One of the most recent important changes in Spanish tax legislation has been the abolition of Spanish thin Capitalisation rules with regard to EU related companies (with effect for year 2004 onwards).
This change, together with the abolition of Spanish CFC rules with regard to EU subsidiaries, responds to the progressive implementation in Spain of the EU Freedom of Establishment, which is being very commonly dealt by the European Court of Justice (ECJ), on a very frequent negation of the arguments raised by the EU Member States governments. One of the most determining ECJ Decision on Thin Capitalisation rules vs. EU Freedom of Establishment was the Lankhorst-Holhorst case (C-324/00), which finally encouraged the Spanish Government to adopt the abolishment of Thin Capitalisation rules with regard to EU companies.
Thin Capitalisation rules seek that Spanish companies do not incur in disproportionate debts with related foreign companies, and is focused on the avoidance of the excessive tax deductible expense that the payment of interests to the foreign related company would produce in Spain. The debt limit is established on the result of multiplying by three times the amount of the Spanish company's equity, being the interests corresponding to the excess of debt (3:1 ratio) recharacterised as dividends for tax purposes, and therefore not being tax-deductible for the Spanish company.
However, such rule does not apply when the related company who granted the loan is Spanish as, although an excessive interest expense is also produced in the interest-paying Spanish company, the correspondent income obtained by the Spanish company who granted the loan would also be taxed in Spain, resulting on a tax neutrality with regard to Spanish taxes. This situation is the one which is actually against the EU Freedom of Establishment, and which has been the base for the Lankhorst-Holhorst ECJ Judgement.
The Spanish Government has, thus, enacted that the Thin Capitalisation rule (3:1 ratio) will not apply, with effects from 1st January 2004, to the loans received by Spanish companies from EU related companies.
This legal amendment was severally criticised by the Spanish Economic and Social Council (CES), due to the reduction in tax-collection that can imply. Indeed, the amendment has important tax implications and, as a last resort, economic, as it will allow that foreign related companies located in EU low-tax jurisdictions grant disproportionate loans to Spanish companies, generating tax-deductible expenses in Spain with the payment of interests (deducted at a normal flat rate of 35%) and generating the correspondent income for interests in the EU low-tax jurisdiction (at a substantially lower tax rate), achieving a lower tax cost on an overall perspective of the Group, and to the detriment of the Spanish Public Treasury.
However, we should bear in mind that Spanish Transfer Pricing rules are still fully applicable to the interests paid the Spanish company with the EU Related company and, even being of dubious legality, it would not be rare that the Spanish Tax Authorities could try to challenge interest tax deduction in the presence of excessive and disproportionate indebtedness.
Eduardo Martínez-Matosas
International Tax and E-Commerce Tax Department
Rodés & Sala Abogados
Barcelona, Spain
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