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Private investors in Lithuania often consider if the financing should be granted borrowing funds from its parent or getting new shares issued in the equity of the company. Most companies choose the first way of financing a company but, unfortunately, they sometimes encounter a "thin capitalisation rule", when companies are barred from deducting distributions paid to shareholders from their pre-tax profits. The “thin capitalisation rule” was created for the purposes of combatting avoidance of payment of corporate taxes when a company is artificially financed by borrowing rather than issuing shares in the equity of the company.
EU rules on the direct tax treatment of debt financing
Advocate General Geelhoed in its opinion delivered on 29 June 2006 in the case C-524/04 (Test Claimants in the Thin Cap Group Litigation v. Commissioners of Inland Revenue) noted the following:
“3. There are two principal means of corporate finance: debt and equity finance. Many Member States draw a distinction in the direct tax treatment of these two forms of finance. In the case of debt finance, companies are generally permitted to deduct interest payments on loans for the purpose of calculating their taxable profits (i.e., pretax), on the basis that this constitutes current expenditure incurred for the pursuit of the business activities. In the case of equity finance, however, companies are not permitted to deduct distributions paid to shareholders from their pre-tax profits; rather, dividends are paid from taxed earnings.
4. This difference in tax treatment means that, in the context of a corporate group, it may be advantageous for a parent company to finance one of the group members by means of loans rather than equity. The tax incentive to do so is particularly evident if the subsidiary is located in a relatively “hightax” jurisdiction, while the parent company (or indeed an intermediate group company which provides the loan) is located in a lower-tax jurisdiction. In such circumstances, what is in substance equity investment may be presented in the form of debt in order to obtain a more favourable tax treatment. This phenomenon is termed 'thin capitalisation'. By thus manipulating the manner in which capital is provided, a parent company can effectively choose where it wishes profits to be taxed”.
The Court of Justice of the European Union, whilst examining the issue of thin capitalisation against the background of Article 43 EC (freedom of establishment) and Article 56 (free movement of capital) justified the national rules that necessary to combat abusive practices and purely artificial arrangements which have purpose to circumvent the tax legislation of that Member States (see: case C-282/12, Itelcar – Automóveis de Aluguer Lda; C-182/08 Glaxo Wellcome GmbH & Co. KG).
However, the fact that a company granted a loan to its subsidiary does not mean that the parent was not willing to circumvent taxes. The European Court of Justice in the case C-524/04 (Test Claimants in the Thin Cap Group Litigation) held that:
"The mere fact that a resident company is granted a loan by a related company which is established in another Member State cannot be the basis of a general presumption of abusive practices and justify a measure which compromises the exercise of a fundamental freedom guaranteed by the Treaty (see, to that effect, Case C-478/98 Commission v Belgium  ECR I-7587, paragraph 45; X and Y, paragraph 62; Case C-334/02 Commission v France  ECR I 2229, paragraph 27; and Cadbury Schweppes and Cadbury Schweppes Overseas, paragraph 50)".
The fact that a resident company has been granted a loan by a non resident company on terms which do not correspond to those which would have been agreed upon at arm’s length constitutes, for the Member State in which the borrowing company is resident, an objective element which can be independently verified in order to determine whether the transaction in question represents, in whole or in part, a purely artificial arrangement, the essential purpose of which is to circumvent the tax legislation of that Member State. In that regard, the question is whether, had there been an arm’s-length relationship between the companies concerned, the loan would not have been granted or would have been granted for a different amount or at a different rate of interest.
Lithuanian rules on the recognition of interest paid on the controlled lent capital
In calculating the corporate tax in Lithuania it is possible and deduct all usual costs that an entity actually incurs for the purpose of earning income or deriving economic benefit unless this Law provides otherwise (Article 17(1) of the Law on Corporate Income Tax). The concept of allowable deductions is further specified in Article of the 40(1) (Adjustment of the Value of Transactions or Economic Operations and Revaluation of Income or Benefits) of the Law on Corporate Income Tax:
“For the purpose of calculating taxable profits in accordance with the procedure laid down in this Law, entities must recognise the amount which is in line with the actual market price of a transaction or economic operation <…”.
Further, the rules of the Resolution of the Government of the Republic of Lithuania No. 1575 as of 9 December 2003 “On the Approval of the Rules for the Requalification of Income and Payments” (the “Rules”) provides for certain regulations of re-qualification of income or payments. These rules were drafted for the purpose of creation an incentive to not to reduce the corporate income tax base, when the investments into equity are replaced by the loans. In particular, clauses 3 and 6 of the Rules set out:
"The share of capital lent for remuneration to the Lithuanian entity by the controlling lender(s), which is in excess of the ratio 4:1 between such lent capital for remuneration and fixed capital, shall be qualified as controlled lent capital. <…> Interest payable on the use of controlled lent capital shall be considered unrelated with the earning of income and shall not be deductible, for the purpose of calculating taxable profit of the controlled Lithuanian entity, from income of the Lithuanian entity. <…> . The aforementioned provisions shall not apply, if the Lithuanian entity proves that an equivalent loan might be taken on the same conditions between independent (unrelated) persons. <..> ."
Thus, in case the funds were loaned to a Lithuanian enterprise by its controlling lender in excess of the ratio 4:1, the Lithuanian company is under obligation to prove that:
• interest rates are paid on the arm’s length principle; one has to consider the possibility of lending under the same conditions;
• the possibility to receive a similar loan from unrelated entities.
Only if those conditions are met, the “thin capitalisation” rule does not come into play and the interest paid on the controlled lent capital can be treated as deductible.
Practice of the Tax Disputes Commission at the Government of the Republic of Lithuania
In Lithuania, the decisions of the State Tax Inspection (being the highest tax authority in Lithuania) are subject to appeal to the Tax Disputes Commission at the Government of the Republic of Lithuania (the “Commission”). Recently, the Commission adopted several rulings on the “thin capitalisation” rule (see for example, the decisions of the Commission No. S-238 (7-239/2015) dated as of 14 December 2015 and No. S-194 (7-156/ 2014) dated as of 29 September 2014).
For example, the Commission in its decision as of 27 November 2015, No. S-227 (7-184/2015) annulled the decision No. 69-79 of the State Tax Inspection as of 3 July 2015 and referred the question back to the State Tax Inspection for re-examination. In this ruling, the Commission has arrived at the conclusion that that the claimant who was linked by “special connection” with its shareholder wanted to exercise taxable activity by lending funds from its shareholders - the controlling lenders, which was, according to the Commission, basically lawful and this was in line with market conditions. However, the Commission further said that this opportunity should be limited if a company abuses this right, enters into an artificial transaction, which is not in line with open market conditions, when the transaction renders something in excess what the company would have received under fair open market conditions. In addition, according to the Commission, the Company should be granted an opportunity, without being imposed substantive administrative hurdles, to prove that such transaction was not made with abuse, but it was conditioned by genuine commercial rationales. This rebuttal should not be too onerous or impossible for a company. According to the Commission, the benchmark of separating an artificial transaction from a real economic transaction is the arm’s length principle, which, according to the Commission, was considered as a proper tool in the international tax law to avoid manipulations in the transaction with foreign elements.
The Commission's view is that tax treatment should not be too rigid and formalistic, which unreasonably reduces the possibilities of a taxable person to prove that the transaction was concluded without abuse, and it was conditioned by genuine commercial reasons. Such interpretation would not be in line with the principle of proportionality.
In other ruling No. S-151 ((7-105(1)/2014) dated as of 12 August 2014 the Commission that the company should be able to refute the presumed abuse without incurring large administrative hurdles and proving that this transaction was caused by genuine commercial reasons. According to the Commission, this rebuttal should not be too onerous or impossible. Among other things, the Commission also invoked the reasoning of the Court of Justice of the European Union made in the cases C-1982/08 (Glaxo Wellcome GmbH & Co. KG) and C-524/04 (Test Claimants in the Thin Cap Group Litigation) to strike out the more formalistic decision of State Tax Authority.
In short, foreign investors should not ignore the thin capitalization rule that is recognized and applied by the Lithuanian tax authorities. However, if the financing is viewed unfavorably by the tax authorities and the interest payable on the use of controlled lent capital is considered as non-deductible because of the thin capitalisation rule, it is still advisable examine each case on its merits and take advantage of all remedies available to a party.
DISCLAIMER: This memorandum should not be treated tax advice or used as basis for calculating the tax liability. Tax treatment depends on individual circumstances.
For more information please contact Dr. Gintautas Šulija.
Šulija Partners Law Firm Vilnius, registered office Jogailos street 4, 3rd floor, Vilnius, LT-01116, Lithuania, fax +370 52051926, e-mail: info@SulijaPartners.com
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