuming a top marginal Paragraph 3 (Reduction of Equity). (available for distribution) are deemed to be rate of 43%, this is tantamount to an distributed before capital reserves. effective tax rate of 21-22%. The distribution of profits (or of dividends according to an alternative terminology) Capital distributions work likewise: • The taxation of individual shareholders has to be resolved by the shareholders’ / ordinarily they are not taxable as dividends, not holding the participation in a quotaholders’ meeting (upon proposal of but reduce the base cost of the shares; business capacity depends on whether

Italy Financing options: Debt versus equity 32 or not qualification thresholds are • the participation is classified as a Nonresidents: Double Tax Conventions exceeded. A participation is considered financial fixed asset in the first balance Most Double Tax Conventions concluded by qualifying if exceeding 2% of voting sheet after acquisition; Italy provide that capital gains on shares are rights in the ordinary shareholders’ only taxable in the State of residence of the meeting or 5% of capital in a listed • the subsidiary is not resident in a tax seller. company; for unlisted companies, the haven and percentages are 20% of voting rights However, some treaties contain a “real in the ordinary shareholders’ meeting • the subsidiary is engaged in active estate company provision”. Under this or 25% of capital. A participation business preceding alienation (real provision, the State where real estate is is considered non-qualifying if estate management does not fulfill this situated retains its taxing rights, even when not exceeding either of the above requirement). such real estate is held by a company, whose thresholds. shares are later sold. Although capital gains are taxable for • Capital gains derived by individual 5%, capital losses are fully (100%) non- Moreover, a few treaties contain a shareholders (no business) from a deductible. “substantial shareholding provision”. Under qualifying participation are taxed like this provision, a capital gain is taxable also those received in a business capacity. Capital gains derived by commercial and in the State where the company sold is • Capital gains derived by individual manufacturing enterprises are not subject to resident, whenever the seller exceeded a shareholders (no business) from a local tax IRAP. Different rules apply to banks certain participation threshold. non- qualifying participation are and financial companies. subject to a 26% substitute tax; this substitute tax can be administered Nonresidents: domestic law Legal constraints (e.g., limits (i) by way of tax return, or (ii) by Nonresidents are taxable in Italy on capital to transfer of cash outbound, intermediaries administering the gains derived from the sale of companies timing, formal requirements, securities, or (iii) by intermediaries resident in Italy. Their taxation depends etc.) managing the portfolio. on whether or not qualification thresholds are exceeded and it is equal to a 13,67% From an Italian corporate law perspective, In both cases, capital gains on participations effective tax rate (i.e. the corporate income the reduction of the corporate capital can in companies resident in tax haven countries tax rate of 27,5% applied to the taxable either be “real” or “nominal”, depending (other than those deriving from the disposal portion of the capital gain equal to 49,72) as to whether or not the reduction is of a non- qualifying participation in a in case of capital gains deriving from the undertaken by means of returning listed company) are fully included in the disposal of a qualifying participation and to capital to the shareholders/quotaholders taxable income for individual income tax a 26% tax rate in case of the disposal of a (in proportion to their respective purposes and taxable at progressive rates not-qualifying participation. contributions). unless a ruling is granted accepting that the participation does not result in sheltering Nonresidents are not taxable in Italy on Capital reductions require a shareholders’ the profits in a tax haven. capital gains derived from the sale of a non- resolution before the Notary Public, qualifying participation in a listed Italian which amends the By-Laws. As a general Capital gains taxation for resident company. White-listed nonresidents are not rule, corporate capital cannot be reduced corporate shareholders taxable in Italy on capital gains derived from below the legal minimum. The discipline Capital gains on shares are 95% exempt the sale of a non-qualifying participation applicable to the “real” reduction of from the 27.5% corporate income tax, in any Italian company (whether listed corporate capital is rather strict, as this leading to a 1.375% effective tax rate (1,2% or not). The “white list” is a list of reduction implies a return of capital to the from 2017 when the corporate income Countries providing a suitable exchange of shareholders / quotaholders (or a release tax rate will be set at 24%), provided information with the Italian Tax Authorities. from the obligation to make the payment that (so called “participation exemption” The current white list can be found at still due); as such it may be detrimental of requirements): this link: http://www.agenziaentrate. both minority shareholders and creditors gov.it/wps/content/Nsilib/Nsi/ of the company. For this reason and • the participation is held for at least Documentazione/Fiscalita+internazionale/ before being effective, creditors have a 12 months (actually, first day of the White+list+e+Autocertificazione/Elenco 90-day period to challenge the capital 12th month period before the date of decrease before Courts. The “nominal” alienation); reduction of the capital might happen in case of operating losses incurred by the company. The discipline is slightly different,

Italy Financing options: Debt versus equity 33 depending on whether losses have affected borrower, and if the reimbursement took 1 Without seeking completeness, it is worth minimum required corporate capital (need place in the year preceding the declaration noting that such limits can be derogated when debentures in excess are destined to to restore the corporate capital above the of bankruptcy, it must be returned. Such professional investors or when debentures minimum, or to resolve the conversion of discipline is specifically set for S.r.l.; are secured by a first degree mortgage on the company) or not ( in this case, losses common opinion is that the same shall real estate property owned by the issuing can be carried forward to the next financial apply mutatis mutandis to S.p.A also. company. year. If by then losses are not reduced, then corporate capital shall be reduced Third party Loans accordingly). The so called ordinary banking loan is by far the most commonly used third party form of medium and long-term financing granted by financial institutions. It can be Debt Financing secured by either pledges or mortgages over the assets of the borrowing party, or by personal guarantees. If the loan is secured Granting of debt by a mortgage, usually the mortgage value is much higher to secure also the Stamp duty or similar taxes reimbursement of interest in addition to Financing transactions (e.g. loans) may principal. fall within the scope of VAT, although exempted. If not subject to VAT (e.g. Debentures / Bonds (Obbligazioni) and because the lender is not a VAT subject) other forms of financial instruments they are subject to registration tax at 3%, The resolution to issue debentures is usually unless they are executed by exchange of taken by the directors before the notary correspondence, which is one of the means public. to conclude a legal contract, requiring less formalities (e.g. registration). In case Under Article 2412 ICC, debentures guarantees are provided, these may trigger (whether bearer or registered debentures) additional registration taxes, as well as can be issued for an amount not exceeding, mortgage / cadastral taxes if real estate is in total, twice the amount of the corporate involved. capital, the legal reserve and other available reserves resulting from the last approved However, medium/long term loans (defined financial statements. Such compliance as exceeding 18 months) granted from shall be certified by the statutory auditors1. banks, may benefit of the application of Under the Law no. 134 of August 7, 2012, an optional substitute tax generally levied the above limitation doesn’t apply to bonds at 0.25% rate of the total amount of the to be listed in a regulated market or in a loan requested, instead of the levying of multilateral trading system, or if the bonds stamp duty, government license tax and give the right to acquire or subscribe shares. registration, mortgage and cadastral taxes. These rules also apply to all those financial instruments, however named, whose return Legal constraints (e.g., limits to transfer is linked to the economic results of the of cash inbound, timing, formal issuing company. requirements, etc.) Amongst the multiple forms of debt Debentures / Bonds convertible into financing, we can list the following. shares (Obbligazioni convertibili in azioni) Shareholder Loans Convertible debentures are ruled by Article In this case it’s worth to notice that there is 2420-bis, ICC and allowed to companies a specific regime (Articles 2497quindquies having the corporate capital fully paid in. and 2467 ICC) under which the The issuance of convertible debentures/ reimbursement of the loan made by a bonds is reserved to the extraordinary shareholder / quotaholder is subordinated shareholders’ meeting, which shall to the payment of other creditors of the resolve about terms and conditions for the

Italy Financing options: Debt versus equity 34 conversion as well as about the increase a rule, interest withholding tax applies Deductibility of the corporate capital requested to serve on a cash basis (upon interest payment). As a basic rule, Italian companies may the conversion. Prior to the conversion Since an interest deduction is granted on deduct interest expenses from the corporate of the bonds into shares the company is an accrual basis, timing mismatches could income tax base at a 27.5% rate (24% prohibited from resolving upon a reduction ensue in certain circumstances. In order to from the 2017 fiscal year). Non-financial of the corporate capital, a merger or a de- avoid those, interest on bonds is subject to a companies may not deduct interest merger or an amendment to the By-laws withholding tax on an accrual basis (even if expenses from the local trade tax IRAP. altering the rules regarding distribution the interest is not paid). Banks, financial and insurance companies of profits; such limitations have been set as well as holding companies may deduct forth in order to protect the rights of the A special regime applies to Government accrued interest expenses for both corporate holders of convertible debentures from bonds, listed bonds, bonds issued by banks income tax and local trade tax purposes: transactions that may modify the value of and listed companies and to unlisted bonds insurance companies may only deduct 96% their rights deriving from the conversion as subscribed by qualified investors. Rather interest expenses, while banks and financial well as their position as future shareholders. than a withholding tax operated by the companies may deduct 100% from 2017 The limitations can be avoided by granting interest payer, a substitute tax applies, (until 2016, they also had the 96% cap). the holders of convertible debentures except for Italian corporate residents, with the right to anticipate the relevant operated by the custodian banks. Non- Transfer pricing rules conversion. Following the reform, also S.r.l. residents are exempt from this substitute Interest expenses incurred by Italian are now permitted to issue debentures/ tax, only if they are resident in “white resident companies on loans borrowed from bonds, if so permitted by the By-Laws, list” Countries (i.e. Countries providing a non-resident related parties must be set at provided that these debts instruments suitable exchange of information with the arm’s length (Article 110(7) of ITC) The shall be underwritten only by supervised Italian Tax Authorities). arm’s length interest rate is determined on professional investors. the basis of that which would be agreed Interest paid to an EU corporate entity upon for a comparable loan entered into are WHT-free under the EU Interest and between unrelated parties. Payments on debt Royalties Directive, provided that (a) the EU company owns directly at least 25 per cent EBITDA rule Withholding taxes of the voting rights of the Italian company, Italy has adopted an EBITDA earnings Italian companies are subject to corporate or vice versa, or (b) a third EU company stripping rule under which interest expenses income tax at a 27.5% rate (as seen above, owns directly at least 25 per cent of the (net of interest income) are deductible up to will become 24% from 2017) on interest voting rights of both companies (a one- 30 per cent of the EBITDA produced by the income. Non-financial companies are not year minimum holding period applies). To company in the same fiscal year. subject to local tax (IRAP) on interest benefit from the exemption, among other income. Banks, financial and insurance conditions, the recipient must qualify as the The system applies to most categories of companies are subject to local tax on “beneficial owner” of the interest; moreover corporate income taxpayers, except few interest income also. Any withholding tax the recipient must be subject to one of the business categories, but not to partnerships, on interest payments to Italian companies is taxes listed in the Annex to the EU Interest for which a different system has been an advance creditable against the corporate and Royalty Directive and the interest must crafted. Subjective exclusions are provided, income tax liability. be fully subject to one of the taxes listed in for instance, for banks, insurance and other the Annex to the EU Interest and Royalty financial institutions (insurance companies Italian-source interest paid to a non-resident Directive in the hands of the recipient. have a flat 4% non-deductible interest is generally subject to a 26% withholding expenses, banks have no limitation from tax: interest is considered as sourced in Italy When the directive requirements are not 2017, while until 2016 they also had the 4% whenever paid by an Italian resident. The met, and for payments destined to entities non-deductible). 26% withholding tax is usually operated resident in non-EU countries, the network of and paid by the borrower, in its capacity 80+ Double Tax Conventions (DTCs) which as the person paying the interest; no WHT Italy has in force comes into play. Where applies to interest due on medium and the income is classified as interest for tax long-term financing granted by EU banks, treaty purposes, the maximum WHT rate insurance companies and white-listed applicable may vary from 10% to 15% (and institutional investors, provided that no the DTC with Argentina 20 per cent) on a regulatory constraints are breached. A case-by-case basis. Few DTCs provide for no reduced 12.5% rate applies to Government WHT. bonds and certain other public debt. As

Italy Financing options: Debt versus equity 35 The adjusted EBITDA is represented by the 3. the issue stipulates the impossibility to Reduction of debt through the waiver of the difference between the value of production reduce the equity, except for dividends; receivable by the lender would represent and production costs – increased not only an extraordinary taxable income for the by the annual amount of depreciation/ 4. the bonds have been purchased by borrower; however, should the waiver amortization, but also by the annual amount qualified investors; be carried out by a shareholder of the of capital/financial lease expense – without borrower, it would be considered taxable accounting for financing costs, passive 5. the qualified investors do not detain, income only for the part exceeding its tax income (e.g. dividends, interest), capital also through fiduciary companies or base (the cost for acquiring the credit). gains and losses, taxes; as an exception, through third parties, more than 2% dividends cashed from foreign subsidiaries of the capital or of the net equity of the are taken into account. The amount of issuer; (adjusted) financing costs exceeding 30% Calculation and Matrix of the EBITDA is not deductible from the 6. the beneficial owner of the income is for General Decision taxable income of the relevant fiscal year. resident in Italy or in a State providing Unrelieved financing costs may be carried an adequate information exchange. forward to a subsequent fiscal year, without any time limitation. In each of the following 7. the issue has an initial duration of at Generally, the decision to finance an fiscal years the same EBITDA threshold will least 36 months. Italian subsidiary with debt or equity apply and so relief will only be granted to an should be taken on a case by case basis, overall amount of financing costs (including 8. the issuer is not listed and it is neither considering the 30% EBITDA interest those carried forward from previous fiscal a bank nor a micro-enterprise (i.e., an deduction limitation and the notional years) not exceeding 30% of the EBITDA. enterprise with less than 10 employees interest deduction (NID) incentive. See the and a turnover below EUR 2 million). following example: Also excess EBITDA capacity (i.e. the difference between 30 percent of the In substance, the provision allows the issuer EBITDA and the financing costs deducted to deduct from its taxable income also the from taxable income) is available for carry- return linked to the profit of the company. forward to increase EBITDA capacity in a following fiscal year. Excess financing Legal constraints (e.g., limits to transfer costs are transferred following a merger of cash outbound, timing, formal or a division: some of the anti-avoidance requirements, etc.) regulations applicable to the transfer of tax When debt arises out of a loan facility losses under mergers or divisions also apply arrangement, the borrowing company shall to excess financing costs carried forward. reimburse the loaned facility in accordance with reimbursement terms. As said before, Excess EBITDA capacity of a company may unless differently agreed between the be offset against post-consolidation excess lending party and the borrower, the loan financing costs of another company (in case is deemed to be an interest-bearing loan. of group relief). Parties are anyhow free to decide that no interest will accrue on the loan amount. Participative subordinated bonds (hybrid securities) As an exception to general tax rules, the Reduction of debt floating return of participative subordinated bonds is deductible from the taxable income Stamp duty or similar taxes of the issuer, according to the ordinary 30% As already mentioned, medium/long term of EBITDA rule, if the following conditions loans (more than 18 months) granted are met: from banks may benefit from the optional application of a substitute tax generally 1. the rate of return is not exclusively a levied at a 0.25% rate of the total amount floating rate (there is a fixed component); of the loan requested, instead of the levying of stamp duty, government license tax and 2. the issue includes a subordination registration, mortgage and cadastral taxes. clause;

Italy Financing options: Debt versus equity 36 Assumptions Equity Debt m EUR m EUR

Equity 2.000 - Debt - 2.000 Interest rate 3,50% 3,50%

EBITDA 190 190 Net interest expenses - 70 Depreciations / amortizations 80 80 Earning before taxes 110 40

Corporate tax rate standard 27,50% 27,50%

Nominal interest deducation on capital increase 4,75% 4,75%

Interest cap set at 30% of the EBITDA 57 57

Italian entity tax computation Equity Debt m EUR m EUR

EBITDA 190 190 Depreciations / amortizations 80 80 Net interest expense - 70 Adjustments due to interest capping rule - 13 Nominal interest deduction 95

Corporate tax base 15 53

Corporate income tax at 27, 50% 4,13 14,58

Net Profit After Tax 105,88 25,43

WHT tax calculation Equity Debt m EUR m EUR

OECD Model WHT on dividend WHT Rate 5% 5% WHT 5,29 1,27

OECH Model WHT on interset WHT Rate 10% 10% WHT - 7

Total WHT 5,29 8,27

Italy Financing options: Debt versus equity 37 Parent Company Taxation assuming interest is taxed at statutory Equity Debt rate and dividend is fully exempt m EUR m EUR

Interest income taxation Hypotetical parent company statutory rate 20% 20% Tax on interest income - 14

Dividend income taxation Hypotetical parent company dividend tax rate 0% 0% Tax on dividend income - -

Creditable WHT (OECD Model ordinary credit method) Dividend exempted, no credit - - Interest taxed at statutory rate, full credit - 7

Total Parent Company Taxation - 7,00

Total Tax: Italian Entity + WHT + Parent Company 9,42 29,85

Net Cash Flow 100,58 80,15

Italy Financing options: Debt versus equity 38 Malaysia

The following article provides an overview of possible forms of financing in Malaysia.

Firstly, we will discuss the financial environment in Malaysia. The focus is on the requirements under the Companies Act 1965 (“the Act”) and outline the tax consequences associated with the forms of financing namely, equity and debt. This article will also discuss briefly redeemable preference shares (“RPS”) which is a hybrid between debt and equity. Finally, the tax consequences associated with Islamic financing in Malaysia will be addressed.

Financing environment in Definition of equity versus debt Kelvin HP Lim Malaysia [email protected] Classification of financing instruments A financial liability is a contractual Frances Po The Malaysian capital market grew obligation to deliver cash or another +60 (3) 21731618 across all segments in 2015, with its financial asset or to exchange financial [email protected] size expanding 2.1% to RM2.82 trillion, instruments with another entity equivalent to 2.5 times the size of the under conditions that are potentially Wai Kuan Phan domestic economy. unfavourable. In contrast, equity is any +60 (3) 21731589 contract that evidences a residual interest [email protected] Malaysia continues to have the largest debt in the entity’s assets after deducting all of securities market in Southeast Asia, at its liabilities. 104.4% of GDP (2014). A company in Malaysia can be financed The equity market also performed well by way of equity, debt or RPS which is in 2014. Overall capitalisation of the a hybrid financing form which exhibits Malaysian equity market expanded to elements of both equity and debt. RM1.7 trillion, representing an increase of 2.6 per cent from 2013. Under accounting principles, RPS may be treated as debt or equity depending on the Over the recent years, Malaysian corporate features of the RPS as governed under FRS funding is more towards equity financing 132. as shown in the table below:

Business Sector: Leverage and Liquidity Indicators

% Times 50 45.5 2.0 42.5 42.7 39.2 40.0 40 1.8

30 1.6

20 1.4

10 1.2

0 1.0 2010 2011 2012 2013 3Q 2014 Debt-to-equity ratio Current ratio (RHS)

Source: Securities Commission and Bank Negara Malaysia

Malaysia Financing options: Debt versus equity 39 From a Malaysian tax perspective, RPS is intends to apply for the Principal The repurchase of its own shares by a treated as equity in the company. As such, Hub Incentive, the minimum capital public listed company also represents the payment of dividends on RPS is treated requirement is RM2,500,000. a form of repayment of equity to the in the same way as payment of dividends shareholders. However, certain conditions for ordinary shares. Public companies seeking for listing on need to be met before the repurchase of Bursa Malaysia are required to fulfil both shares by the company. quantitative and qualitative criteria. Tax-related aspects Equity financing With respect to the transfer of equity, Payments out of equity are not tax there are in principle no legal restrictions, deductible as it is paid out of profit after save for any restrictions provided in the tax. There is also no dividend distribution Contribution of equity company’s Articles of Association. tax in Malaysia. Shareholders are also exempted from income tax on the Legal aspects In the case of partnerships, in principle no dividends paid or credited to them. As from 30 June 2009, the government rules exist regarding the raising of capital has liberalised the Foreign Investment or capital increases due to the fact that the The thin capitalisation rules have been Committee (“FIC”) guidelines. The FIC partners are personally liable to the debts introduced under the Anti-Avoidance guidelines covering the acquisition of of the partnership. For limited liability Provisions relating to Transfer Pricing. equity stakes, mergers and takeovers partnership (“LLP”), the amount of capital Currently there are no “safe harbour” rules have been repealed and as such, no contribution by each partner shall be stated specified in the legislation. equity conditions are imposed on such in the LLP agreement. transactions. Notwithstanding this The implementation of Thin Capitalisation deregulation, the national interest in Tax-related aspects rules have been deferred to post 31 terms of strategic sectors will continue The issuance of capital via equity does not December 2017. to be safeguarded through sector give rise to income tax consequences. regulators. Companies in specific sectors will continue to be subject to equity Reduction of equity conditions as imposed by their respective Payments out of equity sector regulator such as the Energy Legal aspects Commission, National Water Services Legal aspects Capital reduction is a reduction of the Commission, Malaysian Communications Companies limited by shares are allowed issued share capital and if it is authorized and Multimedia Commission, Ministry to make payments out of equity in the by the Articles of Association of a company, of Domestic Trade, Cooperative and form of distributions. The most common it may be carried out with approval of a Consumerism and others. form of distribution is by way of dividends. three-fourth’s majority of members and Dividends must be declared out of profits sanctioned by the Court. Companies Act 1965 (“the Act”) (Section 365 of the Act) and may be an Malaysian companies limited by shares interim or final dividend. For a capital reduction, the underlying can be private (Sdn Bhd) or public (Bhd). principle is to preserve and protect the There are two levels of capital, namely In the case of interim dividend, the interests of creditors and members of authorised capital, being the maximum Board’s recommendation and approval are different classes of shares (if applicable) as amount of shares a company may issue sufficient. However for a final dividend, the the assets available for distribution in the and paid up capital, being the actual Board recommends the dividend amount event of winding up will be reduced. capital subscribed by shareholders and for approval by shareholders at the general contribution to the Company. Authorised meeting. Tax-related aspects capital attracts capital duty. In both cases, There are no tax consequences in the minimum authorised and issued capital Another common form of distribution is connection with a capital reduction. are RM2 respectively. a bonus issue whereby shares are issued to existing shareholders in proportion to For both the private and public companies their shareholdings. A bonus issue does above, the requirement of issued and paid not involve cash, but merely book entries up capital depends on the working capital to capitalize profits or revenue reserves for needs of a company or the guidelines / additional shares in the company. A bonus licence / incentive that may be applicable issue requires approvals from both the to a company. For example, if a company Board and shareholders.

Malaysia Financing options: Debt versus equity 40 Additional considerations - Thin capitalization purposes, only the interest on the portion redemption of RPS The thin capitalisation rules have been used for the business is allowed for introduced under the Anti-Avoidance deduction against gross business income. RPS can only be redeemed out of: Provisions relating to Transfer Pricing. The proportion of interest applicable to the Currently there are no “safe harbour” rules non-business operations would be allowed • proceeds of a fresh issue of shares made specified in the legislation. against gross income from the relevant for purposes of the redemption; or non-business sources. However, interest The implementation of Thin Capitalisation expense attributable to dividend income • out of profits otherwise available for rules have been deferred to post 31 (which is tax exempt) does not qualify for distribution as dividends. December 2015. deduction and is to be disregarded.

RPS can only be redeemed if it is fully paid All qualifying interest deduction is to be up and the redemption is not regarded as a Payments on debt claimed against the income of the year in reduction of share capital of the company. which the interest was payable. However, Any premium payable on redemption Tax-related aspects the claim can only be made when the shall be provided for out of profits or share Withholding tax interest is due to be paid. premium account before the shares are Payment of interest from the Malaysian redeemed. company to a non-resident lender is subject Transfer pricing to Malaysian WHT at the rate of 15 per The interest charged on shareholders’ loan Where the RPS are redeemed out of cent. This rate may be reduced under must be at arm’s length. Under the new profits available for distribution, a non- specific Double Tax Agreements (“DTA”). transfer pricing guidelines, actual transfer distributable ‘capital redemption reserve’ pricing documentation is required to be must be created equal to the nominal Deductibility prepared and the Malaysian tax authorities amount of shares redeemed. The general deduction provisions under are empowered to disregard or vary non- Section 33(1) of the Income Tax Act 1967 arm’s length transactions between related The capital redemption reserve may be provides that expenses are deductible only companies and make adjustments . There applied for the issue of fully paid bonus if they are incurred in the production of must be commercial substance and the shares. The company is required to notify income chargeable to Malaysian tax. charging of expenses should not lead to the Registrar of Companies within 14 days profit extraction or tax avoidance. of redemption of the RPS. Interest expense is deductible under Section 33(1)(a) if it was incurred on money borrowed and: Reduction of debt

Debt financing • used in the production of gross income Tax-related aspects (for example, as working capital); or The repayment of the principal amount does not have any tax effect on the payer. Issuance of debt • laid out on assets used or held for However, the waiver of a loan may be the production of gross income (for taxable in the hands of the borrower if the Stamp duty example, acquiring fixed assets to be loan is revenue in kind. Stamp duty is chargeable on instruments used in generating income). executed in Malaysia and not on Generally, the interest portion waived transactions. Loan agreements executed Where a borrowing is used partly for is taxable to the borrower if a deduction in Malaysia attract stamp duty at the business purposes and partly non-business has previously been taken on the interest following rates:- expense.

Instrument Stamp duty rate RM loan 0.5 per cent Foreign currency loan Maximum of RM500 Loan without security for any sum repayment 0.1 per cent on demand or in single bullet repayment

Malaysia Financing options: Debt versus equity 41 Additional considerations - Cross border transactions involving non- Islamic financing resident borrowers would be treated in the same manner as conventional borrowings Apart from the conventional debt from non-resident borrowers. Islamic financing, Islamic financing is also popular “profits” would be seen as interest for in Malaysia. The Malaysian Islamic Malaysian tax purposes. Generally, due to financial sector is seen as one of the most tax incentives provided to the Bond market progressive and attractive in the world and financial services, there is usually no given the numerous incentives planned withholding tax when profits or “interest” and the further liberation granted over the is paid to non-residents on Malaysian years. Islamic finance players in Malaysia issued Sukuks (bonds) or if paid by a comprise institutions such as Islamic banks, licensed bank in Malaysia. Takaful operators, Islamic unit trusts, and Islamic fund management companies.

Tax-related aspects The Malaysian taxation system caters for Islamic Finance by providing tax neutrality to Islamic transactions.

Under Syariah principles, the concept of “interest” is prohibited. The Malaysian tax legislation provides that all gains or profits received and expenses incurred, in lieu of interest, in transactions conducted in accordance with the principles of Syariah would be treated as interest for tax purposes. Therefore, the taxability or deductibility of “profits” under Islamic finance would be similar to the treatment of “interest” in a conventional financing arrangement. All tax rules relating to “interest”, such as interest withholding tax and tax exemptions will equally apply on the “profits”. This ensures that Islamic financing is accorded the same tax treatment as conventional financing.

In addition, underlying disposal of the assets/properties required for Islamic transactions will be disregarded for income tax purposes. Therefore, there is no additional tax impact on the sale and leaseback required in Islamic transactions.

Malaysia Financing options: Debt versus equity 42 Switzerland

The funding of an enterprise with either equity or debt is often driven by operational needs of the enterprise. It is an important factor for such enterprise as the form of funding typically has an impact on whether and how investors – who may have specific yield expectations – will take influence on the enterprise’s business decisions.

The main forms of business organisation for a Swiss enterprise are governed by the Swiss Civil Code of Obligations (“CO”). In Switzerland, the most common form of organisation is the company limited by shares (“Aktiengesellschaft”, “AG”), followed by the limited liability company (“GmbH”), which is over time gaining importance.1 Both types, the AG and GmbH, are corporate bodies, i.e. entities with their own legal personality and liability to corporate taxes.2 This is also true for the cooperative (“Genossenschaft”), which however is not a very common legal form and hence not widely used in the Swiss economy.

Other business organisations, such as the simple partnership (“einfache Gesellschaft”) or the general/limited partnership (“Kollektivgesellschaft” or “Kommanditgesellschaft”) do not provide for their own corporate body.3 Compared to the AG and GmbH, they are of limited economical significance, as the Swiss forms of simple, general and legal partnerships do always require at least one individual person that is unlimited liable with his personal wealth for any claims raised against the partnership.

As a consequence of the above explained business relevance of the different legal forms, the following considerations will in particular emphasise on the Swiss tax implications of different financing options for Swiss corporates (i.e. mainly on AGs and only where of special interest also on GmbHs).

At the end, a model computation/comparison will demonstrate the positive tax effect of debt financing.

General investment Since the late 90s, Switzerland has Stefan Schmid environment in continually attempted to strengthen its +41 (0)58 792 4482 position in international tax competition, [email protected] Switzerland namely by the implementation of the Corporate Tax Reform I (“CTR I”) and Sarah Dahinden Switzerland offers a favourable investment the Corporate Tax Reform II (“CTR II”). +41 (0)58 792 4425 and tax environment. It is a peaceful, Besides tax reliefs for domestic small [email protected] prosperous and modern market economy and medium-sized enterprises as well as with low unemployment, a highly skilled for Swiss resident investors, the CTR II labour force, and – last but not least – it is also resulted in considerable tax benefits known for moderate corporate tax rates. for multinational groups. This applies namely for the extension of the investment Furthermore, Switzerland provides deduction (participation relief, see below for an extensive treaty network. The section D.II.2.b) and the introduction of communication with the Cantonal and the so called capital contribution principle 1 Daniel Schafer, The debt-equity conundrum, Swiss Branch Reporter on the Swiss Federal Tax Authorities is well (see below section D.II.2.c). In addition, 2012 Boston Congress of the International established and in particular advance tax foreign companies are usually recognised Fiscal Association, Volume 97b, 715 et seq., rulings can be obtained in a fairly short for Swiss tax purposes if they are managed in particular 718. time frame, providing for the necessary and controlled outside of Switzerland advance certainty on how the applicable and are not set up purely for the reason 2 Schafer, 718. tax laws have to be applied on a particular of avoiding Swiss taxes. Switzerland is 3 Schafer, 718. case at hand. currently in the process to draft its third

Switzerland Financing options: Debt versus equity 43 corporate tax reform package (“CTR III”), Classification of financing instruments 4 E.g. (as per their significance) ordinary which will provide for an attractive OECD for tax purposes shares, regular loans, subordinated loans (including mezzanine loans), preference conform tax framework. It is further worth As a matter of principle, the qualification shares and shares with privileged voting noting that the latest draft law package of a financing instrument under Swiss tax rights, participation certificates and divi- of CTR III includes a notional interest law generally follows the qualification of dend rights certificates, participating loans, deduction regime (see below section the respective instrument under Swiss bonds, convertible bonds/bonds with D.II.2.b), in particular footnote 37). corporate law.10 For tax purposes, the warrants; cf. Scha-fer, 718. main consequence of the qualification of a 5 Article 959 and 959a CO. By means of a thorough planning it financing instrument as a debt instrument is generally possible to avoid Swiss is the tax deductibility of interest 6 Basle Commentary to the CO Part II 2012 withholding tax (“Swiss WHT”) and Swiss payments. (BSK OR II), Markus Neuhaus/Jörg Blättler, stamp duty consequences related to the art. 663a CO N 63 et seq.; articles 656 CO et seq.; Schafer, 715. issuance of capital. The principle that the tax qualification of an instrument should be based on Swiss 7 Thomas Meister, Hybride corporate law usually even applies if an Finanzierungsinstrumente und -vehikel im Definition of equity versus debt equity instrument is subject to strong grenzüberschreitenden Verhältnis, ASA 70, elements of a debt instrument, which for 97 et seq., 114; see also BSK OR II, Markus Neuhaus/Jörg Blättler, art. 663a CO N Legal classification of financing example, may be the case with respect to 13/13a. instruments preferred shares. As a result, the formal As is generally known, a company may form prevails over the economical form of 8 Schafer, 718. Quasi-hybrid funding partly be financed by equity and by debt. such instrument.11 structures have been used by domestic and Although the diversity is not as strong as foreign private equity companies (in the form of mere contractual arrangements in other jurisdictions, Swiss corporate law There are however very few cases where between the relevant parties). Moreover, in provides for a valuable amount of financing for tax purposes, a debt instrument and the past years, Swiss banks started to offer instruments for businesses.4 consequently also the payments made different financial products with a quasi- on the debt instrument are re-qualified hybrid model (exclusively) to financial/ Switzerland’s accounting, legal and fiscal as equity instrument, as are shown in the institutional clients. framework adheres to a clear distinction following examples: 9 Decision of the Swiss Supreme Court of 16 between debt and equity.5 Shares (whether October 2014 (4A_138/2014), BGE 140 III ordinary or preferred), participation • There are tax driven thin capitalisation 533. certificates and dividend rights certificates rules which limit the debt to equity all classify as equity.6 ratio and the interest rate paid on 10 Schafer, 715. the debt instruments. In case a debt 11 Meister, ASA 70, 114; Schafer, 715. All other forms of financing instruments instrument violates these rules, the part usually qualify as debt under Swiss in excess of the thin capitalisation rules corporate law.7 This is also true for hybrid is re-qualified as equity and dividends forms of financing, which as such are not respectively. However these rules only known in Swiss corporate (tax) law.8 apply to intercompany debt. See in this respect below sections E.I.2.c) and It is further notable that the highest Swiss E.II.2.c). court rendered in 2014 a decision based on which the company’s freely distributable • In very rare cases, the tax equity was treated as blocked in relation to administration may come to the (up- and cross-stream) intra-group loans conclusion that the application of a that were granted at non at arm’s length’s financing instrument would result in conditions and were at the same time not a pure tax avoidance structure and secured.9 therefore may re-qualify the instrument into equity and the respective interest into a dividend distribution.

Switzerland Financing options: Debt versus equity 44 Hybrid instruments are generally not seen certification by a notary and entry in 12 Meister, ASA 70, 114; Schafer, 718. in domestic relationships as the Swiss the commercial register) and capital 13 Art. 773 CO. corporate and tax treatment of a financing maintenance rules. In the case of a GmbH, instrument is harmonised between the two the minimum capital amounts to CHF 14 Art. 621 CO. The participation rights parties to the instrument.12 20’00013 and for a stock corporation (AG) without nominal capital (the so called to CHF 100’000.14 „Genussscheine“) are only available to Contrary to domestic relationships, related parties (art. 657 para. 1 CO). Generally, participation rights (with/ financing of a Swiss company from abroad A contribution exceeding these amounts without nominal value) are rarely used may result in definition conflicts with the into the reserves (so called “surplus”) by (public) companies and therefore are effect that such an instrument could be is either admissible when issuing new of minor interest for the following consid- treated as debt with corresponding tax shares or at any time else (i.e. without the erations. deductible interest payments in Switzerland issuance of new shares). 15 Art. 5 and 8 of the (Swiss) Stamp Duty Act and equity in the funding country that might (SDA). benefit from a participation exemption. Tax-related aspects Capital contributions into a Swiss AG 16 Art. 6 para. 1 letter h SDA. In future, such international definition are generally subject to the Swiss stamp conflicts for tax purposes should no longer duty of 1% on the issuance of capital.15 17 Art. 6 para. 1 letter k and art. 12 SDA. exist or at least be limited as a result of the Exceptions may apply upon the foundation 18 Art. 6 para. 1 letter j SDA. Actions on Base Erosion and Profit Shifting or a formal capital increase for the first by the OECD (Organisation for Economic CHF 1 million of capital16 or under certain 19 Decision of the Swiss Administrative Court Co-operation and Development). circumstances for a company subject to a dated 15 April 2009 (A 1592/2006). recapitalisation17 or a reorganisation18. In In more detail, the report released on 5 addition, an existing non-resident company October 2015 in relation to Action No. may generally relocate to Switzerland 2 “Neutralising the Effects of Hybrid without incurring Swiss issuance stamp Mismatch Arrangements” should in future duty. However, if the company was formed prevent tax payers from using tax driven abroad and relocated to Switzerland hybrid financings. exclusively or mainly in order to avoid Swiss stamp taxes, the issuance stamp tax It is however worth noting that the BEPS may apply. Last but not least, according report does not have an immediate effect to to a court decision of 2009, indirect the Swiss domestic tax system. capital contributions (e.g. granted by the grandparent company to the additionally paid-in capital only, i.e. without issuance of any new shares) are not subject to the Equity financing Swiss stamp duty of 1% on the issuance of capital.19 A potential abolition of the stamp tax on the issuance of capital is – still with Based on Swiss corporate and accounting uncertain outcome – in discussion in the law, equity usually consists of nominal Swiss Parliament. capital, free and general reserves and retained earnings. There are two forms of Capital contributions (e.g. premiums, equity financing: The company is provided additionally paid-in capital and with new capital (i) through an increase in contributions into the reserves of a the existing contributions from outside or company without increasing the nominal (ii) by the way of self-financing. share capital) of the shareholder(s) which were accumulated after 31 December 1996 and meet some further requirements Contribution of equity (e.g. specific and timely recordings in the Swiss statutory books and vis-à-vis the Legal aspects tax authority) are deemed ‘qualifying For capital companies, the incorporation capital contribution reserves’ for tax and an increase in nominal capital is purposes. If the specific criteria are met, subject to formal requirements (e.g. the capital contribution principle allows

Switzerland Financing options: Debt versus equity 45 the withholding tax-free repayment of the Usually, a distribution is based on the 20 Art. 6 para. 1 letter l SDA. (qualifying) capital contribution reserves previous year-end balance sheet and the 21 0.001% cantonal/communal capital tax is (see below section D.II.2.c). retained profit documented therein. An also the lowest end for companies subject to advance distribution of freely disposable a tax privileged status. In this respect and Usually, convertible bonds will become reserves is feasible based on a special regarding the potential future limitation subject to the Swiss stamp duty of 1% on confirmation/report of the auditor and an of tax privileged companies see below the issuance of capital at the time of their extraordinary shareholders’ meeting.24 It footnote 37. conversion into equity. However, due to should however be noted that current year 22 Effective tax rates of the year 2015. The a recent amendment, the conversion of profits can only be distributed based on a Cantons are allowed to foresee in their tax Contingent Convertible Bonds (so called formal year end-closing balance. acts that corporate income tax is creditable CoCo-bonds/”Pflicht¬wandelanleihen”) against a corporation’s capital tax. As of 1 into equity will not trigger Swiss issuance In order to maintain the nominal share January 2016, the following Cantons have implemented such credit system: Argovie, stamp duty on the newly created equity capital and the minimally required Appenzell Innerrhoden, Bern, Basel-Land, anymore.20 This relief applies to CoCos amount of legal reserves25, other regular Geneva, Glarus, Neuchâtel, St. Gallen, according to the Swiss Banking Act only. disbursements from equity are principally Solothurn, Schwyz, Thurgau, and Vaud. Other convertible bonds will still trigger not allowed for Swiss capital companies. It Swiss issuance stamp duty if converted into is yet notable that larger Swiss companies 23 Art. 671 CO. According to art. 671 CO, 5% of the annual profit must be allocated equity. may regularly repay part of their nominal to the general reserve until it equals 20% capital instead of paying out a dividend.26 of the paid-up share capital. Further, if a There are three levels of corporate taxation dividend distribution amounts of more than in Switzerland. There is the Swiss federal The acquisition of treasury shares takes 5% of the nominal value, another 10% of income (but not capital) tax based on the place either with the intention to cancel the profit has to be allocated to the general reserve (this second rule is not applicable Swiss Federal Tax Act. In addition, each of such shares or to hold them in treasury. De for holding companies). To the extent that the 26 cantons has its own Cantonal Tax facto, the former case also represents a form the general reserve does not exceed an Act, whereupon a cantonal and communal of repayment of equity to the shareholders amount equal to 50% of the share capital, income and capital tax is levied. With as it leads to a reduction of the company’s the general reserve may only be used for the exception of the applicable cantonal assets. From a corporate law perspective, very specific purposes, e.g. for covering losses. Special rules apply for holding and communal tax rates, the Cantonal the repurchase of treasury shares is only companies. Tax Acts are widely harmonized. The admissible, if freely disposable equity is equity of a Swiss company is subject to available and the nominal value of the 24 Forstmoser/Zindel/Meyer Bahar, annual cantonal and communal capital treasury shares amounts at maximum to Zulässigkeit der Interimsdividende im tax. The applicable capital tax rates vary 10% of the aggregate nominal capital.27 schweizerischen Recht, SJZ 2009, pages 205 et seq., 206. No report/confirmation of from canton to canton, respectively from In special cases, the threshold is 20%, the auditor is required, if the extraordinary community to community and amount to whereas the additional 10% have to be distribution takes place within 6 months of a range of bet-ween 0.0010% and 0.525% sold or cancelled within two years.28 the last close of business. for an ordinarily taxed21 company22. At a The instrument of the purchase of federal level, no capital tax is levied. treasury shares can be utilized in many 25 Art. 671 CO. See also footnote 23 above. constellations, for example in connection 26 See in this respect below section D.III.2.b). with employee incentive programmes, with Payments out of equity larger changes at the shareholder level or as 27 Art. 659 para. 1 CO. defence measure against tender offers. Until Legal aspects 31 December 2012, treasury shares were to 28 Art. 659 para 2 CO. Capital companies may principally pay out be documented in the assets whilst a special their equity in the form of distributions. reserve for treasury shares was required on Such resolution has to be adopted by the the liabilities side of the balance sheet. As of shareholders. Usually, the management/ 1 January 2013, a Swiss accounting revision management board submits an appropriate entered into force, whereupon it is not proposal towards the shareholders. admissible anymore to report the treasury shares on the asset side of the balance A distribution is only feasible if freely sheet. Rather, the treasury shares are to be disposable reserves are available.23 documented as a negative item of the equity According to art. 675 para. 2 CO, dividends section. The new accounting law provided may only be paid from the disposable profit for a transition period of two years which and from reserves formed for this purpose. has in the meantime lapsed.

Switzerland Financing options: Debt versus equity 46 Tax-related aspects International beneficiaries within a group 29 Art. 4 para. 1 letter b and art. 13 (Swiss) Overview may be entitled to full or partial recovery Withholding Tax Act (“WTA”); see also art. 21 para. 1 of the Ordinance to the WTA. As a general rule, payments out of equity of Swiss withholding tax, either based on Different forms may apply for extraordinary are not tax deductible. As a consequence, an applicable double tax treaty or – for dividend distributions or for legal forms Swiss tax law does typically not grant the beneficiaries that are tax residents in the other than the legal form of a company right to a deemed interest deduction on EU – based on article 15 of the Agreement limited by shares. equity. An exception applies up to date on the Taxation of Savings Income between 30 Art. 12 and art. 16 WTA; see also art. 21 for Swiss Finance branches (see below cf. the European Union and Switzerland para. 2/3 of the Ordinance to the WTA. If E.II.2.e). (“Savings Agreement”).34 Under the no explicit maturity date of the distribution double tax treaties, the (partial) refund was defined at the shareholders’ meeting, it Dividend distributions deriving from of the Swiss withholding tax regularly is assumed that the maturity date is equal retained earnings requires a minimum ownership in share to the date of the shareholders’ meeting. A dividend distributed by a Swiss capital and typically a mini¬mum holding 31 Art. 20 WTA in connection with art. 26a of company and deriving from retained period. Similarly, under article 15 of the the Ordinance to the WTA. earnings is principally subject to Swiss Savings Agreement the refund of the withholding tax of 35%. The distributing Swiss withholding tax regularly requires a 32 Art. 20 WTA in connection with art. 26a Swiss company has to declare the Swiss minimum holding period of two years and para. 2 of the Ordinance to the WTA. withholding tax towards the Swiss Federal a minimum ownership of 25% in the share 33 Decision of the Swiss Supreme Court Tax Administration within 30 days from capital. For foreign dividend recipients, dated 19 January 2011, decision number the date of the shareholders’ meeting (the the refund of the Swiss withholding tax 2C_756/2010. declaration has typically to be made with may only be feasible if certain anti-abuse the so called form 103)29 and has to pay the provisions (for example thin-cap rules, 34 On 1 July 2005, the Swiss-EU Savings Agreement entered into force, providing – Swiss withholding tax to the Swiss Federal substance requirements, etc.) are met. among other measures – for rules similar Tax Administration within 30 days after the to those laid down in the EU Parent- dividend became due.30 In case of a delayed Similar to distributions from a Swiss Subsidiary Directive (2003/123/EC) and payment of the Swiss withholding tax, late subsidiary to its Swiss parent company, the EU Interest and Royalty Payments payment interest applies and the regular a notification procedure may also be Directive (2003/49/EC). Thereafter, cross- border dividends, interest and royalty 3-years-period in order to claim for refund applicable in an international context. payments between EU and Swiss companies of the Swiss withholding tax may elapse. A precedent for a notification in the are, under certain conditions, no longer international context, is a confirmation subject to withholding tax. Swiss domestic beneficiaries which meet by the Swiss Federal Tax Administration certain standard conditions are usually that the notification procedure is available 35 See also footnote 33 above. entitled to full recovery of the Swiss (form 823B or 823C). Such confirmation withholding tax. Among domestic group is typically valid for three years. If the companies it is possible to notify instead of notification procedure is in principle paying the Swiss withholding tax, provided available, the distributing company has that the beneficiary of the dividend not only to file form 103 (see above), but distribution owns at least 20% in the has also to notify the dividend distribution share capital of the payer of the dividend within 30 days of the maturity date of distribution.31 If the notification procedure the dividend (so called form 108 for applies, the distributing company has not international distributions). As already only to file form 103 (see above) but has mentioned above, the deadline of 30 also to notify the dividend distribution days is strictly mandatory also in an within 30 days of the maturity date of international context, as the right to apply the dividend (so called form 106).32 The for the notification procedure is considered Swiss Supreme Court decided in 2011 forfeited if the respective deadline is not that the deadline of 30 days is to be met met.35 mandatorily as otherwise, the advantages of the notification procedures are forfeited and late payment interest may apply.33

Switzerland Financing options: Debt versus equity 47 In general, dividend distributions are ongoing in connection with CTR III, see 36 Art. 69 (Swiss) Federal Tax Act (“FTA”); taxable income at the level of the Swiss also footnote 37). art. 28 para. 1 of the (Swiss) Federal Tax Harmonization Act (“FTHA”). beneficiary. But there are also certain mechanisms to reduce the taxation At the level of Swiss individual 37 The various cantonal tax acts do foresee of dividend income from qualified shareholders (holding their shares as specific tax privileges as for example the participations. At corporate level, private assets), dividend income deriving “holding privilege” or the “mixed privilege”. dividends qualifying for participation relief from retained earnings is subject to income A qualifying “holding company” is generally exempt from cantonal/communal corporate are those from participations representing tax; as mentioned above, a relief may apply income tax (with the exception of income at least 10% of the share capital or 10% of for qualified interest in such company. from Swiss real estate). Consequently, profits and reserves of another company a holding company is in principle only or those having a market value of at least Dividend distributions deriving from subject to an effective income tax rate of CHF 1 million.36 It is notable that there capital contribution reserves 7.83% (i.e. effective federal corporate rate) prior to participation relief for qualifying is neither a minimum holding period nor In relation with the Corporate Tax Reform dividends and capital gains. Further, a requirement that the dividend paying II, the capital contribution principle was usually a reduced capital tax rate at the subsidiary is liable to income tax in its introduced in Switzerland in 2011. cantonal/communal level applies. jurisdiction of residence. Participation Companies that only carry out relief is not an outright tax exemption, Based on the applicable legal provisions, administrative functions in Switzerland (but no real commercial activities) may be but rather a tax abatement mechanism. capital contribution reserves that were eligible for the “mixed company” tax status It is a percentage deduction from the accumulated after 31 December 1996 (note that different names exist in different corporate income tax which is equal to net and meet some further requirements cantons for the “mixed company” tax status, participation income divided by taxable (e.g. specific and timely recordings in the e.g. “domicile company” tax status). The income. It is commonly also referred to as Swiss statutory books and vis-à-vis the conditions to qualify as a mixed company vary from canton to canton. For mixed ‘participation deduction’ or ‘participation tax authority) are deemed ‘qualifying companies, only a modest fraction – this exemption’. For Swiss tax resident capital contribution reserves’. The capital in accordance with the importance of the individuals, holding their shares as contribution principle generally applies administrative functions in Switzerland – of private assets, there also exists a relief for for premiums, additionally paid-in capital foreign sourced income (typically some dividend income deriving from qualified and contributions into the reserves of a 10% to 20%) is subject to Swiss corporate income tax. Income from qualifying participations. company without increasing the nominal participations (including dividends, capital share capital. Treasury shares may also gains, and re-evaluation gains) is usually The income taxation at the level of a be allocated to the capital contribution tax exempt, whereas all income from Swiss recipient company depends on how reserves. Swiss sources is taxed at ordinary rates. A such income is treated in its statutory mixed company may usually benefit from an effective tax rate in the range of 8% to books. As mentioned beforehand, the tax If the specific criteria are met, the 12%. Further, reduced capital tax rates are relief for dividend income from qualified capital contribution principle allows usually applicable. participations may further apply. For the withholding tax-free repayment of It is mentioned at the end of section Swiss recipient companies subject to the the (qualifying) capital contribution D.II.2.b), that as a result of discussions of privileged tax status of a ‘holding company’ reserves.38 Care has been taken that Switzerland with the EU and the OECD, the above mentioned tax privileges shall in or a ‘mixed company’, the dividend income the shareholders’ meeting adopting the a few years be replaced by other tax relief would usually be exempt from cantonal/ distribution positively makes reference schemes. In this context, Switzerland is communal corporate income taxation37 and to the distribution of capital contribution currently in the process to draft its third only be subject to Swiss federal income tax reserves (instead of retained earnings). corporate tax reform package (“CTR III”), of 7.83% (effective tax rate), whereas the Note that the Swiss distribution company which will provide for an attractive OECD conform tax framework. It is further worth above mentioned participation deduction usually needs to record the distribution noting that the latest draft law package applies for dividends from qualified out of capital contribution reserves within of CTR III includes a notional interest investments. 30 days of the shareholders’ meeting with deduction regime. As the draft bill is still form 170. debated in the Swiss Parliament, the timing Note that as a result of discussions of is not yet clear. One can however expect that CTR III will not be implemented before Switzerland with the EU and the OECD, 1 January 2018. the tax privileges as mentioned in the paragraph above shall in a few years be replaced by other measures (discussions

Switzerland Financing options: Debt versus equity 48 The income taxation at the level of a Swiss In more detail, such a “distribution”, which 39 Cantonal Tax Acts do foresee specific tax recipient company depends on how such is technically a repayment of capital, does privileges as for example the “holding privilege” or the “mixed privilege” for income is treated in its statutory books (i.e. not trigger any Swiss withholding tax at the cantonal and communal taxes. See in as substance dividend usually leading to a level of the Swiss source company. Further, more detail footnote 37 above. As a result depreciation of the value in the subsidiary at the level of Swiss individual investors of discussions of Switzerland with the EU or as a “regular” dividend on which the (holding their shares as private assets), and the OECD, such tax privileges may in relief for dividend income from qualified income deriving from capital reductions is a few years be replaced by other tax relief schemes. participations may apply) and on its tax fully exempt from individual income tax. status.39 Further, the tax relief for dividend The income taxation at the level of a Swiss 40 See for Swiss federal tax art. 20 para. 3 FTA income from qualified participations may recipient company depends on how such and for cantonal/communal tax art. 7b apply. At the level of Swiss individual income is treated in its statutory books and FTHA. shareholders (holding their shares as on its tax status.42 41 See art. 732 et seq. CO. private assets), dividend income deriving from capital contribution reserves is fully Further, some companies aim at 42 Cantonal Tax Acts do foresee specific tax exempt from income tax.40 minimizing their equity in order to enhance privileges as for example the “holding the rate of return. privilege” or the “mixed privilege” for cantonal and communal taxes. See in more detail footnote 37 above. As a result Capital reduction Repurchase of own shares for of discussions of Switzerland with the EU cancellation and the OECD, such tax privileges may in Legal aspects As outlined above, Swiss corporate law a few years be replaced by other tax relief At the level of Swiss capital companies, allows a limited (re-)purchase of own schemes. the nominal capital may be reduced for shares if they shall be held in treasury 43 Art. 4a WTA. different reasons, for example for investors’ (see also above, section D.II.1). These reasons, to eliminate an existing adverse limitations do not apply if own shares are 44 Art. 4a para. 2 WTA. balance sheet, for the purpose of reducing repurchased for cancellation. share capital by repurchasing own shares for 45 Art. 4a WTA. cancellation and for various other reasons. In case a company repurchases own shares for cancellation, Swiss withholding tax An ordinary capital reduction is subject is due, on the difference between the to a number of restrictions to protect the sum of nominal value and attributable creditors.41 In particular, the nominal capital qualifying capital contribution reserves remaining after the reduction has to be and the purchase price of the shares. The covered by assets, i.e., there is no adverse same applies, if the restrictions or time balance after the capital reduction. A limits of Swiss corporate law (see above, condition for an ordinary capital reduction section D.II.1) are violated for shares is a notarised resolution of the shareholders. that were originally repurchased to hold them in treasury, as the violation of these restrictions/time limitations does have Tax-related aspects the effect that these shares are deemed cancelled.43 In this context, it is worth Overview noting that Swiss tax law foresees an As a matter of principle, a mere reduction ordinary maximum holding period of six in share capital does usually not trigger any years for the usually admissible threshold tax consequences except for reducing the of treasury shares of 10% of the aggregate applicable municipal/cantonal capital tax. nominal value as stipulated under Swiss corporate law.44 Otherwise, the company “Distribution” of nominal capital that acquired its own shares is liable In Switzerland, larger companies, usually for Swiss withholding tax as if it had quoted at the stock exchange, frequently repurchased these shares for cancellation.45 use capital reductions as an instrument An extension of time may apply, if the in order to distribute funds without Swiss company holds own shares for equity plans tax implications to Swiss tax resident or for convertible bonds. shareholders (similar to a dividend, but principally without Swiss tax implications).

Switzerland Financing options: Debt versus equity 49 Furthermore, an exemption from market instruments. Accordingly, the 46 The former art. 5a SDA – stipulating above described Swiss withholding tax issuance of Swiss bonds and money market generally a stamp duty on the issuance of bonds – was cancelled effective 1 March implications may apply in case of a deemed instruments is no longer subject to Swiss 2012. cancellation of such shares if the treasury issuance stamp tax.46 shares in question respectively their value 47 Art. 6 para. 1 letter l SDA. were beforehand allocated to the reserves As already mentioned above, the from capital contributions and all relevant conversion of contingent convertible bonds criteria are met (see above, section (CoCos) into equity will not trigger Swiss D.II.2.c). issuance stamp tax on the newly created equity.47 This relief applies to CoCos according to the Swiss Banking Act only; Additional tax-related aspects other convertible bonds will still trigger Swiss issuance stamp tax if converted into Disproportionate contributions of capital equity. can trigger deemed profit distributions and trigger various other tax implications and Swiss thin cap rules should therefore be analysed in detail and Swiss thin capitalisation rules are, in ruled in advance. general, only applicable for related parties. The respective circular letter number 6, “Hidden Equity”, issued by the Swiss Federal Tax Administration on 6 June 1997 Debt financing provides for debt-to-equity ratios as safe harbour rules. In general, an asset test is required, based on which at least 30% Issuance of debt of the weighted assets should be equity- financed. As an exception thereof, the Legal aspects debt-to-equity ratio is generally fixed at Other than equity, debt fundamentally 6:1 for finance companies (safe harbour). establishes an obligation for repayment It is further worth noting that a company to the creditor. Care has to be taken that which is not in line with the safe harbour the issuance of debt does not create any rules can always provide evidence that over-indebtedness under commercial (or the applied debt-to-equity ratios are insolvency) law at the level of the company. nevertheless arm’s length ratios. There are no limitations on debt-financing of Swiss Under Swiss corporate law, specific corporations by independent third parties minimal-equity-rules apply for Swiss banks (e.g. banks). and insurances. In case of a thin capitalisation, the related Tax-related aspects party debts may be treated as taxable Overview equity. Interest paid on loans that exceed In Switzerland, interest is generally treated the relevant debt-to-equity ratios are not as ordinary business expense and is tax deductible; further, such interest may consequently as such tax deductible. There be deemed as a hidden distribution and are certain limitations, such as for example hence be subject to Swiss withholding tax. arm’s length rules for interest rates and thin capitalisation rules. In addition, interest paid to affiliated companies is subject to periodically fixed Taxes on the issuance of bonds ceilings. The tax deduction of interest On 1 March 2012, the amendment of the in excess of the permitted safe harbour Swiss Banking Act (so called ‘too big to fail rate may be disallowed and also treated rules’) was enacted. This Act included the as a hidden distribution subject to Swiss abolition of Swiss issuance stamp tax on withholding tax (see section E.II.2.c). the issuance of Swiss bonds and money

Switzerland Financing options: Debt versus equity 50 On 5 October 2015, the OECD released exemption.51 This temporary exemption 48 Art. 313 para. 2 CO. the report to BEPS Action 4 “Limiting Base is to be seen in connection with ongoing 49 Art. 314 para. 2 CO. Erosion Involving Interest Deductions and political discussions in order to replace Other Financial Payments”. Switzerland the Swiss withholding tax system by 50 BBl 2016, 2097 et seq. will thoroughly observe the OECD and a “paying agent system” (in German international environment in order to “Zahlstellenprinzip”), aimed at facilitating 51 Art. 5 para. 1 letter g WTA. assess whether in future, adaptions to the the issuance of bonds on the Swiss capital 52 Group companies in the context of the law currently existing Swiss thin cap rules (e.g. market. are companies whose financial statements EBITDA fixed ratio rules) may become are fully consolidated in the group accounts necessary. 10/20 lender rule according to recognised accounting Overview standards. A bond for Swiss withholding tax purposes 53 Art. 14a of the Ordinance to the WTA. The Interest payments on debt is given if a Swiss borrower is granted a stamp duty on the issuance of bonds was credit facility from more than 10 non-bank abolished effective 1 March 2012, see above Legal aspects lenders at identical conditions against footnote 46. Swiss corporate law stipulates that in the issuance of certificates (the written commercial transactions, interest on loans credit agreement is already considered a is due, even if not expressly agreed.48 certificate) and the entire credit exceeds Where the interest rate is not specifically the amount of CHF 500’000. stipulated, it is presumed to be the ordinary rate for loans of the same type at A medium-term note for Swiss WHT the same time and place that the loan was purposes is given, if a Swiss borrower is received.49 granted a credit facility from more than 20 non-bank lenders at varying conditions Tax-related aspects against the issuance of certificates (note Withholding tax/Stamp duty that the written credit agreement is already Overview considered a certificate) and the entire In principle, the granting of credit facilities credit exceeds the amount of CHF 500’000. to a non-bank Swiss borrower does not trigger Swiss stamp duty, and interest Based on a regulation which came into payments by a Swiss non-bank borrower force on 1 August 2010, loans between are not subject to Swiss withholding tax. related companies52 are no longer considered as bonds or medium-term Exceptions are to be considered, in case notes under the 10/20 rule. According to a credit facility qualifies as a collective the new standards, interest payments on funding scheme. A collective funding liabilities to group (affiliated) companies, scheme would be assumed in case of a regardless of their terms, their number bond (so called Anleihensobligation), or their amount, are no longer subject a medium-term note (so called to withholding tax.53 As a consequence, Kassenobligation) under the 10/20 (non- interest on inter-company debt does not banks) lender rule (see below) or an carry withholding tax. Note however, that interest bearing debt/deposit under the for tax evasion reasons, these rules are 100 (non-banks) lender rule (see below) not available where a domestic (Swiss) for purposes of Swiss withholding tax. company provides a guarantee for a non- domestic group company raising funds by The Swiss withholding tax exemption on means of issuing foreign bonds. interest of contingent convertible bonds (CoCos) is restricted to interest on bonds Consequences of the 10/20 Rule issued by respective bank institutions in Interest payments by a Swiss borrower the period between 2013 and 2016. A under a credit facility that qualifies as a draft bill in order to extend the exemption bond or a medium-term note are subject is currently pending.50 These bonds must, to Swiss withholding tax levied at a rate of furthermore, fulfil specific criteria in order 35%. to benefit from the Swiss withholding tax

Switzerland Financing options: Debt versus equity 51 Swiss resident lenders are in principle Taxation at source for loans secured by 54 See above footnote 46. entitled to a full refund of the Swiss mortgage 55 Circular letter number 34 withholding tax, if they are the The (Swiss) Federal Tax Act as well as “Kundenguthaben” (customer credit beneficiaries of and have duly declared some of the Cantonal Tax Acts (e.g. the Tax balance) of the Swiss Federal Tax Admin- the interest payments as income. Other Act of the Canton of Zurich) stipulate that istration dated 26 July 2011. lenders are entitled to a refund of the an income taxation at source is levied on Swiss withholding tax depending on the the interest to be paid to a foreign lender, if applicable double tax treaty, if any. No the respective loan is secured by mortgage. refund is granted to residents of countries Some double tax treaties foresee an with which Switzerland has not concluded elimination or mitigation of these rules. a double tax treaty. Deductibility In the past, in addition to the Swiss In general, interest paid by a corporation withholding tax on the interest payments, to a third party is qualified as deductible the granting of such a credit facility would business expense. Interest paid to related have been subject to Swiss stamp duty. parties (affiliated company or shareholder) However, the stamp duty on the issuance has to meet the arm’s length test and is of bonds was abolished effective 1 March subject to limitations (regarding thin 2012.54 capitalisation see section E.I.2.c) above.

Due to the limited application of the With respect to related parties, the Swiss 10/20 rule to non-related parties, its Federal Tax Administration annually relevance has significantly dropped. There publishes safe harbour interest rates to be might nevertheless be cases where these used on loans denominated in Swiss francs principles have to be observed (e.g. capital- on the one hand and in foreign currencies intensive real estate acquisition with on the other hand. Related companies may several third-party investors). deviate from these safe harbour rates to the extent that they can prove that the used Qualification as bank rates are at arm’s length. The burden of Interest paid on any kind of debt or proof is however high. The cantons usually deposits are subject to Swiss interest follow for cantonal and communal taxes withholding tax if a Swiss borrower these federal guidelines. is granted credit facilities from more than 100 non-bank creditors and the entire credit exceeds the amount of CHF 5’000’000.55

The relevance of this test dropped when the threshold of 100 (instead of 10) was introduced in 2011.

Switzerland Financing options: Debt versus equity 52 The safe harbour rules for loans For loans granted to related parties Minimum interest rate (%) denominated in Swiss francs applicable Financed from equity ¼ as of 1 January 2016 are as follows (rates Financed from debt (actual costs plus at least): are reviewed and possibly adjusted on an On amounts up to CHF 10 million ½ annual basis): On amounts of more than CHF 10 million ¼ But in all cases at least ¼ Type of loan Home construction/ Industry and agriculture business Real estate loans: 1 1½ A loan up to the amount generally acceptable for mortgages (i.e. of the market value of the real estate) Rest, whereby the following maximum interest 1¾ 2¼ rates for debt are applicable: Land, villas, residences, vacation houses, busi- ness premises up to 70% of the market value Other real estate up to 80% of the market value Operational loans up to CHF 1 million: Granted to trading and production companies - 3 Granted to holding and asset management - 2½ companies Operational loans of more than CHF 1 million: Granted to trading and production companies 1 Granted to holding and asset management ¾ companies

In addition, special practice rules apply for Finance branch 56 See in this context also the circular letter short-term (usually < 1 year) cash pool Overview dated 9 October 1991 of the Swiss Federal deposits and drawings. A qualifying Swiss Finance branch may Tax Administration with respect to a Dutch financing company with a Swiss Finance apply for a tax ruling covering the tax branch. This circular letter is currently still The tax deduction of interest in excess treatment of the branch dotation capital. the main base for the Swiss Finance branch of the permitted safe harbour rate may Typically, the foreign head office would practice. be disallowed and treated as a deemed provide funds to the Swiss branch for dividend distribution subject to Swiss financing group companies. Consequently, 57 See above footnote 35. withholding tax. the Swiss branch would receive dotation capital that is treated like dotation For calculating the amount of the capital of a Bank with branches within maximum interest permissible from a Switzerland. With other words 10/11th Swiss tax perspective, any potentially of the dotation capital would qualify as existing hidden equity (under Swiss thin interest bearing debt providing for a tax capitalisation rules, see above section accepted interest deduction.56 E.I.2.c) has to be considered. Due to the interest deduction on such Arm’s length principle dotation capital qualifying as debt and the The Swiss tax law adheres to the arm’s status of a mixed company for cantonal and length principle. Consequently, a tax communal tax purposes57, a Swiss Finance commissioner may question a not at arm’s branch can benefit from an effective length interest rate which may lead to a income tax rate that may be as low as correction of the taxable income and a 2 % - 4 %. The branch’s dotation capital related deemed dividend distribution. treated as equity (1/11 of the total branch assets) is considered taxable capital.

Switzerland Financing options: Debt versus equity 53 Often, mixed companies are subject to a Reduction of debt 58 See in more detail, in particular regarding reduced cantonal capital tax rate. the mixed companies, above footnote 37. Legal aspects Usually, the taxable income at the head The reduction of debt is usually not subject office country (e.g. Luxembourg) is low to specific legal provisions. and limited to income directly allocable to the head office. This obviously requires Tax-related aspects that the head office country applies the In principal, the repayment of debt does exemption method for branch income not have tax implications. (either unilaterally or based on the applicable double taxation treaty with Switzerland). Example General requirements A Swiss branch may qualify as “Swiss Debt financing of Swiss operations Finance Branch” if the following conditions is from a Swiss tax perspective often are fulfilled: advantageous, as at arm’s length interest payments are generally tax • Finance branch must have assets in deductible. Furthermore, debt is its balance sheet of at least CHF 100 usually not considered as taxable million equity with respect to the cantonal and communal capital tax. See in this • ¾ of the average balance sheet must be respect in particular sections E.II.2.c) investments in financial activities (e.g. and E.I.2.c) above. loans) and ¾ of the gross income must be derived from such sources The following example compares equity and debt financing. The • Qualifying financial services usually computation is based on an ordinarily include: granting loans, cash taxed company with its tax residency management, factoring, leasing, in the City of Zurich. Note that as netting, re-invoicing, centralising of outlined above (at the end of section group-wide currency risks etc. D.I.2), the overall effective Swiss tax burden may vary from canton • Loans and advances to Swiss affiliates to canton and from community may not exceed 10% of the total balance to community. Furthermore, the sheet cantonal/communal effective tax rate may be lower in case a cantonal/ • The Swiss branch must maintain its own communal tax privilege applies branch accounts and records, financial (currently subject to discussions state-ments can be kept in foreign between Switzerland and the EU/ currencies, but must be converted to OECD, see footnote 37). Swiss Francs for the determination of taxable profit and capital

Ongoing developments As a result of discussions of Switzerland with the EU and the OECD, the Swiss Finance branch concept as well as the cantonal mixed tax privilege may in a few years be replaced by other measures.58

Switzerland Financing options: Debt versus equity 54 Assumptions Equity financing Debt financing m CHF m CHF

Income Earnings before taxes 165 143 + Net interest expense 0 22 + Depreciations / amortizations 15 15 EBITDA 180 180

Funding Equity 10’000 7’000 Debt (intercompany / third parties) 0 3’000 Total 10’000 10’000

Corporate income tax rates 2016 1) statutory 2) effective 2) for Zurich cantonal / communal tax purposes 18.32% 14.45% for direct federal tax purposes (in ZH) 8.50% 6.70% Total 26.82% 21.15%

Corporate capital tax rate 2016 1), 3) statutory Total for Zurich cantonal / communal tax purposes 0.1718%

Computation / comparison of total tax liability Equity financing Debt financing m CHF m CHF

Corporate income tax EBITDA 180 180 Depreciations / amortizations -15 -15 Net interest expense n/a -22 Corporate income tax base (earnings before taxes) 165 143 Corporate income tax (effective tax rate) 34.90 30.24

Corporate capital tax Equity 10’000 7’000 Debt (intercompany / third parties) 0 3’000 Corporate capital tax base 10’000 7’000 Corporate capital tax 17.18 12.03

Summary of taxes Corporate income tax 34.90 30.24 Corporate cantonal / communal capital tax 17.18 12.03 Total 52.08 42.27

1) For the above model calculation, the tax rates of the City of Zurich / Canton of Zurich (ZH) were chosen. Please note that the cantonal and commumal income and capital tax rate may vary from canton and also from commune to commune depending on the place of the residency of the company

2) Please note that in Switzerland, taxes are tax deductible. The statutory tax rate applies to earnings after taxes, where as the effective tax rates report the effective tax rate before taxes.

3) Please note that annual capital tax is levied on cantonal / communal level only. In several cantons (but not in the Canton of Zurich), income tax can be credited against capital tax.

Switzerland Financing options: Debt versus equity 55 The Netherlands

Funding of a Dutch company with either equity or debt is a decision often based on business reasons, as the form of funding typically coincides with the influence of the investors in such company. Legal aspects and tax consequences are however of equal importance when deciding the way of financing a company.

This article provides an overview of the financing possibilities in the Netherlands. In the first section, we will elaborate on the general economic aspects as well as the financial environment in the Netherlands. In the subsequent section, the definitions of equity and debt according to Dutch law are examined, whereby both legal and tax aspects are taken into account. Section D and section E consider the specific consequences of each form of financing. The final section of this article provides a comparative calculation of a Dutch company funded with equity versus a company funded with debt.

Financing environment in exceeds that of most other European Jeroen Schmitz the Netherlands countries results in the fact that the +31 (0)88 792 73 52 Netherlands are currently regarded as third [email protected] out of 138 countries in the Enabling Trade The Netherlands, situated in north- Index and eight-best business climate in the Pieter Ruige west Europe, functions as strategic world by the World Economic Forum. +31 (0)88 792 34 08 gateway to Europe and the Middle East. [email protected] Approximately 160 million people live From a tax point of view, the Netherlands within a 300 mile radius of Amsterdam, is regarded an attractive location for Guido Dam the capital city of the Netherlands, with a holding, financing and principal activities. +31 (0)88 792 52 26 population density three times higher than The Dutch tax authorities are known for [email protected] New York or Tokyo. The Dutch economy their open and pragmatic approach, while is stable and open, with low inflation, the Netherlands also have an extensive relatively low deficits and high labour tax treaty network, an established ruling participation. As such, the Netherlands practice, special tax features such as have a prominent role in world economy: it Innovation Box regime (resulting in an is the world’s 5th largest exporter of goods, effective tax rate of 5 per cent on income the world’s 6th largest recipient of foreign from qualifying IP) and a moderate investment and the 6th largest foreign corporate income tax rate of 25 per cent investor abroad. (FY 2014).

The stable Dutch economy is supported The Dutch Agency for Statistics examined by its superior infrastructure: Europe’s the way Dutch companies are financed over largest port (third largest port worldwide) the last decades. This study demonstrated is located in Rotterdam and Amsterdam that Dutch companies are generally Airport Schiphol, with its optimal logistics financed in a robust way, whereby debt infrastructure, continual supply-chain slightly outweighs the amount of equity innovation and the added value of highly in a Dutch company. This conclusion qualified team of experts, finds itself firmly applied both to small companies as well in the top five of European Cargo airports. larger companies. Please refer to the table below, that reflects the solvency of Dutch The above, in combination with the world- companies in the past three decades. class ICT infrastructure, highly developed R&D facilities and highly educated, multilingual workforce whose productivity

The Netherlands Financing options: Debt versus equity 56 Titel? 2 HR 27 January 1988, BNB 1988, 217 / HR 25 November 2011, V-N 2011, 63.10. 50

2 HR 8 September 2006, 42 015, BNB 2007/104. 48

46

44

Procent 42

40

38

36 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 Solvency

Definition of equity versus The starting point for determining whether debt an instrument qualifies as debt or as equity is the qualification of such instrument for civil law purposes. In the “Caspian Sea” Legal classification of financing case, the Dutch Supreme Court judged that instruments the essential characteristic of debt is the repayment obligation of the debtor.2 This Under Dutch civil law (7A:1793 DCC) means that if the recipient of the funds the main characteristic of a financial is not obliged to repay the amount, the instrument qualifying as debt, is financing is, in principle, not considered whether the debtor has an obligation debt. for repayment. In principle financing instruments qualifying as debt are due There are however three exceptions to be repaid independent of results, and which result in the requalification of debt in case of insolvency of the debtor the to equity. These apply in case of a ‘sham creditor has preference over the providers transaction’, certain hybrid financing of equity. The Dutch Supreme Court has loans and ‘loss financing loans’. If any of however identified a few situations of the above exceptions apply, the relevant “fake transactions”, in which there is no financing arrangement qualifies as equity realistic intention or possibility to meet for Dutch purposes. Interest paid on a the repayment obligation. In these cases requalified financial instrument qualifies the alleged loan was classified as equity a dividend distribution for Dutch tax contribution.1 purposes and is treated accordingly.

In its February 2014 rulings, the Dutch Classification of financing Supreme Court made clear that in order to instruments for tax purposes determine whether an instrument should be treated as debt (instead of equity) for In principle, a Dutch taxpayer is unrestricted Dutch corporate income tax purposes, in the way it finances its enterprise: this can the qualification of such instrument in be either equity or debt. another jurisdiction is not relevant for the

The Netherlands Financing options: Debt versus equity 57 (civil law) qualification of such instrument maintenance rules. In case of a private 3 HR 15 December 1999, BNB 2000/126. in the Netherlands. As a result, financial company (B.V.) the minimum capital instruments qualifying as equity in a amounts to the nominal value of at least foreign jurisdiction may very well qualify one share, which is determined in the as debt for Dutch tax purposes and vice Articles of Association (can be lower versa. This used to be important, as the than EUR 0,01). For public companies Dutch participation used to apply to all the minimum capital amounts to EUR income derived from active subsidiaries, 45,000 and needs to be validated by a even to payments received on hybrid bank statement (cash contribution) or an finance instruments that were deductible in auditor statement (contribution in kind). a foreign jurisdiction. Under the new Dutch Contributions exceeding the nominal value participation exemption rules applicable of the issued shares are registered as share as per January 1, 2016, payments that premium (agio). are deductible in the payor’s jurisdiction are no longer tax exempt under the Dutch In case of partnerships, the law does participation exemption. not provide specific regulations on raising capital or capital increases. The Based on a decision of the Dutch Partnership Agreement can however Supreme Court on 15 December 1999,3 contain all kinds of stipulations regarding in exceptional cases a transaction may capitalization. The partnership becomes be qualified for Dutch tax purposes on a the beneficiary of a contribution, but stand-alone basis, despite its qualification cannot hold legal title, which remains with for Dutch civil law purposes. This the partner(s). Despite of the fact that the exception only applies if the Dutch tax partnership does not hold legal title to the consequences of the civil law qualification equity, the equity is separated from the of the transaction leads to unacceptable other possessions of the partners, and can economic results, and this outcome is not be subject to recourse by the partnerships in line with the ‘rationale’ of Dutch tax law. creditors, with preference over private creditors of the partners.

Tax-related aspects Equity financing Capital contributions (both formal and informal capital contributions) do not have adverse Dutch corporate income tax Contribution of equity consequences, as a capital contribution is not regarded as a taxable event. Legal aspects In the Netherlands enterprises can be In addition, the Netherlands do not levy a organized in various ways, such as a stamp duty. one-person enterprise (eenmanszaak), partnerships with partners bearing full or limited liability (maatschap, VOF, CV) and Payments out of equity private or public capital companies (B.V., N.V.). Legal aspects With respect to capital companies, Contributions to equity can be paid in cash payments out of equity are principally or in kind. In case of capital companies possible in the form of distributions. In these contributions can be made to formal general this requires a formal resolution capital (shares) or informal capital (share of the shareholders; however, the Articles premium). Contributions to formal capital of Association can delegate this authority are subject to formal requirements (i.e. to another corporate body (2:216 par. issue of shares instrumented by public 1 DCC). There is a distinction between deed signed by a notary and entry in repayment of formal share capital the commercial register) and capital (repurchase of shares, cancellation

The Netherlands Financing options: Debt versus equity 58 of shares or capital reduction), which dividend a recent balance sheet is required. 4 Reinout De Boer and Frederik Boulogne, are subject to specific formal legal In practice, although the liquidity test is “Country Report: the Netherlands” Taxation of Intercompany Dividends under Tax Treaties requirements, and distribution out not applicable to the public company, the and EU Law, Publisher: Amsterdam: IBFD, of freely distributable reserves (e.g. management board of the public company Editors: G. Maisto, pp.771-867. retained earnings or share premium). should make a similar judgment to whether For the purpose of this chapter we will distribution is justified, considering the use the term “Distributions” covering all financial health of the company. abovementioned distributions. In case of partnerships, there are basically For private companies Dutch law no corresponding restrictions. Here, a introduced rules creating a liability disbursement from capital is essentially for the managing directors and/or the possible without restriction, unless counterparty of the B.V. for Distributions otherwise agreed in the partnership if the position of the B.V.’s creditors is agreement. harmed. A resolution of the shareholders to make a Distribution is subject to approval Tax-related aspects by the management board, based on two Payments out of equity are not tax criteria: a “balance test” and a “liquidity deductible at the level of the Dutch test”. company making the payments. In addition, Dutch tax law does not grant The balance test is to identify reserves deemed interest deductions on equity. For which need to be maintained, based Dutch tax purposes, it is relevant whether on legislation or Articles of Association or not the payment out of equity qualifies (mandatory reserves). These reserves may as dividend distribution. Capital reductions not be distributed. that do not qualify as dividend distribution for Dutch dividend withholding tax The liquidity test is to establish whether purposes will be considered in Reduction of the B.V. will remain able to fulfil its due equity. and payable debts after the contemplated Distribution. If the B.V. fails this test, the To the extent that a Dutch company with management board must refuse approval. a capital divided into shares distributes profits to its shareholder(s), Dutch If after a Distribution the B.V. is unable dividend withholding tax may be levied to continue payment of its debts, and at a rate of 15 per cent. A taxable profit the managing directors knew or should distribution can be described as follows: reasonably have foreseen this at the moment of the Distribution, each [T]he term “profit distribution” individual managing director will be held can be defined as a shift of assets jointly and severally liable. The liability will [vermogensverschuiving] by the company to be to compensate the B.V. for the shortfall its shareholder, as a consequence of which resulting from the Distribution plus interest an amount of money or other item of value, as of the date of the Distribution. covered by profit [reserves] that is [are] part of its assets, is withdrawn from the For public companies a more formal assets of the company for the benefit of the criterion applies. According to the legal shareholder.4 provisions for the maintenance of the nominal share capital pursuant to 2:105 The above definition covers both formal DCC a public company can only make and deemed dividend distributions by a distributions to the extent that its equity Dutch company. exceeds the issued and paid up share capital plus the reserves which mandatory At the level of the (Dutch) shareholder need to be maintained, based on legislation receiving the dividends, such distributions or Articles of Association (mandatory are considered part of the (taxable) profit. reserves). For distribution of interim Two important exceptions apply to this

The Netherlands Financing options: Debt versus equity 59 main principle: i) the dividend is paid the commercial register and published in (Legal) actions by the management board out of profit reserves that were already a nationally distributed newspaper. The within one year previous of a bankruptcy present at the time of the acquisition of the publication triggers a two month creditor of the company may be examined to shareholding and ii) the dividend is exempt opposition period, in which creditors determine whether they deliberately at the level of the shareholder under the have the opportunity to object and ask for harmed the position of creditors (Pauliana) Dutch participation exemption. additional security for their claims. and may in that event be judged as being null and void. Partial repayments of paid-in capital, if Tax-related aspects and to the extent that there are existing To the extent that the capital reduction Tax-related aspects and anticipated profit reserves (‘zuivere does not relate to existing and anticipated Issuance of debt should occur at arm’s winsten’), also qualify as a taxable profit re-serves, capital can be repaid tax- length terms and conditions. If this is the dividend. An exception may apply if the neutral (i.e., no dividend withholding tax case, such issuance is not subject to Dutch general meeting of shareholders has will be levied). tax. resolved in advance to make the repayment and also decided that the nominal value To the extent that there are existing and Exceptions may apply with respect to the of the shares involved has been reduced anticipated profit reserves, we refer to our issuance of certain debt instruments such by a corresponding amount by way of an comments in Payments out of equity. as zero coupon bonds. If such bonds are amendment of the articles of association of issued for value less than its nominal value, the company. the difference between such value and the nominal value is subject to Dutch corporate Profit distributions made by Dutch Debt financing income tax. cooperatives are in principle not subject to Dutch dividend withholding tax (subject to certain anti-abuse provisions). Issuance of debt Payments on debt

Legal aspects Legal aspects Reduction of equity As described under Definition of equity In relation to the payment of interest on versus debt - Legal classification of financing shareholder loans which qualify as debt, Legal aspects instruments, for a financial instrument the principles already described above In the Netherlands the term capital to qualify as debt, it is essential that the regarding contestability of such payments reduction is in practice used for the debtor has an obligation for repayment. must be considered. With each payment decrease of formal share capital of capital In other words, debt fundamentally the management board must judge the companies, which can be executed by establishes an obligation for repayment solvability of the company and determine reducing the number of issued shares to the creditor. With regards to this debt whether it does not advantage one creditor (either (i) through repurchase of shares, financing it is the responsibility of the over another, and whether it is still is in followed by cancellation, or (ii) through management board to ensure that no over- a position in which it is able to pay other direct cancellation of shares or (iii) indebtedness is incurred, hazarding the creditors as well. through a devaluation share capital by financial health and the solvability position lowering the nominal value per share). of the company. Tax-related aspects The pre-conditions for and effects of a On an instrument that qualifies as debt capital reduction depend on the nature In the event of granting of shareholder for Dutch tax purposes, an at arm’s length of the reduction. For private companies payments/loans which qualify as debt, the interest expense is in principle deductible repurchase of shares is resolved by management board must be on its guard to for Dutch corporate income tax purposes. the management board. The Articles treat all creditors equally. Especially if the of Association can limit the authority company’s financial position is weak, it is The terms and conditions of the debt to repurchase shares. Cancellation of essential to treat all creditors the same way instrument meet the arm’s length criteria. shares and decrease of nominal value (paritas creditorum). If shareholders are Regardless the actual interest expenses, in are shareholder resolutions, subject to paid to the disadvantage of other creditors, principle interest expenses are deductible management board approval (see Payments both the shareholder and the management at the arm’s length rate. If there is a out of equity). board run the risk of being charged with difference between arm’s length and actual claims for unlawful acts, and in that respect interest expenses, an informal capital For public companies specific rules for of being exposed to personal liability. contribution or a deemed dividend is creditor protection apply. The resolution recognized. Dividend withholding tax may to decrease share capital must be filed at have to be considered in the latter case. An

The Netherlands Financing options: Debt versus equity 60 exception is laid down in article 10b Dutch This mathematical rule may limit the 5 HR 25 November 2011, 08/05323, BNB Corporate Income Tax Act 1969 (“CITA”), deductibility of interest expenses relating 2012/37. which states that interest is non-deductible to “participation debt”. Participation if a loan has a term of 10 years or longer debt can be defined as an amount by and no interest has to be paid with respect which the cost price of the non-qualifying to this loan or the interest is 30 per cent participations exceeds the equity for Dutch lower than the interest that would have corporate income tax purposes. been paid if the loan had been concluded between non-related parties. Further, A participation is considered as non- deductibility of interest on loans that qualifying if the Dutch participation would not have been granted by unrelated exemption applies and the participation parties may be restricted, such based on investment is not a so-called expansion case law.5 investment. The exclusion of expansion investments is meant to avoid interest Dutch tax law provides some other deduction restrictions for operational provisions that may have an impact on the expansion investments by Dutch tax payers. deductibility of interest expenses on debt. Thus, interest expenses on debt financed In the overview below, these provisions are expansions of the group’s operational considered. activities (e.g., manufacturing, R&D, distribution and sales activities) through Tainted transactions acquisitions of or capital investments in The anti-base erosion rule of article 10a subsidiaries remain deductible. CITA needs to be considered if one of the following tainted transactions take place: The expansion investment exception, however, does not apply if the expansion a. Dutch tax payer borrows from an related interest expenses is deducted affiliated company and such loan can be elsewhere within the group (‘double directly or indirectly linked to dip’) or if the participation financing is predominantly tax driven. This might occur 1. a dividend distribution by that Dutch when, for example, the taxpayer cannot taxpayer or an affiliated Dutch taxpayer; demonstrate a management link between the Dutch taxpayer and the participation. 2. a capital contribution by that Dutch taxpayer or an affiliated Dutch taxpayer; Up to EUR 750,ooo (threshold), excessive or participation interest expenses do not fall under this limitation. 3. an acquisition of shares in an affiliated company by that Dutch taxpayer or an Limitation of interest deduction with affiliated Dutch taxpayer. respect to debt-funded acquisitions Restrictions apply to set off interest In such case, interest expenses (including expenses on debt related to the acquisition foreign currency exchange results) relating of a Dutch target company, against the to this debt instrument may not be tax taxable profits of that target company, deductible if the corresponding interest within a Dutch tax consolidated group income is not sufficiently taxed and both (i.e., a Dutch fiscal unity). the transaction and the financing thereof are not based on sound business reasons. Up to EUR 1,000,000 (threshold), interest expenses relating to the above-mentioned Excessive’ participation debt rule debt-funded acquisition do not fall under With the abolishment of the thin- this limitation. Further, acquisition debt capitalisation rules, the Dutch legislator is only regarded as excessive if and to the introduced article 13l CITA, a provision extent that debt exceeds 60 per cent of the that limits the deduction of so-called acquisition price. During the subsequent “excessive participation interest”. seven years the percentage is reduced by

The Netherlands Financing options: Debt versus equity 61 5 per cent per year. After seven years the Tax-related aspects part of the acquisition debt that exceeds The reduction of debt in principle does 25 per cent of the acquisition price remains not result in Dutch corporate income tax as excessive. purposes.

Reduction of debt If debt is waived by the creditor based on business motives, such waiver may in Legal aspects principle result in profit at the level of the Reduction of the debt position can be debtor. However, Dutch tax law provides achieved: for an exemption if such debt should be regarded as ‘uncollectable’ at the level of • By repayment of debt. When repaying the creditor. a shareholder loan to shareholders, paritas creditorum should be considered If debt is waived by the creditor based (see Debt financing - Issuance of debt, on shareholder motives, such waiver is Legal aspects). regarded as informal capital contribution in the debtor. As such, no profits should • By converting debt into equity. A arise at the level of the debtor. shareholders can resolve to contribute the receivable it holds on the company to shares (or share premium), which improves the solvability of the company.

• By waiver of the debt by the creditor.

The Netherlands Financing options: Debt versus equity 62 Turkey

In general, the enterprises require external/internal funding in order to be able to maintain the operations, to fund new acquisitions or investments. Depending on the circumstances bank loans, or more complex financing instruments (i.e. mezzanine funding) as well as intra-group financing and equity financing.

This article intends to elaborate Turkish tax and legal implications of equity or debt financing and to focus on the main differences between these two different funding instruments for Turkish corporates.

Financing environment in The Turkish government has also Burcu Canpolat Turkey introduced flexible exchange rate policies +90 212 326 64 52 and liberal import regulations in order to [email protected] promote and sustain foreign investment. Turkey is located at a close proximity to Cem Erkus Europe (between two and three hours’ The Turkish legal framework offers a +41 58 792 1344 flight to major European destinations). level playing field to foreign investors and [email protected] Turkey benefits from its location as a bridge domestic companies. Foreign ownership is between Europe and Asia. It also acts as an unrestricted, with no pre-entry screening Aycan Koc energy corridor connecting Asia to Europe. requirements, except for certain regulated +90 212 326 66 39 sectors. [email protected] Turkey entered into a customs union with the EU in 1996 and has been an EU As legal entity forms, Joint Stock accession candidate since 2005. This has Companies (“JSC”), Limited Liability resulted in the expansion of trade relations Companies (“LLC”) and Limited with Europe, which now accounts for Partnerships divided into shares are approximately 40 per cent of Turkey’s trade. defined as capital companies under the Turkish Commercial Code.1 In general, Turkey offers an accessible, skilled, young JSCs and LLCs are most common legal and cost-effective workforce, providing forms that are used by the investors in the fourth largest labour force amongst EU Turkish business environment. members and accession countries. It boasts a large population of over 74 m people, of which 47 per cent is under age 30. Definition of equity versus debt

The Turkish government provides various Legal aspects tax and non-tax incentives to foreign Turkish companies can be financed investors, in line with those provided either by equity or debt. The equity can to domestic companies. These include be contributed by the shareholders into customs and VAT exemptions on various the companies in the form of (i) cash, imported or locally delivered goods, receivable, security and participation including machinery and equipment, as shares, (ii) intangible rights, (iii) movable/ well as priority regions offering incentives immovable properties and other rights such as free land and energy support. which are transferrable and have economic Investors are also able to benefit from R&D value. Accordingly, the equity contribution support and market research with the aim can be classified as a cash contribution and of encouraging exports and increasing the in-kind contribution which can be provided 1 Turkish Commercial Code numbered 6102 competitiveness of firms in international through (i) the internal resources of the dated 2011, Article 124. markets. company (i.e. previous year’s profits, share

Turkey Financing options: Debt versus equity 63 premiums, etc.) or (ii) external financing been previous cases where long term loan 2 Turkish Commercial Code numbered 6102, by the shareholders or third parties. All agreements having arm’s length interest Article 127. such economic values are qualified as were implanted in the market. 3 Turkish Commercial Code numbered 6102, equity once they are registered as a capital/ Article 332 and Article 580. share premium. In contrast to equity, debt fundamentally establishes an obligation for 4 Turkish Commercial Code numbered 6102, repayment to the lender. Article 344. Equity financing

5 Turkish Commercial Code numbered 6102, Tax-related aspects Article 345. In principle, equity financing and debt Based on the Turkish corporate law, financing have different tax implications in the equity can be contributed by the Turkey. Equity financing (mainly registered shareholders into the companies in the capital and share premium) does not allow form of (i) cash, receivable, security and companies to claim any interest expense participation shares, (ii) intangible rights, (or foreign exchange loss) deduction for (iii) movable and immovable properties corporate tax purposes. and other rights which are transferrable and have economic value.2 Accordingly, the All other financing instruments which do equity contribution can be classified as a not fall under equity are qualified as a debt cash and in-kind contribution which can be for tax purposes. The key consideration for provided through (i) the internal resources the financing instrument is deductibility of the company (i.e. previous year’s profits, of financing expenses (i.e. interest, foreign share premiums, etc.) or (ii) external exchange losses/gains). financing by the shareholders.

Depending on who is the lender (or guarantor) of the financing arrangement Contribution of equity there may be restrictions as follows: Legal aspects • Thin capitalisation rules limit the The increase in nominal capital is subject to debt to equity ratio for intercompany legal procedures and should be registered borrowings. As explained in a before the Trade Registry. The minimum detailed way under the section Thin capital requirement for JSC is TRY50,000, capitalization), the portion of the whereas it is TRY10,000 in case of a LLC.3 debt which exceeds 3 times the total equity is deemed as a thin capital and According to the legislation, it is corresponding interest payments are not mandatory that at least 25 per cent of the deductible for corporate tax purposes. nominal capital that is committed by the shareholders in the form of cash should • As per recent changes within the be paid before the registration of the new legislation, the deductibility of capital. The remaining capital (if any) financial expenses on external should be paid within 24 months following borrowings (related/unrelated) is also the registration. In case of having a share limited up to the 10 per cent of the premium at the capital contribution, the total financial expenses. (Please see share premium amount should be fully Limitation on interest deductibility). paid up before the registration.4 In addition Although the legislation is introduced to this, the amounts that are transferred by the Government, it is not currently by the shareholders to the accounts of applicable since the details have not the company as a capital contribution are been announced yet. blocked by the banks and cannot be used for other purposes until the registration of Hybrid instruments are neither well the capital.5 recognized in Turkish tax and legal legislation nor have been tested in the Tax-related aspects eyes of tax authority. However, there have A capital contribution is not a taxable

Turkey Financing options: Debt versus equity 64 in Turkey. It is possible to contribute a Code. Accordingly; 6 Turkish Corporate Tax Law numbered 5520 share premium to the equity at the capital The interest rate will be based on the dated 2006, Article 5. contribution or increase for the increasing announcement of Turkish Republic 7 Law on the Protection of Competition value over face value of the shares issued. Central Bank’s on the average weight numbered 4054 dated 1994, Article 39. Under Turkish Corporate Tax Law, share interest rates applied to the commercial premium is treated as a profit received by bank credits (denominated in Turkish 8 Law numbered 6637 dated 2015, Article 8. the company which is fully exempted for Lira) in the respective year in which the 6 9 Communique numbered 9 dated 4 March joint stock companies. capital increase takes place. The interest 2016. rate will be calculated as of (i)the month Under the Law on the Protection of covering the registration date of the capital 10 Turkish Commercial Code numbered 6102, Competition, the capital amount increase for the capital paid before the Article 507/508. contributed at the establishment of new registration, and (ii)the month covering 11 Turkish Commercial Code numbered 6102, JSC/LLC, or the increased capital amount the transfer date for the capital paid after Article 519. to an existing JSC / LLC are subject to the the registration (no interest deduction is contribution fund at the rate of 0.04 per available for unpaid capital increases). cent.7 The companies eligible for this incentive Notional interest deduction can use the interest deduction as of 4th According to a recent legislative change advance corporate tax period of the year notional interest deduction for cash in which the capital increase has been capital increases will be possible for registered. The deduction cannot be Turkish companies excluding bank, taken into account for first three advance financial institutions, insurance companies corporate tax returns during the year. and public economic enterprises8. In accordance with this new incentive, Payments out of equity • 50% of the interest (Council of Ministers has authority to change the deduction Legal aspects ratio with certain limitations) to be Under the Turkish Commercial Code, each calculated over increased cash capital shareholder of a capital company has the amount that is paid after 1 July 2015 right to receive dividend from the yearly will be regarded as allowance from net profit at the ratio of their participation. corporate tax base, The dividend can only be distributed from the current year’s profit or freely disposable • notional interest deduction will be reserves (i.e. previous year’s profits).10 calculated by taking into consideration the “annual weighted average interest It is mandatory to allocate 5 per cent of the rate applied to Turkish denominated annual profit as a general first legal reserve commercial loans provided by banks” for capital companies up to 20 per cent of which is announced annually by the paid in capital. Furthermore, following the Central Bank of Turkey for the year payment of dividend to the shareholders up when the deduction is availed. to 5 per cent of paid in capital, 10 per cent of the total distributed profit is allocated • if the portion of the deduction that as a second legal reserve.. The legislation is not utilized in a given fiscal year as explicitly specify the utilization area of a result of insufficient corporate tax the legal reserves set aside up to 50 per base, it can be carried forward to the cent of the paid in capital.11 Although it is subsequent year. not explicitly stated within the legislation, in practice general understanding is that The details of the new legislation has been the exceeding portion of 50 per cent of announced by Ministry of Finance via a paid in capital (if any) is deemed as freely Communique which makes respective disposable reserves. In addition to the changes on the General Communique requirements set out under the Turkish numbered 1 on Corporate Income Tax Commercial Code, a dividend distribution

Turkey Financing options: Debt versus equity 65 should be in line with the principles The dividend income received by a Turkish 12 Communique on Interim Dividend of the articles of association of the company from a Turkish resident company Distribution published in Official Gazette dated 9 August 2012 and numbered company, where the general assembly of is fully exempt from corporate tax. For 28379. Although the details have not been shareholders meeting resolution should be Turkish individuals, 50% of dividends announced clearly, the interim dividend adopted for the distribution both for JSCs received from a Turkish company is exempt cannot exceed 50 per cent of the below and LLCs. from income tax, while the other half is calculation: subject to income tax at the rate of 35 per (+) Interim Period Profit (-) Taxes, funds, levies and provisions As a general rule, the distributable profit cent (effectively 17.5 per cent ignoring (-) Legal reserves to be allocated as per the amount is determined based on the the progressive rates).14 Turkish resident relevant laws year-end balance sheet. However, with individuals can credit the withholding tax (-) any amount to be allocated for owners of new regulations introduced recently, (15 per cent) paid by the company against preferred shares, usufruct shares and other capital companies can distribute interim their calculated income tax (which ends parties that have right in the profit of the company, if any dividends on a quarterly basis with some up an effective cash out tax payment at (-) interim dividends distributed in limitations.12 roughly 2.5 per cent at individual level).15 previous interim periods of the relevant fiscal year Tax-related aspects Dividends out of equity are not tax 13 Turkish Corporate Tax Law numbered 5520, Article 15 and 30 and Turkish Income deductible in Turkey. In principle, the Reduction of equity Tax Law numbered 193, Article 94. dividend distribution is subject to a withholding tax at a rate of 15 per Legal aspects 14 Turkish Corporate Tax Law numbered cent. The dividend distributed between Capital reduction is defined under Article 5520, Article 5 and Turkish Income Tax Law Turkish resident entities is exempt 473 et seq. of the Turkish Commercial numbered 193, Article 22. from withholding tax, where the profit Code and requires a set of procedures to 15 Turkish Income Tax Law numbered 193 repatriated to a Turkish individual or be completed from a legal perspective. dated 1960, Article 121. non-resident entity is subject to a 15 per In principle it may take 2-3 months to cent withholding tax. The withholding complete as there is a waiting period tax amount is declared and paid by the of 2 months for creditors to claim and company on behalf of the recipient via the secure their receivables from the company withholding tax declaration of the related (therefore the key issue is to get consent month when the dividend is distributed.13 of creditors in capital increase processes). However, there is an exception to this Among the double tax treaty network of rule as stipulated under Article 474 of the Turkey, the withholding tax rate is reduced Turkish Commercial Code which foresees to 10 per cent (i.e. the Netherlands, a possibility for board of directors to waive Luxembourg) or 5 per cent (i.e. Germany, from making an announcement for the Switzerland, Spain) which is generally creditors and getting their consent under subject to a minimum ownership ratio of a certain condition (i.e. previous year 25 per cent in the share capital. losses). In other words, according to the said Article, the board may decide on not getting the consent of the creditors if the capital decrease is to be made due to the previous year losses.

Turkey Financing options: Debt versus equity 66 With reference to the principle of Debt financing is possible in Turkey 16 Pursuant to Article 376/1 of the New protection of creditor’s rights, after the without a specific format. Loans to be TCC, if it is ascertained from the last annual balance sheet that half of the sum capital reduction, the Company cannot granted from abroad for Turkish residents of the capital and legal reserves of the be in a technical insolvency position as must be arranged through banks according company has been lost, the Managers per article 376 of the Turkish Commercial to the foreign exchange rules in Turkey.17 must immediately resolve on holding a Code.16 To this end, in case of a technical general assembly meeting. At such meeting, insolvency position following the capital Tax-related aspects the Managers shall clearly explain and inform the general assembly regarding reduction, such reduction resolution of There is no requirement for registering the financial downfall of the company, the company cannot be registered at the the loan agreement to the Tax Authorities. the reasons that have caused the losses relevant Trade Registry Office in Turkey. However, the intermediary bank which is and present the necessary reformative facilitating the cash transfer requests the precautions that should be taken by the Tax-related aspects loan agreement from the local entity. company. The Managers shall be liable if they fail to inform the general assembly In principle, a capital repayment made to on the reasons for the financial status the shareholders from the paid in capital According to the Turkish Tax Legislation and present reformative precautions. In of the company is not taxable in Turkey, loan agreements signed in Turkey or case the downfall of the company can be as long as the components of the capital abroad are subject to stamp tax once the realized from the interim balance sheet, the have previously been paid in cash. On the clauses are somehow benefitted in Turkey Managers shall not wait for the preparation of the annual balance sheet and shall other hand, if there is some portion of the at the rate of 0.948 per cent on the highest immediately call the general assembly for a capital arising from previous conversions figure stated on the agreement in year meeting. of internal reserves into the capital (i.e. 2016.18 Maximum payable stamp tax Pursuant to Article 376/2 of the New TCC, retained earnings, inflation adjustment, cannot exceed TL1.797k. Note that the if it is ascertained from the last annual other funds and reserves), the reduced signing parties are jointly and severally balance sheet that two thirds of the sum of the capital and legal reserves of the capital would be deemed as a dividend responsible for payment of stamp tax in the company has been lost, the Managers must distribution being subject to withholding eyes of the authority. immediately resolve on holding a general taxation at 15 per cent (to be reduced assembly meeting. At such meeting, the further down to 5 per cent depending on On the other hand, the financing general assembly must resolve on either (i) the double tax treaty, for Turkish receivers documents signed by Turkish companies recovering the lost capital of the company or (ii) decreasing the capital of the the rate is 0%) as described above. regarding loans provided by resident or company to one third of the original level. Furthermore, in case of having non-cash non-resident banks or financial institutions If the general assembly does not resolve on items within the share capital, repayment are exempt from stamp tax under stamp tax one of the foregoing, the company shall be may, in addition, be subject to corporate exemption list no.2/IV/23. The underlying dissolved. If the general assembly resolves tax at 20 per cent as well as the dividend purpose of this exemption is to avail on recovering the lost capital unanimously, each shareholder shall make the payment taxation. Turkish companies having less borrowing in order to recover the lost capital. costs. Accordingly, if such documents bring additional liabilities to the Turkish 17 Article 17 of Decree on the Protection of company on top of usual liabilities Turkish Currency numbered 32 Debt financing on a regular borrowing, i.e. any cross 18 The Stamp Tax Law, numbered 488, Article guarantees for group companies, stamp tax 1- Attached List 1-Section I. may apply on such document as well. Issuance of debt 19 Turkish Commercial Code numbered 6102, Article 8. Legal aspects Payments on debt In contrast to equity, debt fundamentally establishes an obligation for repayment Legal aspects to the creditor. From a commercial law In case of debt financing, the most essential perspective, there is no restriction on concept is the interest rate. the loans provided by the shareholder. However, since the Turkish commercial law According to the Commercial Code, the aims to protect third parties (i.e. creditors), interest rate related to the commercial in order to ensure the repayments of transactions can be freely specified by the debts, technical insolvency positions are transaction parties.19 There is no exchange regulated under Article 376 of the Turkish control for intercompany lending in Turkey. Commercial Code which brings equity/ capital ratio conditions for the companies.

Turkey Financing options: Debt versus equity 67 If an interest rate is not determined in institutions. Please refer the above 20 Law on Legal Interest and Default Interest, an agreement, the provisions of the Law explanations on the definition of the Article 1. (The current applicable rate is 9 per cent per year.) on Legal Interest and Default Interest financial institutions. numbered 3095 are applicable. 21 Banking and Insurance Transaction Tax Deductibility Code numbered 6802, Article 28. Tax-related aspects In principle, interest payments are Withholding tax deductible for corporate tax purposes 22 Value Added Tax Law numbered 3065 dated 1984, Article 24. Under the corporate tax law, there is no assuming they are related to the company’s withholding tax on interest payments made operations. On the other hand, interest 23 Value Added Tax Law numbered 3065, to a Turkish resident entity. On the other payments regarding shareholder loans Article 27. hand, interest payments made to non- or loans provided by related parties are resident entities are subject to withholding subject to limitations as follows: 24 Turkish Corporate Tax Law numbered 5520, Article 13. tax at the rate of 10 per cent. There is no reduced withholding tax rate on interest Arm’s length principle / transfer pricing 25 Turkish Corporate Tax Law numbered payments among the double tax treaties Under the transfer pricing regulations, the 5520, Article 12. concluded by Turkey. conditions of the related party borrowing should be in line with the arm’s length The withholding tax rate is nil on the principle, i.e. the interest rate and the payments made to non-resident banks and terms of the agreement should be based financial institutions. on fair commercial terms and comparable to third party agreements. Otherwise, the In addition to above, interests and interest payment corresponding to the commissions gained by banks operating portion exceeding the arm’s length price, is in Turkey are subject to Banking and deemed to have been a disguised dividend Insurance Transaction Tax (BITT)21 at a distribution which will be subject to a rate of 5 per cent. The responsibility of withholding tax at 15 per cent considering BITT filing is at Turkish banks. On the other the lender is a non-resident company hand, interest payments to foreign banks (lower withholding tax might be applicable would not trigger BITT. depending on tax treaty rates subject to conditions).24 Value Added Tax (VAT) Interest payments on loans are subject Thin capitalization rules to VAT at 18 per cent, if the lender is a According to Turkish legislation, if the non-financial institution.22 VAT has to be ratio of the borrowings from shareholders calculated and paid by a Turkish company or from related parties exceeds three under the “reverse charge mechanism”. times the shareholders’ equity of the This VAT is recoverable with the future borrower company at any time within the sales (subject to VAT) of Turkish company. relevant year, the exceeding portion of the borrowing will be considered as thin Although it has not been explicitly stated capital. within the legislation, the VAT might be applicable on an interest free loan although For loans received from related party banks no interest is accrued as per recent or financial institutions that also provide inspections. This is due to a provision lending to third parties, the debt equity within the VAT Law stating that VAT should ratio will be considered as 6:1 instead of be completed upon fair values of any 3:1. The equity capital is the equity of the delivery of service.23 Until recently, interest corporation at the beginning of the fiscal free loans were the basic funding tools in year, hence capital increases within the Turkey. However, the tax authority claimed year are not taken into account for that VAT on deemed interest in an inspection year but for the following years.25 performed recently. Should borrowings be deemed as thin VAT is not applicable to interest accruals/ capital, interest and foreign exchange payments to foreign banks or financial losses incurred in relation to the thin

Turkey Financing options: Debt versus equity 68 capital portion should be non-deductible 1 per cent on the principal if the average 26 • A provision of the Article 11 of the Turkish for corporate tax purposes. Moreover, maturity period of the foreign currency Corporate Tax Code has been amended by the Law numbered 6322. The enforcement interest payments will be considered as denominated loan is between 1 and 2 date is 01.01.2013. deemed dividend distributions at the years (including 1 year), period end, hence subject to a dividend 27 Decree of Council of Ministers numbered withholding tax at 15 per cent considering • 0.5 per cent on the principal if the 2012/4116. the lender is a non-resident company average maturity period of the foreign 28 Turkish Tax Procedural Law numbered 213, (lower withholding tax might be applicable currency denominated loan is between 2 Article 324. depending on tax treaty rates subject to and 3 years (including 2 years), conditions). • 0 per cent on the principal if the average Limitation on interest deductibility maturity period of the foreign currency A new legislation on the deductibility of denominated loan is longer than 3 years financial expenses has been introduced (including 3 years). very recently.26 Accordingly, some portion of the financial expenses (i.e. interest, Any foreign sourced TL denominated loans foreign exchange losses) of non-financial would attract RUSF over interest payments companies, associated with the portion at 3 per cent regardless of maturity.27 of external leverage (third party / related party) exceeding the total equity of the companies cannot be deductible for tax Reduction of debt purposes. The Legislation authorizes the Council of Ministers to set the ratio of Legal aspects disallowable financial expenses which The reduction of debt is generally not cannot exceed 10 per cent of the total subject to specific legal provisions. financial expenses. This legislation excludes all kind of financing expenses Tax-related aspects which are capitalized as part of an In principle, the repayment of debt investment and the debts obtained from does not have tax consequences. If the financial institutions or banks. receivables are waived by the shareholders, the amount would be tracked in a special The new legislation is effective from 1 equity reserve account for three years January 2013. However, the rate of the following the end of the relevant year in disallowable portion of the financial which the receivable has been waived. expenses still has not been announced by The amount should be reflected in the P&L the Council of Ministers. Therefore, there is account being taxable unless any loss offset still no limitation for financial expenses on is done.28 current status.

Other costs on debt financing - Resource Utilisation Support Fund (RUSF) Foreign sourced loans obtained by Turkish resident individuals or legal entities (except for banks or financial institutions), are subject to RUSF at the rate of,

• 3 per cent on the principal if the average maturity period of the foreign currency denominated loan does not exceed 1 year,

Turkey Financing options: Debt versus equity 69 Illustrative calculation

Assumptions Equity financing Debt financing TRY TRY

Fund amount 10,000 10,000

Shareholding equity of the entity Capital 60,000 50,000 Retained earnings 18,000 18,000 Total 78,000 68,000

Financing expenses

Competition fund 4 - Stamp duty on loan agreement* 95 Gross interest payments** - 500 WHT on interest (10%) - 50 Reverse charge VAT on interest (18%)*** - 90 RU SF (between 0% - 3%)**** - - Annual financing expenses 4 595

Profit of the company Annual Gross income 8,000 8,000 Annual Financing exprenses 4 595 Income before tax 7,996 7,405 Corporate tax (20%) 1,599 1,481 Profit after tax (= a-b) 6,397 5,924 Net tax difference 473

Legal reserves****** 1st and 2nd legal reserves 628 603

With holding tax Dividend with holding tax (15%)***** 865 798 Net dividend to be distributed 4,903 4,523

Notes

* Assuming that there is only one original copy. One time cost.

** Assuming that the interest rate is %5-yearly basis

*** The reverse charge VAT is not a cash cost for Turkish entity if it is in Vat paying position.

**** Assuming that the maturity of the debt is more than 3 years, and the loan is denominated in foreign currency.

***** The rate (i) is not for Turkish resident companies as receiving company and (ii) can be reduced by double tax treaty provisions (generally down to 5% or 10% if the shareholder is non-resident.

****** Legal reserve requirements have been ignored for the sake of simplicity.

Turkey Financing options: Debt versus equity 70 United Kingdom

This article provides an overview of the two main forms of financing a UK company. It includes consideration of the UK company law requirements and highlights the key UK corporation tax and stamp duty issues associated with financing a UK company with equity or debt. This article does not seek to address non-UK matters and does not address any indirect tax matters.

At the time of writing, it is noted that the OECD have published various papers with recommendations for changes to domestic law or double tax treaties as part of the Base Erosion and Profit Shifting (“BEPS”) initiative. The UK is in the process of amending or consulting on amending its domestic UK tax legislation, may sign a multilateral instrument in due course and/or re-negotiate treaties to make them BEPS compliant. This article is based on UK legislation announced or enacted as at 30 June 2016, does not provide legal or tax advice and does not consider any possible changes in UK legislation that may arise if the UK leaves the European Union.

Equity financing in the case of a private company, shares Raj Julleekeea can be issued partly paid or nil paid. There +44 (0)1895 52 2398 are a number of further special rules in [email protected] Contribution of equity relation to public companies that must be adhered to. For example, a public company Mark Sefton Legal aspects requires a minimum amount of £50,000 +44 (0)20 721 33184 In relation to a private company and an in terms of the value of its nominal share [email protected] unlisted public company, provided that capital with each allotted share being paid there are no restrictions on the amount up to a quarter of its nominal value and the Edward Dempster of share capital that a company can full amount of any premium. +44 (0)118 938 3078 have or the requirement for shareholder [email protected] authorisation either in the company’s Listed companies will also need to bear in articles of association or because the mind the views expressed by institutional Richard Edmundson company has more than one share class, investor’s representative bodies and must +44 (0)20 721 21512 shares can be allotted by a resolution of the comply with the relevant listing rules in [email protected] directors of a company. the UK. These rules require an explanatory circular to be sent to shareholders seeking Michael Brunnock The allotment and issue of shares may be the relevant shareholder authorisations in +44 (0)20 780 48352 subject to pre-emption rights. Statutory pre- relation to the directors’ authority to allot [email protected] emption rights require that where shares are and the disapplication of statutory pre- issued for cash (and only cash), they must emption rights. first be offered on the same terms to existing shareholders in the company. Where shares Tax-related aspects are issued wholly or partly for non-cash The contribution of equity to a UK company consideration this is not relevant. Private in exchange for the issue of shares companies can remove or disapply this should not give rise to any immediate provision by passing a resolution or having tax consequences. In the case of a parent a provision excluding this provision in its company subscribing for new shares in articles. Companies can also adopt specific a subsidiary, the tax base cost for the contractual pre-emption rights. parent in the new shares is determined by reference to the number of shares issued Non-cash consideration can be accepted by and/or the market value of the shares the board of directors to pay up shares and issued. Particular attention is required in

United Kingdom Financing options: Debt versus equity 71 the case of an insolvent subsidiary as the full must be called to discuss the issue; and (v) of a dividend or other distribution by a amount actually paid by the parent might a subsidiary may not be a member of its company. A UK resident company should not represent good base cost. own UK incorporated holding company. generally be exempt from UK tax on dividend income from its subsidiaries. The contribution of equity to a company Shareholders may obtain cash or other There are five different classes of dividend may also take the form of a capital assets from the company by way of exemption under UK corporation tax law. contribution, being a gratuitous payment distributions made by the company. A detailed discussion of the dividend by one company to another (typically by a Generally, the power rests with the exemption regime is outside the scope of parent to its wholly owned subsidiary) for directors to recommend a distribution, this article. nil consideration, usually to strengthen the but a company proposing to make a subsidiary’s balance sheet. distribution must satisfy two basic rules: Dividends by a UK company can be paid (i) it must have profits available to make gross irrespective of any double taxation There is a risk that a capital contribution a distribution; and (ii) the distribution agreement between the UK and the received by a trading company could be must be justified by relevant accounts. In recipient’s state, as there is no domestic taxed as a profit of the trade. Practical addition a public company is only able to requirement for withholding tax on steps in respect of documenting the pay a dividend provided that both before dividends in the UK. donor’s intention for making the capital and after the distribution, the net assets contribution can mitigate this risk. of the company are not less than the aggregate of its share capital and non- Reducing capital: repayment A capital contribution without an issue distributable reserves (a private company of share capital & capital shares is unlikely to carry or create any can therefore ignore unrealized losses in reduction additional base cost even if the donor assessing its ability to pay a dividend, a already holds share capital of the recipient. public company needs to have realised Legal aspects The absence of good base cost may not be profits sufficient to cover such losses). A company may reduce its share capital of significant consequence if the Substantial for several reasons (for example, to create Shareholdings Exemption (“SSE” – the If the articles of a company are silent on the additional distributable reserves or return UK regime for participation exemption on basis of payment then dividends must be surplus capital to shareholders). capital gains for companies) is available. divided among shareholders in proportion to the nominal value of their shares. This Private companies limited by shares can No UK stamp duty should arise on an issue can be adjusted by provisions in the articles, reduce their share capital in three principle of new shares by a UK company. so that, for example, dividends are paid in ways: (i) by a Court approved capital relation to the amount paid up on shares. reduction; (ii) by a capital reduction If the default Model Articles are used, or supported by a solvency statement; Payments out of equity as they were previously known, Table A, and (iii) by a buy-back of shares out of the position is that interim cash dividends distributable reserves, de-minimis cash, Legal aspects are approved and paid by the directors proceeds from a fresh issue of shares or The capital maintenance doctrine provides alone and that final cash and non-cash share capital. Public companies can use the that the share capital of a company forms a dividends are declared by the directors, but Court approved route and buy-back shares fund that should be permanently available approved by an ordinary resolution of the out of distributable reserves or proceeds to the creditors of a company to satisfy any shareholders of a company. from the fresh issue of shares. An unlimited claims against the company. Paid up share company is free to reduce its capital by capital must not be returned to shareholders The power to declare a dividend can be a resolution of its shareholders without and shareholders liability in relation to reserved to a company’s shareholders, but the need for Court approval or a solvency capital not fully paid up on shares must not shareholders should not declare a dividend statement. These entities may also enter be reduced. in excess of the directors’ recommendation. into a scheme of arrangement to change On the recommendation of the directors, a their capital structures (such a scheme is The above principle means that: (i) a company can declare a non-cash dividend a Court approved arrangement between company must not generally purchase its by way of an ordinary resolution of its a company and its shareholders and/or own shares; (ii) a public company must shareholders. creditors). not give financial assistance to anybody acquiring its shares; (iii) dividends must Tax-related aspects The Court approved capital reduction will not be paid out of share capital; (iv) if a UK tax law explicitly provides that no involve agreeing a timetable to issue the public company suffers a serious loss of deduction is allowed for UK corporation claim form, book a date for the directions capital, a general meeting of the company tax purposes in respect of the payment hearing and for the final hearing. The claim

United Kingdom Financing options: Debt versus equity 72 form may need to be advertised but this is bought back by a company, it must be A buy-back by a public company follows not always necessary if creditor protection paid out of distributable profits. There is similar principles to that carried out by measures are put into place. The reduction an exception to this rule, if the shares to a private company out of distributable will take effect once the Court order and be purchased were issued at a premium, profits except a public company cannot act the forms have been registered with the any premium payable on their repurchase by written resolution but must instead hold Registrar of Companies. may be paid out of the proceeds of a fresh a general meeting to approve the buy-back. issue of shares, up to an amount equal to In addition, public companies will need to The statement of solvency capital reduction the lower of: (i) the aggregate amount of consider various regulations depending process instead of involving the Court has the premiums received by the company on on whether they are listed or not including the directors make a solvency statement the issue of the shares to be bought back the Takeover Code, the Listing Rules confirming that the company will be able (this can be difficult to establish, especially and the Aim Rules, as well as investor to pay its debts as when they fall due for a where the company has been in existence representative guidelines. period of a year. A creditor cannot object for a long time during which there have to a reduction of capital supported by a been numerous share issues with different A reduction of capital may be combined solvency statement but they are effectively premiums paid on the shares at different with a scheme of arrangement. This makes protected by the requirement of the times); and (ii) the current amount of particular sense in connection with a company’s directors to take into account all the company’s share premium account Court approved reduction as the scheme of the company’s liabilities. (including any sum transferred to that itself necessitates Court approval. There account in respect of premiums on the new are specific rules for buy-backs in respect Directors of companies could face claims shares). of employee share schemes (including for breach of duty if the solvency statement the approval by a special resolution of the was found to be incorrect and criminal There are additional requirements for a company supported by a solvency statement penalties can be imposed if the directors buy-back of shares out of capital. Available for a buy-back out of capital and a general make the statement without reasonable profits must be first extinguished before authority to undertake buy-backs). grounds for doing so. capital can be used to fund the buy-back. A directors’ statement must be produced Tax-related aspects A private company may buy-back its shares accompanied by an auditor’s report. Repayment of capital and buy-back of out of distributable reserves or capital Broadly speaking the statement would shares whereas a public company may only buy- set out that, immediately following the There should generally be no UK tax back its shares out of distributable reserves. date on which the payment out of capital consequence for the UK company effecting A company can be restricted from doing so is proposed to be made, that there will be the repayment of capital or buying-back by a prohibition in its articles and a private no grounds on which the company could its own shares from its shareholder company needs to be expressly authorised then be found unable to pay its debts and company(ies). to take advantage of the new de minimis that the company will be able to continue buy-back out of capital provisions which do to carry on business as a going concern The UK corporate tax consequences for the not need to follow the steps for a buy-back throughout the year following the date of recipient company can vary as there is an out of capital. the buy-back. interaction between the UK capital gains rules and the dividend exemption rules A buy-back needs to take place pursuant Details of the proposed buy-back must as to whether the proceeds are entirely to a contract between the company and a be published in the London Gazette and or partially taken into account for capital shareholder approved by the shareholders a national newspaper within a week gains purposes. As a broad principle, if of a company by an ordinary resolution. immediately following the shareholders’ the dividend exemption applies to exempt Shares must be fully paid to be bought resolution. Any member or creditor of the distributions received by the corporate back and there must be at least one non- company may, at any time within the five shareholder and SSE would exempt the redeemable share in issue following the weeks immediately following the date disposal of shares, then the final UK buy-back. of the resolution, apply to the Court for corporation tax position should be that the an order preventing the payment. If such corporate shareholder should be exempt on For a private company, a buy-back may an application is made then notice must all the proceeds of the repayment of capital be funded by distributable profits, out of be given to the Registrar of Companies. or buy-back of shares. the proceeds from a fresh issue of shares, A payment out of capital must be made out of capital or with cash up to the no earlier than five weeks and no later In certain cases, the recipient company value in any financial year of the lower than seven weeks after the date that the may not qualify for dividend exemption of £15,000 and 5% of its share capital. resolution approving the payment out of and part of the proceeds would in that If a premium is payable on shares to be capital is passed. case be treated as a taxable dividend with

United Kingdom Financing options: Debt versus equity 73 the rest of the proceeds subject to the many forms depending on their terms and only affects payments triggered by a breach capital gains rules with a deduction for any include instruments such as bonds, term of contract. base cost and an allowance for inflation notes and commercial paper. Bank loans as applicable. The portion attributable to also take a variety of forms depending on If an interest clause is held to be a penalty, capital should of course be exempt if SSE their terms for example overdraft facilities, it is unenforceable and will not displace applies. revolving facilities and term facilities. any statutory rights to interest. A penalty clause is one that obliges the debtor to Capital reduction There are no specific legal requirements pay an excessive amount, which cannot be There should be no immediate UK tax set down by statute relating to lending and justified commercially. impact when a UK company undertakes a borrowing arrangements. The issuance capital reduction, as the capital reduction of debt is therefore based on the common Tax-related aspects process simply serves to reclassify law of contract and the parties involved Withholding tax shareholders’ funds on the balance sheet in the lending and borrowing process Where any payment of “yearly interest” between share capital and distributable are free to determine the terms on which arising in the UK is made by a company, reserves. The capital reduction is effectively they want to conduct that relationship. the company making the payment must treated as a form of tax-free reorganisation There are organisations that attempt to deduct withholding tax from the payment for the parent company. regularize these private arrangements; for (subject to various exemptions) at the basic example, the London Market Association income tax rate currently set at 20%. The Tax consequences should only arise when a provides for standard syndicated loan broad principle is that “yearly interest” distribution is subsequently made from the documentation in an attempt to improve is interest that arises on a loan that is reserves created as a result of the reduction liquidity, transparency and efficiency in capable of lasting for more than one year. of capital. Where the recipient of such a debt markets. Accordingly, interest payments in respect of distribution is a UK tax resident company, borrowing with a term of less than one year the distribution should in principle be Tax-related aspects may be made gross, without deducting UK treated as an exempt dividend subject to one The issue of a debt instrument by a UK income tax. of the five classes of dividend exemption company does not in itself generally applying. Consideration should be given to present any major UK tax consequences. Although there is a requirement to the UK tax implications of a later disposal of The key tax issues are typically ensuring withhold UK income tax from payments the shares. that there is a loan relationship for UK tax of yearly interest, there is generally purpose, the deductibility of the interest no requirement to withhold tax from expense on the debt instrument, any payments of discounts. Therefore, where obligation to withhold income tax on the a debt is structured as a zero coupon deep Debt financing payment of interest and the corporation discounted bond, withholding tax would tax treatment of any foreign exchange not be due on the discount when the bond differences. These issues are addressed in is redeemed at maturity. Issuance of debt more detail below. There are a number of exceptions to the Legal aspects No UK stamp taxes should generally arise requirement to withhold tax from interest Debt finance, the raising of money by a on the issue of debt by a UK company. payments. For example, loans to and company borrowing from a lender with a from UK banks may be made without promise to repay the sum at a later date, is the deduction of withholding tax, as can generally available to all companies unless Interest payments on debt interest payments made to a UK resident their articles of association restrict such company or made in respect of a quoted financing. The ability to borrow usually Legal aspects Eurobond and certain Private Placement rests in the hands of the directors of the Interest payments are made in accordance debts. company unless expressly restricted by the with the contractual agreed arrangements company’s articles of association. between the parties. The parties are free to Relief from withholding tax may also be agree the amounts of interest, how this is available under Double Tax Treaties or the Debt finance can be divided into two main calculated and how it should be paid. EU Interest & Royalties Directive. Prior to types of financing: (i) the company issuing applying any reduced rate of withholding debt securities and (ii) the company The rate of interest and the manner in tax under a treaty or the Directive, the taking out a bank loan. Debt securities which it is charged should be chosen recipient of the interest must apply to are a promise to repay by the company to carefully to avoid the common law rules on the UK tax authorities, HM Revenue & the holder of the security. They can take penalty clauses. The rule against penalties Customs (“HMRC”), stating that tax need

United Kingdom Financing options: Debt versus equity 74 not be deducted from future payments or the borrowing. A tax avoidance purpose corporation tax return. UK tax law does to deduct tax at a reduced rate specified includes any purpose which consists not provide a set formula to determine under an applicable treaty. There is anti- of securing a UK tax advantage for the whether the transactions would have conduit case law precedence in the UK borrowing company or any other person. taken place absent the group relationship, and many treaties, including the Directive, The meaning of tax advantage includes nor guidance on what would constitute have some form of anti-conduit provisions. a relief or increased relief from tax, a appropriate levels of debt or arm’s length HMRC can therefore deny treaty relief if repayment of tax or increased repayment terms of that debt. Consequently, there are they consider that loans have been routed of tax and the reduction of a charge to tax. no statutory rules as to an acceptable debt via particular territories purely to reduce level for a UK company or safe harbour withholding tax to nil. The reduced rate of In practice, a UK issuing company should ratios. withholding cannot be applied until HMRC maintain adequate documentation setting have accepted the application. out the relevant transactions and the HMRC approaches thin capitalisation by purpose of the relevant loans to support the considering what a bank would do and The EU Interest & Royalties Directive case for obtaining a tax deduction for the their current approach is to agree leverage only applies where payments are made interest. and interest cover ratios, generally with between ‘associated’ companies who are reference to Earnings Before Interest both resident in the EU or have a PE in Thin capitalisation and transfer pricing Tax Depreciation and Amortisation the EU. Two companies are ‘associated’ In respect of connected party loans, (“EBITDA”). EBITDA is commonly used as for the purposes of the EU Directive if companies can only deduct interest a gearing indicator for financial covenants one company directly holds at least 25% expense up to an “arm’s length” maximum set in third party lending agreements, of the share capital and/or voting rights amount in calculating the profits subject and is therefore a common measure used of the other or a third company directly to UK corporation tax. If the actual by HMRC in evaluating a company’s thin controls at least 25% of both the payer and interest expense exceeds this maximum, capitalisation position. recipient. which is established by considering the quantum and terms of debt which the The UK has announced that it will Deductibility of interest expense company could and would have borrowed introduce new rules from 1 April 2017 to The availability of a tax deduction for from an independent lender, then the restrict interest deductions in line with interest in the UK is complex area and company is “thinly capitalised” and some the OECD BEPS recommendations under the following UK tax provisions should of the intercompany interest incurred Action 4. This is addressed briefly below. be considered when determining the will be disallowed for UK corporation tax deductibility of interest expense for UK purposes. Clearly, the interest rate on the Worldwide debt cap and Interest cap corporation tax purposes: loan would also need to be an arm’s length under BEPS Action 4 rate and any interest exceeding an arm’s The worldwide debt cap rules are aimed • Unallowable purpose; length rate would also be disallowed. at limiting the net amount of interest • Thin capitalisation and transfer pricing; that is deductible for a UK company by • Worldwide debt cap and Interest When determining the arm’s length reference to the gross external interest restriction under BEPS Action 4; borrowing capacity of a company, the of the consolidated group. The excessive • Anti-arbitrage and anti-hybrid; separate entity principle must be used. net finance costs (if any) are treated • Late paid interest; and However, HMRC acknowledge that, even as permanently disallowable for UK • General Anti-Abuse Rule (“GAAR”). on a standalone basis, any third party corporation tax purposes. lender would take into consideration the Unallowable purpose assets and liabilities of the borrower’s 51% The debt cap is only applicable for groups The unallowable purpose provisions may subsidiaries (UK and foreign). Once this where a “gateway test” is satisfied. If the restrict tax deductions on UK borrowing ‘borrowing unit’ (i.e. the grouping whose gateway test is not met then the debt where a loan is entered into for an assets and liabilities are considered when cap provisions will not apply and there unallowable purpose. An unallowable assessing whether or not a company is should be no disallowance in respect of purpose for a loan relationship includes a thinly capitalised) has been determined UK borrowing or any filing obligations as purpose which is not amongst the business for a particular company, the consolidated a result of these rules. The gateway test or other commercial purposes of the figures are used to determine the thin cap is satisfied where the net debt of the UK company. position. group exceeds 75% of the gross debt of the worldwide group. The UK net debt is the A tax avoidance purpose will be an A company must self-assess that its sum of the net debt amounts (an average unallowable purpose if it is the main borrowing is at arm’s length so it must of the opening and closing amounts for purpose or one of the main purposes for make any necessary adjustments in its the period) for each UK group company

United Kingdom Financing options: Debt versus equity 75 as shown in each UK company’s statutory The anti-arbitrage rules apply in respect of • the qualifying payment constitutes accounts. The worldwide gross debt is an deductions (deduction cases) where four a contribution to the capital of the average figure for the group as a whole conditions are satisfied: company. for that accounting period. Both of these measures are tested with reference to the • the company is party to a scheme The UK is introducing new anti-hybrid companies’ financial statements prepared that involves a hybrid entity, hybrid rules which have effect for payments under GAAP. instrument or hybrid effect; made on or after 1 January 2017. The new rules effectively replace the current anti- It was recently announced that the UK • a UK tax deduction is due or an amount arbitrage rules and are being introduced in plans to repeal the worldwide debt cap can be offset against profits in respect of response to BEPS Action 2. rules and introduce a new restriction the scheme; for the corporation tax deductibility of The new rules seek to address the interest expenditure, in response to BEPS • the main purpose, or one of the main mismatches between tax jurisdictions Action 4. It is proposed that the rules will purposes, of the scheme is to obtain a achieved through the use of hybrid apply for accounting periods beginning UK tax advantage; and entities and hybrid financial instruments on or after 1 April 2017 and restrict the and companies with exempt or low tax amount of interest deductible to 30% • the amount of the tax advantage is permanent establishments, in particular of the UK group’s taxable EBITDA. The not minimal (this is typically taken to situations arising whereby: restriction will only take effect where the mean that the tax advantage exceeds net UK interest expense is in excess of £50,000). • an amount is deductible for one party £2 million. A higher amount of interest and the other party is not taxed on the deduction may be available if the ratio of A hybrid entity is an entity that is corresponding credit (a “deduction/ net interest to accounting EBITDA on a recognised as a taxable person under non-inclusion mismatch”) consolidated basis is higher but the overall one tax code, and whose profits or gains tax deduction available for interest in the are treated as the profits or gains of a • an amount is deductible more than once UK will be subject to an overall restriction different person or persons under the (a “double deduction mismatch”) by reference to a group’s interest cost. same or another tax code. A common example is a UK “check the box” The hybrid mismatches will be At the time of writing, detailed guidance subsidiary of a US resident company – counteracted by primary response. If a has not been provided and the mechanics where an election is made (by the US deduction/non-inclusion mismatch is of the EBITDA restriction have not been parent) for the subsidiary to be taxed in achieved and the payer entity is resident in released. the US as if it were a branch of the US the UK, the rules will deny the deduction. company rather than a separate entity. A If the payer is resident in a foreign Anti-arbitrage and anti-hybrid hybrid instrument would include a loan jurisdiction and the deduction is not The UK anti-arbitrage rules counteract instrument which is characterised as denied in that territory, the credit will be perceived tax avoidance achieved through debt under the laws of one territory but brought into account for the UK payee. arbitrage between the tax laws of different as equity in another territory. The rules will tackle the double deduction territories. The legislation potentially applies In respect of receipts (receipts cases) mismatch by denying the deduction in the where an arbitrage scheme using a hybrid there is no need for a scheme in which parent if the entity is resident in the UK. entity or hybrid instrument results in either: there is hybrid entity or instrument. If the parent is resident overseas and the (i) a double deduction for the same expense Rather, the legislation will apply where: deduction is not denied in that jurisdiction, (deduction cases); (ii) a UK deduction for the rules will deny the deduction for the the payer where the recipient is not taxed • a company has entered into a scheme UK payer entity. on the receipt (deduction cases); or (iii) under which it receives a qualifying amounts being received by a company in a payment at least part of which it is not One of the key changes of the new rules non-taxable form (receipts cases). liable to tax on; is that there is no longer a “commercial purpose test”. The rules will be applied In order for these provisions to take • that amount may be deducted from or regardless of whether the hybrid mismatch effect HMRC is required to issue a notice allowed against taxable income of the was intentional or not. specifying the effect that HMRC considers person making the payment; the legislation will have. In broad terms, the notice will specify that deductions will • the mismatch of tax treatment (i.e. the be denied and receipts will become taxable arbitrage) is a reasonable expectation of to the extent of the arbitrage. the parties to the scheme; and

United Kingdom Financing options: Debt versus equity 76 Late paid interest The term “tax advantage” includes relief shareholders in very limited circumstances. Corporation tax relief for interest expense or increased relief from tax, repayment or For example, should a subsidiary waive is normally given on an accruals basis. increased repayment of tax and avoidance its right to money owed to it by its parent Until fairly recently, when the parties to a of an obligation to deduct or account for then this would be a distribution and loan are connected, the late paid interest tax. Tax arrangements are “abusive” if would have to fall in line with the rules rules would operate to defer tax relief for the entering into or carrying out of those on the maintenance of share capital and the interest expense to the period in which arrangements cannot reasonably be distributions. There would not be the same it is paid if the following conditions are regarded as a reasonable course of action issue if a holding company were to waive met: in relation to the relevant tax provisions. its rights to be repaid by its subsidiary Situations where the tax result does not company as this would be considered to be • the interest is not paid within 12 months follow the economics of a transaction a capital contribution to the subsidiary or a of the end of the period in which it may be an indicator of abusive tax mere gift. accrued; arrangements. Arrangements may not be regarded as abusive if they accord with A debt waiver will constitute a transaction • credits for the full amount of interest are established practice at the time they were at an undervalue should the company not brought into account by the lender entered into and HMRC is aware of and has waiving the repayment have solvency under the loan relationship rules; and not challenged that practice. difficulties. Moreover, regardless of the solvency of the entities involved in the • the lender is tax resident in a “non- There is no advanced clearance procedure waiver and release, the directors of the qualifying territory” or effectively and taxpayers must self-assess whether respective companies need to consider managed in a non-taxing “non- they consider that the GAAR applies. their duties to act in the best interests of qualifying territory”. their respective companies. In practice, the UK GAAR may be seen as A “qualifying territory” is, broadly, one having limited application in the area of Tax-related aspects with which the UK has a double taxation debt financing as there is already a rule in The repayment of a loan at maturity agreement which contains a non- respect of loans for unallowable purposes. should generally not give rise to any discrimination provision. A “non-qualifying UK corporation tax consequences in territory” is therefore a territory which is the borrower or the lender. There are not a “qualifying territory”. Similar rules Reduction of debt situations where the early settlement or the operated to delay tax relief for the issuer transfer of a loan by a UK company gives of discounted securities until the issuer Legal aspects rise to an economic profit or loss. The profit pays the discount on redemption, when the Repayments are made in accordance with would be taxable but the losses may in creditor is connected to the issuer. the contractual agreed arrangements certain cases not be deductible. between the parties. The parties are free to Legislation was announced in December agree the amounts to be repaid including The UK corporation tax treatment of the 2014 which effectively repeals the deferral the calculation of amounts, when these waiver of a debt is a complex area, with rules for late paid interest such that interest payments should be made and how they different tax rules applying to transactions is now generally deductible on an accruals should be paid. between connected parties and those basis. between unconnected parties. The tax Parties are free to waive or release debts treatment is also determined by the type of General Anti-Abuse Rule (‘GAAR’) subject to certain overriding considerations debt in question (for example debts which Following a period of consultation, Finance and restrictions. A debt waiver or release constitute loan relationships, trading debts Act 2013 introduced a GAAR to UK tax law. is a non-market value transaction as the or other debts). The comments that follow The purpose of the GAAR is to counteract waived debt is deemed a gift/contribution apply to loan relationships. or deter “abusive” arrangements while to the party who owes the debt. As such a ensuring normal business transactions number of legal considerations need to be In a connected party situation, no are unaffected. The GAAR should only taken into account by the borrower and the deduction is available to the lender for the apply to counteract tax advantages arising lender. full or partial release of the debt. Where from tax arrangements that are abusive. there is an informal release of a debt, an Amongst other taxes, the GAAR applies If the parties are in the same group of accounting credit would be taxable on the to corporation tax, income tax (including companies then thought should be given borrower. However, a formal release would withholding taxes on interest) and stamp to the maintenance of capital principles not be taxable so it is typically preferable to duty. outlined above whereby a company’s structure a waiver as a formal release of the capital can only be returned to its debt in a connected party context.

United Kingdom Financing options: Debt versus equity 77 In a non-connected party situation, a deduction should generally be available to the lender on the release of a debt provided that an accounting debit arises in the lender’s financial statements. A formal or informal release would be taxable if a credit arises in the accounts of the borrower.

As noted above, it is necessary to distinguish carefully between formal and informal debt releases as their tax treatment may be different. To achieve a formal release, the agreement between the debtor and creditor must either be executed by way of a deed or evidenced by a valid contract for valuable consideration.

The repayment or release of a loan should not attract UK stamp taxes.

United Kingdom Financing options: Debt versus equity 78 United States

The following article provides an overview of the U.S. federal income tax rules associated with financing U.S. business operations by foreign corporations. The article first describes the current economic environment related to financing U.S. business operations and then focuses on the relevant tax rules associated with determining whether a particular financing constitutes equity or indebtedness for U.S. federal income tax purposes and the consequences of such characterization. 1

Financing Environment in The following chart demonstrates the debt Bernard E. Moens the United States to equity ratios of large and small U.S. [email protected] companies. For most large companies, the debt to equity ratio has remained largely Most U.S. businesses have a capital constant - hovering around 90 percent over structure that is comprised of a mix of debt the past decade, excluding those years that and equity. The U.S. federal income tax were impacted by the global financial crisis. implications of financing U.S. operations This percentage indicates that large U.S. with debt or equity, particularly when companies’ capital structures (measured the lender is a foreign related party, by book value) are generally comprised of often influence a company’s decision slightly less than 50 percent debt. regarding the capital structure of its U.S. investment for two key reasons: (1) The proportion of debt issued by small U.S. the tax rules provide that interest on companies appears to be more volatile than indebtedness is generally deductible for for large companies and to have decreased U.S. federal income tax purposes, whereas over the past five years. This perhaps dividends paid on equity are generally indicates an increase in the regulatory non-deductible; and (2) repayments of restrictions placed on potential borrowers principal generally are not subject to and lenders after the financial crisis, or U.S. federal income tax or withholding. increased scrutiny from U.S. regulatory Moreover, payments of interest made by agencies, including the Internal Revenue a U.S. corporation to a related foreign Service.2 Although the reasons behind the corporation may be subject to a lower rate fluctuations are unclear, it is clear that both of U.S. tax and withholding than payments large and small companies include debt as 1 A discussion of the U.S. laws applicable to of dividends. Thus, the tax implications an integral part of their capital structure, debt and equity instruments is outside of of the characterization of an instrument albeit at different levels. the scope of this article as PwC U.S. is not as debt or stock are integral to a foreign permitted to engage in the practice of law investor’s decision regarding how to in the United States. finance U.S. business operations. 2 References to the “IRS” or the “Service” are to the U.S. Internal Revenue Service.

United States Financing options: Debt versus equity 79 Debt-Equity Ratio of US Corporations 3 Notice 94-47, 1994-19 I.R.B. 1 (Apr. 18, 1994).

4 Farley Reality Corp. v. Comm’r, 279 F.2d 120% 701 (2d Cir. 1960); United States v. Title Guarantee & Trust, 133 F.2d 990, 993 (6th Cir. 1943). 100%

5 Gilbert v. Comm’r, 248 F.2d 399, 402 (2d 80% Cir. 1957), cert. denied, 359 U.S. 1002 (1959). 60%

40%

20%

0% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Large Corporations (Revenues in Excess of $ 121 MM) Small Corporations (Revenues in Excess of $ 121 MM) All Corporations

Source: PwC US calculation based on data from Capital IQ. Financial companies were excluded from this data set.

Definition of Debt versus Equity An equity interest has traditionally been described as “embarking on a corporate In the United States, investors can finance venture and taking the risks of loss their U.S. business operations with equity, attendant upon it so that one might share debt, or some combination thereof. In in the profits of its success.”4 A debt, on the general, whether a particular instrument other hand, is a contractual relationship constitutes “equity” or “debt” for U.S. that involves “an unqualified obligation federal income tax purposes is based to pay a sum certain at a reasonably close on the terms of the instrument and all fixed maturity date along with a fixed surrounding facts and circumstances.3 percentage in interest payable regardless of This analysis requires an examination of the debtor’s income or lack thereof.”5 various factors that have been developed in U.S. case law. Hybrid instruments are also U.S. federal tax law draws a clear used to finance U.S. business operations distinction between the U.S. federal and, unless specific U.S. federal income income tax consequences of debt and tax rules apply, require an analysis of the equity. In general, U.S. federal tax rules same factors applied to a debt or equity provide that interest incurred under the instrument in order to determine whether terms of an instrument that is properly the hybrid instrument is treated as debt treated as indebtedness, is deductible by or equity for U.S. federal income tax the U.S. corporate issuer, whereas dividend purposes. distributions on equity are nondeductible.

United States Financing options: Debt versus equity 80 Thus, for U.S. federal income tax Treasury to prescribe such regulations 6 Unless otherwise noted, all “section” or purposes, U.S. corporations often consider as may be necessary or appropriate to “§” references contained herein are to the Internal Revenue Code (“IRC” or the financing some portion of their business determine whether an “interest” in a “Code”) of 1986, as amended, or to the operations with third-party or related party corporation is to be treated as stock Treasury Regulations (“Treas. Reg.”) indebtedness. Consequently, much of the or indebtedness (or as part stock and promulgated thereunder. development of the U.S. federal tax rules part indebtedness). Section 385(b) sets associated with the characterization of an forth some of the factors that any such 7 Section 385(b). instrument as either debt or equity arose regulations must take into account in 8 T.D. 7920, 1983-2 C.B. 69. in situations where the IRS challenged determining whether a debtor-creditor a taxpayer’s debt characterization of a relationship exists. These factors include: particular instrument. (i) whether there is a written unconditional promise to pay on demand or on a specified Notwithstanding the significant amount date a sum certain in money in return for of controversy in this area of U.S. tax an adequate consideration in money or law, no uniform set of standards exists money’s worth, and to pay a fixed rate of for determining whether an instrument interest; (ii) whether there is subordination constitutes debt or equity for U.S. federal to or preference over any indebtedness of income tax purposes. As noted above, the corporation; (iii) the ratio of debt to U.S. courts and the IRS have articulated equity of the corporation; (iv) whether various factors to be considered in the there is convertibility into the stock of analysis. To determine which factors the corporation; and (v) the relationship are relevant to a particular taxpayer’s between holdings of stock in the instrument, the taxpayer must generally corporation and holdings of the interest in look to the applicable case law that exists question.7 in the jurisdiction where the corporation’s principal place of business or principal Proposed Regulations which set forth the office is located in the United States. If the factors to be considered in determining corporation does not have a principal place whether an instrument is stock or debt first of business or office in the United States, were issued in 1980 and final regulations it must look to the relevant case law in the followed the same year (with a delayed jurisdiction where the corporation’s U.S. effective date that was extended several federal income tax return is, or would be, times). Those final regulations, however, filed with the IRS. However, although the were withdrawn in 1983.8 There was case law in the relevant jurisdiction may be no regulatory guidance until April 4, of particular importance, a corporation’s 2016, when Treasury and the Service analysis of whether an instrument released new proposed regulations under constitutes debt or equity for U.S. federal section 385. The Proposed Regulations income tax purposes must also consider recharacterize certain interests issued pertinent U.S. case law that is seminal in between related parties as stock for U.S. the development of the U.S. debt-equity federal income tax purposes, even where analysis and may be used to assess the they are issued in the form of indebtedness. characterization of a particular instrument. Because the proposed regulations under section 385 characterize certain U.S. Statutory Rules instruments as equity, but do not definitively Although the U.S. Internal Revenue Code characterize any instruments as debt, debt includes a specific statutory provision, instruments still must be evaluated under section 385,6 which purports to address the multi-factor tests set forth in case law. characterization of a financial instrument for U.S. federal income tax purposes, Section 385(c) indicates that a U.S. it does not provide a specific definition corporation’s characterization of an of when a particular instrument will instrument at the time of issuance is constitute equity or debt for U.S. federal binding on the parties to the instrument income tax purposes. This provision (subject to potential recharacterization authorizes the Secretary of the U.S. under the proposed regulations).

United States Financing options: Debt versus equity 81 Thus, once an issuer characterizes a Although the precise list of factors varies 9 John Kelley Co. v. Comm’r, 326 U.S. 521 financing arrangement as either equity or throughout the U.S. court system, the (1946). indebtedness, the parties are bound by that foregoing IRS factors generally highlight 10 Notice 94-47, 1994-19 I.R.B. 1. The IRS characterization and cannot argue against it the key issues that must be analyzed when issued this Notice to address certain without disclosing inconsistent treatment on making a characterization determination considerations related to instruments that the U.S. corporation’s U.S. federal income of a particular instrument. The factors can are treated as debt for U.S. federal tax tax return. This binding characterization generally be broken down into four sub- purposes but that are treated as equity for regulatory, rating agency, or financial rule does not apply to the IRS. groupings of related categories: accounting purposes, and that therefore, contain a combination of debt and equity Factors Considered in the U.S. Analysis 1. Formalities of the Instrument: Factors characteristics. However, the Notice Consistent with the statutory standards (i) whether there is an unconditional outlines the IRS’s view of the important described above, the IRS announced promise on the part of the issuer to pay factors to consider in the analysis. its view that the characterization of an a sum certain on demand or at a fixed instrument as debt or equity for U.S. maturity date that is in the reasonably federal income tax purposes depends foreseeable future, and (vii) the label on the terms of the instrument and all placed upon the instrument by the surrounding facts and circumstances,9 parties, relate to the formalities of including: the instrument in terms of whether the instrument on its face purports to i. whether there is an unconditional establish a debtor-creditor relationship or promise on the part of the issuer to pay a shareholder-corporation relationship. a sum certain on demand or at a fixed maturity date that is in the reasonably 2. Intent of the Parties: Factors (vi) foreseeable future, whether there is identity between the holder of the instruments and the equity ii. whether holders possess the right to holders of the issuer, and (viii) whether enforce the payment of principal and the instrument is intended to be treated interest, as debt or equity for non-tax purposes, including regulatory, rating agency, iii. whether the rights of the holders of or financial accounting purposes, the instrument are subordinate to provide information concerning certain rights of general creditors, factors that go beyond the face of the instrument, which further shed light iv. whether the instruments give the on the intent of the parties and the holders the right to participate in the genuineness of the undertaking. management of the issuer, 3. Creditors’ Rights: Factors (ii) whether v. whether the issuer is thinly capitalized, the holder possesses the right to enforce the payment of principal and interest, vi. whether there is identity between (iii) whether the rights of the holder of holders of the instruments and the the instrument are subordinate to rights equity holders of the issuer, of general creditors, and (iv) whether the instruments give the holder the vii. the label placed upon the instrument right to participate in the management by the parties, and of the issuer, pertain to creditors’ rights and remedies and the extent of their viii. whether the instrument is intended to involvement in the operations of the be treated as debt or equity for non- issuer. tax purposes, including regulatory, rating agency, or financial accounting purposes.10

United States Financing options: Debt versus equity 82 4. Debt Capacity: Factor (v) whether deemed issued on or after the date the 11 Prop. Treas. Reg. § 1.385-1(d). the issuer is thinly capitalized, relates Proposed Regulations are finalized. 12 Prop. Treas. Reg. § 1.385-3(h). to the issuer’s capacity to repay the advance and is related to similar factors b. Prop. Treas. Reg. § 1.385-2 prescribes 13 Prop. Treas. Reg. § 1.385-1(b)(3)(i)(A)-(C). traditionally emphasized by the courts, the documentation that taxpayers must including the source of repayment and prepare and maintain to substantiate 14 Prop. Treas. Reg. § 1.385-1(b)(3)(ii). the ability of the issuer to obtain loans the treatment of a Purported Debt 15 Prop. Treas. Reg. § 1.385-1(b)(3)(i)(C). from outside lenders on similar terms. Instrument as indebtedness for federal The common denominator for each of tax purposes. Failure to do so within these factors pertains to whether there thirty days of issuance results in the is a reasonable expectation that the instrument being treated as stock issuer will meet its obligations under for U.S. tax purposes. The required the instrument as it relates to timely documentation must demonstrate: (i) repayments of interest and principal an unconditional obligation to pay a on the required dates specified in the sum certain; (ii) creditor’s rights; (iii) a instrument. reasonable expectation of repayment; and (iv) actions evidencing a debt- The enumerated factors above demonstrate creditor relationship. This rule would that for U.S. federal tax purposes, there is apply to instruments issued or deemed no bright-line test that applies to determine issued on or after the date the Proposed whether an instrument is stock or debt. Regulations are finalized. Moreover, the factors are generally not weighed equally by either the IRS or c. Prop. Treas. Reg. § 1.385-3 provides the U.S. courts when applying them to a additional rules that may treat taxpayer’s particular set of facts. When a purported debt instruments as stock U.S. corporate issuer seeks to characterize for U.S. federal tax purposes if they an instrument as debt, one key factor that are issued in, or treated as funding, must be carefully considered is whether, certain related-party distributions, stock at the time of issuance, the issuer can acquisitions, or asset reorganizations. demonstrate an ability to repay both the This rule would generally be applicable interest and principal within the term of to purported debt instruments issued the instrument. Related party transactions on or after April 4, 2016, though re- will likely raise additional scrutiny by the characterization under this rule would IRS and U.S. courts and therefore, it is occur 90 days after the date on which imperative that the parties act according to the final regulations are issued.12 These the intended treatment of the instrument rules have wide-ranging consequences as either stock or debt. for global multinationals.

Proposed Regulations under Section 385 d. Generally, the Proposed Regulations Even though a financial instrument is only apply to Purported Debt properly characterized as debt for U.S. Instruments issued between members tax purposes under the multi-factor tests of an “expanded group,” meaning an described above, the proposed regulations affiliated group as defined in Section can change this result. 1504(a), with various modifications.13 The expanded group definition includes The Proposed Regulations are comprised of non-U.S. and tax-exempt corporations, four sections: corporations held indirectly (e.g., through partnerships)14 and corporations a. Prop. Treas. Reg. 1.385-1 includes a connected by ownership of 80% vote or rule that allows the Service to treat value.15 Special rules apply to attribute a Purported Debt Instrument as part ownership. indebtedness and part stock.11 This rule would apply to instruments issued or

United States Financing options: Debt versus equity 83 even if the other requirements for tax-free 16 Equity Financing Sections 351 & 1032. treatment are satisfied. 17 Section 368(c). Corporate Formation 18 Section 351(g). Corporate Distributions In general, money or other property can 19 See sections 301 and 316. be contributed to a U.S. corporation in In general, distributions of property made 20 Section 312. exchange for stock in such corporation by a U.S. corporation to its shareholders without the recognition of gain or loss by are considered to be dividends to the 21 Section 301(c). either the contributing shareholder or the extent that the distribution is made out of U.S. corporation.16 If the transferor receives the corporation’s current or accumulated 22 Id. money or other property in the exchange earnings and profits.19 Broadly, the concept 23 See section 881(a). (in addition to any stock) the transferor of “earnings and profits” attempts to will recognize gain as the result of the approximate a corporation’s economic transfer to the extent of the fair market income that is available for distribution value of the property received. to its shareholders; however, the term is not specifically defined for U.S. federal In order to qualify for tax-free treatment income tax purposes. In general, the on the contribution of property, the determination of a corporation’s earning transferor must have or obtain “control” and profits begins with the corporation’s of the corporation immediately after the taxable income and various adjustments exchange. For this purpose, “control” is (additions and subtractions) are made defined as the actual (and not constructive) to that amount.20 The computation of ownership of stock of the transferee a corporation’s earnings and profits is corporation possessing at least 80 percent made at the end of a given tax year. If a of the total combined voting power of all corporation has no current or accumulated classes of stock entitled to vote and at least earnings and profits, a distribution by 80 percent of the total number of shares of the corporation is not considered to be all other classes of stock of the transferee a dividend distribution for U.S. federal corporation.17 income tax purposes.

What it means for the transferor to be If a corporation makes a distribution in in control of the transferee corporation excess of its current and accumulated “immediately after the exchange” is the earnings and profits, such distribution is subject of a significant amount of litigation first applied to reduce the shareholder’s between taxpayers and the IRS. Therefore, basis in its stock of the corporation careful consideration should be given to and is treated as a return of capital whether this requirement is satisfied. distribution.21 Any distribution in excess of the shareholder’s basis in its stock is The stock that may be received in the treated as gain from the sale or exchange of exchange by the transferee generally property.22 includes either common stock or preferred stock of the U.S. corporation. Certain preferred stock where the issuer is Taxation of Distributions required, or is more likely than not, to redeem, or preferred stock which has a Dividend distributions (i.e., distributions dividend rate that varies with reference to made out of current and/or accumulated interest rates, commodity prices, or other earnings and profits) made to foreign similar indices, is generally considered to persons are subject to U.S. tax and be “nonqualified preferred stock” and is withholding at a rate of 30 percent, treated as “boot” in an exchange.18 Thus, unless such amount is reduced under an if the transferor receives nonqualified applicable U.S. income tax treaty.23 Return preferred stock as part of the exchange, the of capital distributions are generally non- transferor must generally recognize gain taxable to shareholders (whether U.S. or

United States Financing options: Debt versus equity 84 foreign) and result in an adjustment to the U.S. federal income tax purposes if it gives 24 See sections 897 and 1445. shareholder’s basis in its stock of the U.S. rise to the potential for a conversion of 25 Certain distributions made by U.S. corporation. Distributions in excess of a ordinary dividend income into capital corporations to other U.S. corporate shareholder’s basis give rise to capital gain gain and a reduction in the earnings of the shareholders may be eligible for a dividends that, with one exception, are generally not U.S. corporation.28 These rules can apply received deduction with respect to some subject to U.S. federal income tax where if a shareholder received a stock dividend portion, or all, of a dividend distribution the shareholder is a foreign corporation. of preferred shares or received preferred depending on the shareholders ownership interest in the distributing U.S. corporation. The one exception is where the majority of stock in a tax-free reorganization and the U.S. corporation’s assets are comprised then subsequently sells its preferred stock. 26 Section 311(a) & (b). of U.S. real property.24 Thus, if a foreign corporation owns certain preferred stock of a U.S. corporation, the 27 Section 305. Distributions made on equity instruments disposition of such stock may be treated 28 Section 306. are generally non-deductible for U.S. as a dividend distribution that is subject federal income tax purposes to the to U.S. tax and withholding at a rate of 29 Section 1445. distributing corporation.25 Distributions of 30 percent, instead of giving rise to non- appreciated property by a U.S. corporation taxable capital gains. to its shareholders require the corporation to recognize gain as if the property were Disposition of Stock of a “FIRPTA” sold to the shareholder at its fair market Company value.26 However, the recognition of losses As noted above, the sale or other resulting from a distribution of depreciated disposition of U.S. corporate stock property to a shareholder is not permitted generally does not give rise to U.S. federal for U.S. federal income tax purposes. income tax to a foreign shareholder. However, if the fair market value of a Additional Tax-Related Considerations U.S. corporation’s assets are comprised of 50 percent or more of U.S. real property Special Rules for Stock Dividends interests (e.g., land, buildings, other Special U.S. federal income tax rules apply inherently permanent structures, etc.), to distributions by a U.S. corporation of then the foreign selling shareholder may its own stock to a shareholder, i.e., a stock be subject to U.S. tax and withholding dividend.27 In general, a stock dividend on the sale of its equity interest in distributed by a U.S. corporation is not the U.S. corporation. The rules under included in the gross income of a foreign section 897 (commonly referred to as receiving shareholder, and therefore, is the “FIRPTA” rules) treat gains or losses not subject to U.S. tax and withholding. derived by a foreign shareholder’s sale However, if the stock dividend results in a or other disposition of its U.S. corporate change to the equity interest of all of the stock as if the foreign shareholder were corporation’s shareholders (for example, engaged in a U.S. trade or business and if the shareholders can elect whether to as if such gains or losses were effectively receive a distribution of property or a connected with such trade or business. distribution of the corporation’s stock) Thus, gains arising from the sale of a then such stock distribution may be a FIRPTA company by a foreign corporation taxable dividend distribution. In such are subject to U.S. federal income tax at case, even though the dividend is not paid graduated tax rates, i.e., 35 percent for in cash, to the extent the distribution is most foreign corporations. A withholding treated as giving rise to dividend income provision applies to dispositions of FIRPTA to a foreign shareholder, the distribution companies by foreign persons and requires is subject to U.S. tax and withholding at a the purchaser (or other transferee) to rate of 30 percent, unless reduced by a U.S. withhold 10 percent of the gross proceeds tax treaty. from the sale and remit the withholding to the IRS.29 In addition, the proceeds from the sale or redemption of certain types of preferred Even if a majority of a U.S. corporation’s stock may be treated as a dividend for assets are not comprised of U.S. real estate,

United States Financing options: Debt versus equity 85 and therefore, the company is not a FIRPTA price paid in the actual or deemed 30 See Treas. Reg. section 1.1001-3. company, certain procedural and notice exchange is less than the issue price of the 31 Note that this discussion does not include requirements are generally required to be original instrument. all of the potentially applicable U.S. federal filed with the IRS upon a foreign person’s income tax rules that could apply to limit a sale of stock of the U.S. corporation. U.S. corporation’s ability to deduct interest Payments on Indebtedness expense. Payments of principal on an instrument Debt Financing that is properly characterized as debt for U.S. federal income tax purposes are not subject to U.S. federal income tax or Granting of Indebtedness and withholding. However, interest payments Subsequent Modifications made on a debt instrument are generally subject to U.S. tax and withholding at a The issuance of a note by a U.S. corporation rate of 30 percent, which may be reduced to a related foreign corporation generally under an applicable U.S. income tax treaty. does not give rise to U.S. federal income tax to either the holder or the issuer. In general, periodic payments made with However, the actual or deemed transfer of respect to an instrument are deductible a debt instrument by either the holder or for U.S. federal income tax purposes only the issuer can result in the recognition of if the instrument is properly characterized gain or loss to the holder, and cancellation as indebtedness of the payor. However, of indebtedness to the issuer.30 A deemed various restrictions may apply to limit transfer may arise if the parties to an the deductibility of such interest even in existing instrument make modifications circumstances where an instrument is to the terms of the instrument and such properly characterized as indebtedness. modifications are “significant.” Applicable Limitations on Interest A “significant modification” results Deductibility31 in a deemed exchange of the existing Section 163(j) (commonly referred to as instrument for a new instrument that the “earnings stripping rules”) applies to differs materially either in kind or limit a payor’s interest expense deduction extent and, based on all of the facts when the interest is paid to a related and circumstances, the legal rights party where no U.S. federal income tax is or obligations under the terms of the imposed on such interest or where such instrument that are altered, and the degree interest expense is subject to a reduced to which they are altered, is economically rate of U.S. tax under an income tax treaty. significant. Various safe harbors exist when Section 163(j) can also apply to interest determining whether a particular debt payments made to unrelated parties where instrument has undergone a significant there is a guarantee of the indebtedness modification as the result of changes to the by a related person who is either a foreign terms of the instrument. person or who is exempt from U.S. tax. The rules under section 163(j) provide a safe If a debt instrument issued by a U.S. harbor where the debtor’s debt-to-equity corporation to its foreign corporate ratio does not exceed 1.5 to 1. In general, shareholder is significantly modified, the the amount of deductible interest expense parties are deemed to have exchanged the is limited to the debtor’s “excess interest original instrument for a new instrument expense” for the tax year, which is broadly in a taxable transaction. Such an exchange intended to measure the company’s debt- generally does not give rise to U.S. federal paying capacity. Any amount of excess income tax to the foreign corporate interest expense that is not used in the shareholder; however, the U.S. corporate current year may be carried forward by the issuer may recognize cancellation of company indefinitely. indebtedness income if the repurchase

United States Financing options: Debt versus equity 86 Other rules may also apply to limit interest Additional Tax-Related Considerations 32 Section 267(a)(2). deductibility in circumstances involving Anti-Conduit Financing Rules 33 This restriction on deductions for payments interest payments made to related foreign In circumstances where a recipient of made to foreign related persons applies persons. In general, a company that owes an interest payment from a related U.S. broadly to interest payments as well as a payment to a related foreign person corporation seeks to qualify for a reduced other types of U.S. source income. must report the payments on a cash basis rate of U.S. tax and withholding under a method of accounting in order to deduct U.S. tax treaty, consideration must also be 34 Section 163(l). the payment.32 That is, interest payments given to the application of the U.S. anti- 35 Treas. Reg. section 1.881-3. due under the terms of a debt instrument conduit financing rules.35 If applicable, owed to a related foreign person are the anti-conduit rules may disallow the 36 Other examples include bank deposit not deductible until actually paid and benefits of an income tax treaty with interest, short term original issue discount, includible in the related party’s gross respect to interest payments made by a U.S. and interest from so-called “80-20” 33 companies. income. corporation to a foreign corporation.

37 Section 881(c). Under section 163(e), certain limitations In general, the anti-conduit financing rules apply to interest payments made by a U.S. limit the ability of taxpayers to reduce company to a related foreign person on or eliminate tax on obligations through a debt instrument that has original issue the use of “conduit” entities organized in discount (“OID”). Similar to the rules jurisdictions for which the applicable tax under section 267, OID on such instrument rate is reduced or eliminated by a treaty. must actually be paid before the issuer can These rules permit the IRS to disregard one deduct the payment for U.S. federal income or more intermediate entities in a financing tax purposes. arrangement if these entities act as conduit entities. If a conduit entity is disregarded, Additional rules apply to limit interest the financing arrangement generally is deductions on certain types of recharacterized as a transaction between indebtedness of a corporation where the remaining parties to the financing the terms of the instrument provide for arrangement and the interest payments repayment using equity of the issuer or a are treated as made between those related party.34 In such case, interest paid remaining parties. Recharacterization of a or accrued on the indebtedness is non- transaction by the IRS will result in a U.S. deductible for U.S. federal income tax tax obligation and also may result in the purposes. application of certain penalties.

U.S. transfer pricing rules also generally Portfolio Interest Exception require that debt between two related Certain types of U.S. source interest paid parties reflect an arm’s length rate of by a U.S. corporation to foreign persons interest. If the debt does not reflect an are exempt from U.S. tax and withholding. arm’s length rate of interest, section 482 Interest that satisfies the requirements provides the IRS with the ability to make of the portfolio interest exception is one appropriate allocations of the interest in example.36 In general, foreign corporations order to clearly reflect income and to adjust are not subject to U.S. tax on interest U.S. federal income taxation accordingly. received on portfolio debt instruments.37 The rules provide a safe harbor interest Broadly, portfolio interest includes interest rate that is generally equal to at least the paid on debt obligations that are in applicable federal rate, as published by the registered form and with respect to which IRS on a monthly basis, and not more than the person who is otherwise required to 130 percent of the applicable federal rate. deduct and withhold tax from such interest (e.g., the U.S. corporate issuer), receives a statement that the beneficial owner of the obligation is not a U.S. person.

United States Financing options: Debt versus equity 87 An obligation is in registered form if (1) Parent Guarantees of Third-Party Debt 38 The portfolio interest exception rules were it is issued by a natural person; (2) is not Third-party debt that is issued by a U.S. modified in March 2012 and therefore if an obligation was issued before this date, of a type offered to the public; (3) has a corporation and guaranteed by its foreign parties should consider the potential maturity date of not more than one year; parent company, may implicate not only application of the prior rules. (4) is reasonably designed to ensure that the earnings stripping rules described the obligation will be sold only to a non- above, but it also may require consideration 39 See Plantation Patterns, Inc. v. Comm’r, 462 U.S. person; or (5) is debt that is held of whether such arrangement may, in F.2d 712 (5th Cir. 1972). through a dematerialized book entry substance, be viewed as a loan made system or other book entry system specified directly by the third-party lender to the by the IRS.38 foreign parent company. Where it is clear that the third-party lender would never Certain parties are excluded from those have been willing to make a loan to the who may receive portfolio interest. This U.S. corporation, U.S. case law39 can apply includes interest paid to: (1) a bank that to recharacterize the lending arrangement receives the interest on a loan made in as a loan by the third-party to the foreign the bank’s ordinary course of business; parent and a capital contribution by (2) interest paid by a corporation to a the foreign parent to its U.S. corporate shareholder who owns 10 percent or more subsidiary. If the lending arrangement is of the total combined voting power of all so recharacterized, payments by the U.S. classes of stock of the issuing corporation; corporation would result in non-deductible (3) interest paid by a partnership to a dividend distributions that may be subject partner who owns 10 percent or more of to U.S. tax and withholding, instead of the capital or profits interest in the issuing deductible interest payments. partnership; (4) interest that is received by a controlled foreign corporation from Preventing this potential recast of a certain related persons; or (5) certain financing arrangement generally requires types of contingent interest. Because of an assessment of whether the U.S. these restrictions, it is unlikely that most corporation could have obtained the types of related party indebtedness would financing from the third-party lender, satisfy the requirements of portfolio debt; under similar terms, without the foreign however, foreign corporate investors who parent guarantee, i.e., on a stand-alone intend only to make passive-type debt basis. Thus, a debt-equity analysis using investments in U.S. companies should the factors described above, must be consider the potential applicability of these applied to third-party loans made to a U.S. rules to exempt interest payments from corporation that are subject to a foreign U.S. federal income tax and withholding. parent guarantee in order to determine whether the financing arrangement will qualify as indebtedness of the U.S. corporate issuer for U.S. federal income tax purposes.

United States Financing options: Debt versus equity 88 Contact

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This document was concluded on 1 November 2016. Subsequent developments have not been included.

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