Recent Spanish tax developments impacting dividend recaps

The Supreme Court has recently confirmed in three decisions (STS 1088/2020, STS 3199/2022 and STS 3200/2022) that financial expenses incurred in relation to a dividend recapitalisation are deductible for Corporate Income Tax purposes. At the same time, the Spanish Tax Authorities’ Consultative Commission responsible for assessing abuse of law scenarios has issued a report commenting on the application of the Spanish General Anti-avoidance Rules (GAARs) in a specific case involving several consecutive transactions, including a dividend recapitalisation.

These developments have shed light on the treatment of dividend recap transactions in Spain, providing welcome clarity on both the application of the general rules around deduction of expenses and the potential application of the GAARs.

Background

Traditionally, where the Spanish Tax Authorities (STA) have not used general anti-abuse rules to challenge dividend recapitalisation arrangements, they have challenged them on the basis that any interest expenses borne by the Spanish borrowing entities relating to those arrangements are not deductible, since they exclusively benefit the shareholders, and as such they are not directly related to the business activity of the relevant company, rather than on abuse of law arguments.

This is the argument put forward by the STA in the recent cases analysed by the Supreme Court (dating from 2006 to 2008), where the companies arranged loans (both with independent financial institutions and group entities) to finance the return to the shareholders of share premium, to pay dividends and to acquire their own shares for amortisation.

However, the recent report issued by Consultative Commission has shifted the focus of the STA’s challenge to the application of GAARs set out in Article 15 of General Tax Law to such transactions.

Supreme Court decisions

In the three recent cases, the Supreme Court bases its reasoning on its earlier decision of 30 March 2021, where, in a very similar scenario, the STA challenged interest expenses on a loan from a shareholder to acquire its own shares. The Supreme Court confirmed the criteria applied in its earlier decision and confirmed that the existence and nature of the interest expense cannot be ignored. In addition, the Court held that the interest expense could not be considered as a gift or donation (a non-business expense) as it arises from an onerous financial agreement. In this sense, the Supreme Court considers that the connection between expenses incurred by a company and the generation of income must be considered in the broader context of the business of a company as a whole. This is a different approach to expenses which are treated as donations/gifts (non-business expenses), where the Spanish Corporate Income Tax law requires that the connection to the income generated must be strong and direct to be deductible.

Consultative Commission report

A key aspect of the Supreme Court decisions is that the interest expenses did not arise as a consequence of artificial or fraudulent transactions with a purpose to obtain a tax advantage. However, this is the focus of the recent report of Consultative Commission of the STA. In the specific case analysed in the report, there were a number of preparatory transactions for the transfer of a 50% interest in a Spanish entity (the target). These transactions included the incorporation of three entities in the holding structure, including a Spanish HoldCo. When the shares of the target are contributed to the Spanish HoldCo, a significant share premium arises from goodwill based on the valuation agreed in the subsequent transfer. The loan granted to the Spanish HoldCo is designed partially to repay that share premium.

The Consultative Commission concludes that the Spanish GAARs would be applicable in such a scenario based on the artificiality of the transaction as a whole, and the lack of any economic effects that justify carrying out such transactions other than the tax advantage obtained.

Comment

The decisions issued by the Supreme Court should be very welcome as they provide certainty on the deductibility of interest expenses connected with dividend recaps, which are widely used within the private equity industry for genuine business reasons.

On the other hand, the report of the Consultative Commission of the STA stresses the importance of implementing dividends recaps rationally and in a valid business context, and not as a mechanism for merely obtaining a tax advantage.