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Tax Flash Report by PwC experts
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Debt push-down: to be or not to be?
February 2017 / Issue No. 9
In brief The development of a court practice on debt push-down strategy is in the initial stage. In November 2016, the Perm Region Arbitrazh Court upheld a taxpayer’s position on the deduction of interest expenses. The original loan was raised by a Russian company, which then used it to purchase an equity interest in a taxpayer. Later, the buyer company merged with the taxpayer. As a result, the obligations under the loan were transferred to the taxpayer. The court agreed with the taxpayer’s arguments that the interest expenses were justified and that there was a business purpose in the sequence of transactions. On 13 February 2017, the Seventeenth Arbitrazh Appellate Court reversed the Perm Region Arbitrazh Court decision. It stated that the taxpayer did not substantiate the chain of transactions based on considerations other than taxes. The court also pointed out that the taxpayer’s equity interests were the target of the transaction, and therefore, the expenses for their acquisition should have been borne by the taxpayer’s shareholders, rather than the taxpayer itself. The dispute in the arbitrazh courts is not yet over (the taxpayer will most likely file a cassational appeal). However, even now one may say that the tax authorities are increasingly focusing on the economic rationale behind complex financial transactions and are considering the context and all surrounding circumstances in which transactions are made. We expect that debt push-down will be under the radar of other territorial tax authorities, who will most likely attempt to use the arguments of their peers.
In detail What is a debt push-down strategy? Many investors prefer a strategy when a buyer company raises debt financing, acquires the target and then mergers with it. This approach makes it possible to ‘push down’ debt obligations to the level of the target company and to service it out of its cash flows. The burden of debt, therefore, shifts to the profit-making operating company, which is able to settle it in the course of its normal operational activities. The operating company will also pay the interests, which in general may be deducted for tax purposes. This tax deduction was challenged by the tax authorities in the case concerning the above-mentioned taxpayer (the “Company”). Court case background (Ruling No. 17АП-20131/2016-АК of the 17th Arbitrazh Appellate Court dated 13 February 2017 ) The transaction structure are presented in the picture to the right. After completing a chain of transactions for purchasing the Company’s shares from individuals, the Company became a full member in a foreign holding group. The tax authorities challenged the deduction of interest expenses at the Company’s level and stated that the key objective behind such structuring was to shift the debt liabilities of the buyer to the Company. In November 2016, a first instance court concluded that there had been no unjustified tax benefit and ruled that the Company had rightfully deducted respective interest
expenses. Among other things, the court stated that an entity may opt to choose the most expedient way to achieve a goal, unless it contradicts the spirit and essence of the respective transactions and violates basic laws. The appellate instance court disagreed with the conclusion. It stated that to justify the economic feasibility of the expenses, it is necessary to trace a connection between the expenses incurred and profit generating activities. Despite the fact that businesses may resort to various civil law instruments, they must exercise their rights in such a manner as not to affect the interests of any other persons or entities (including the state). Taxpayers may perform their business in a tax effective manner provided the selected options are not artificial and are economically justified. In light of the above concept, the appellate instance court backed the following arguments voiced by the tax authorities:
The Company did not justify the chain of transactions for purposes other than tax saving;
The buyer was a loss-making company and would not be able to settle the loan and respective interest (and the lender was fully aware of it);
The new Company’s shareholders must incur expenses on purchasing the Company’s shares;
All the transactions were planned in advance, performed within a short time among a limited number of affiliated contractors who were able to affect their business results;
The entire debt amount was shifted to the Company, which used its own resources to ultimately finance the said transaction.
Another distinctive feature of the case There is also another important aspect considered in this case. The tax authorities applied thin capitalisation rules to the disputed debt (in fact a loan provided by a foreign sister company) and additionally assessed respective withholding tax at 15%. The Company, in turn, insisted on applying a 5% rate under the Russia-Netherlands DTT, as the foreign parent and foreign sister companies were Dutch tax residents in this case. According to the tax authorities, a reduced rate cannot be applied in this situation because the lender has no direct participation in the Company and did not invest into its capital (as Article 10 of the Russia-Netherlands DTT requires applying a reduced rate). Such a position was supported by the court.
We would like to note that thin capitalisation rules can be applied in a wide range of situations, not only to loans received directly from foreign parent companies. With that Article 269 of the Russian Tax code does not regulate DTT application. Accordingly, the following questions may arise:
Which DTT may be applied? The one with the foreign parent company’s jurisdiction (if any), or the one with the jurisdiction of the direct lender (e.g. a foreign sister company)?
If the DTT with the parent company’s jurisdiction is applicable, can taxpayers apply a reduced withholding tax rate provided it could be applied when paying dividends directly to a foreign parent company1?
Court practice on this matter has been contradictory so far.
The takeaway
The development of a court practice, especially negative, may increase the risks for companies using the debt push-down strategy.
The tax authorities and courts are reviewing a wide spectrum of transactions and assess all the respective circumstances.
In the above dispute, the parties did not interpret the provisions of the Russian Tax Code as such, but considered the actual facts and circumstances and the evidence of unjustified tax benefit.
In the light of the current approach taken by the tax authorities and courts, successful application of the debt push down strategy will depend on commercial justification of taxpayers’ transactions effected in the course of the strategy and will require thorough planning.
1 The majority of DTTs include a condition on direct participation in the capital of a company that pays out for application a reduced withholding tax rate (in particular, Cyprus, Luxembourg and Switzerland).
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