The tax authorities recently issued an internal binding information (1195/05) on the interpretation of the thin capitalization rules vis-à-vis the European Court of Justice (ECJ) ruling on the Lankhorst-Hohorstcase (C-324/00). The binding information mentions that interpretative decisions of the ECJ, unless otherwise mentioned, have ex tunc effect, i.e. from the entry into force of the relevant tax provision. As a result, the Portuguese thin capitalization rules (both in their current and previous text) should be interpreted in light of the Lankhorst-Hohorst ruling, i.e. as not applying to EU-related entities. As such, tax inspectors are requested not to disallow excessive interest expenses in EU scenarios, even in situations which pre-date the 2006 amendment that specifically exclude EU entities from the scope of application of those rules. The binding information also mentions that such approach does not however jeopardize the application of the transfer pricing rules in related party situations.
Note: The Administrative and Tax Court of Lisbon on 21 July 2006 ruled that Portugal's pre-2006 thin capitalization rules, limiting the deduction of interest paid to EU parent companies but not to Portuguese ones, were incompatible with freedom of establishment, services and capital.
Court decision on pre-2006 thin capitalization rules
On 21 July 2006, the Administrative and Tax Court of Lisbon ruled that Portugal's pre-2006 thin capitalization rules, limiting the deduction of interest paid to EU parent companies but not to Portuguese ones, were incompatible with freedom of establishment, services and capital (Arts. 43, 49 and 56 EC Treaty).
(a) Background law. Portuguese thin capitalization rules, introduced in 1996, provide that interest paid by a resident company in respect of excessive debt to a non-resident related party is generally not deductible. The thin capitalization rules apply to non-resident entities, which are shareholders in Portuguese companies and fall within the concept of related parties. This includes, amongst others, shareholders directly or indirectly holding currently 10% (previously, 25%) or more of the capital of a Portuguese entity.
For the purposes of the thin capitalization rules, excessive debt is the part of the total debt (including any loans, guarantees and trade-related credits more than 6 months overdue) with non-resident related parties, which exceeds – at any date in the tax period – twice the amount of the corporate borrower's net equity held by such non-residents. If the 2:1 debt to equity ratio is therefore exceeded, the interest payable on the excess is not deductible for tax purposes. The rules do not however provide for a recharacterization of the excess interest.
Interest on excessive debt may nevertheless be deducted if the taxpayer can prove (on the grounds of the kind of activity, the sector in which it operates, its size or other relevant criteria, and provided that the risk factor in the transaction does not involve any related party) that the loan conditions are comparable to those agreed by non-related parties in comparable transactions under the same circumstances.
As from 1 January 2006 and in order to comply with the decision of the European Court of Justice (ECJ) in the Lankhorst-Hohorst case, thin capitalization rules no longer apply to EU resident entities.
(b) Background facts. The case concerned an almost fully-owned (99.9%) Portuguese subsidiary held by a Danish parent company, which from mid-2000 was held by a Dutch parent company.
The Portuguese subsidiary required funds in order to finance its local activities. Before entering into a loan agreement with a related party, the Portuguese subsidiary considered other loan proposals presented by Citibank and a Portuguese bank. Despite those proposals, the Portuguese subsidiary concluded in 1998 an interest-bearing loan with a group financing subsidiary established in Ireland.
Under the said loan agreement, the Irish subsidiary granted cash advance loans, for a period of 1, 3, 6, or 12 months, the aggregate amount of which would not exceed EUR 5 million. Each advance loan accrued interest at the London Interbank Offered Rate (LIBOR) plus a margin to be negotiated by the parties. The parties agreed that interest was payable at the end of the year at a rate of 4.91%. Due to its start-up situation, the Portuguese subsidiary largely exceeded the 2:1 debt to equity ratio.
In its corporation tax assessment notices for 1999 and 2000, the tax authorities disallowed the deductibility of interest paid to the Irish entity amounting to EUR 131,878 and 170,370, respectively. The tax authorities referred to the difference in interest rates provided by the Irish lender and expressed in the Citibank proposal and concluded that that the evidence was not sufficient to prove that the arm's length principle had been respected.
The Portuguese subsidiary challenged the application of Art. 61 of the Corporate Income Tax Law (previously, Art. 57-C) on the grounds that these provisions infringed the principle of freedom of establishment and capital under EC law, since Portuguese Law indirectly discriminated against subsidiaries on the grounds of the nationality of their parent companies. The Portuguese subsidiary also raised the issue of incompatibility of the thin capitalization rules with the tax treaty between Ireland and Portugal.
(c) Decision. The Court, following closely the language of the ECJ in the Lankhorst-Hohorst case, considered that the difference in treatment between resident subsidiary companies according to the seat of their parent company constitutes an obstacle to the freedom of establishment (Art. 43 EC Treaty) since it makes it less attractive for companies established in other Member States to exercise their freedom of establishment.
The Court also held the rules in question restrict the movement of capital (Art. 56 EC Treaty). In that respect, the court held that the thin capitalization rules did not respect the arm's length principle in as much as that the non-deductibility of interest was not limited and justified by reference to transactions entered into between independent entities, but by the fact that the 2:1 debt to equity ratio was exceeded.
Lastly, the Court referred that since the application of thin capitalization rules to non-resident lenders results in an increase of the financing costs, such rules impede or dissuade a provider of services from actually exercising the freedom to provide services. As such, the rules were also considered incompatible with the freedom to provide services (Art. 49 EC Treaty). In reaching that conclusion, the Court cited the ECJ decision in the Safir case (C-118/96).
The court did not address the issue of compatibility of the thin capitalization rules with tax treaties, namely the treaty between Portugal and Ireland.
Note: The tax authorities recently issued an internal binding information (1195/05) on the interpretation of the thin capitalization rules vis-à-vis the ECJ ruling on the Lankhorst-Hohorst.