Deductibility of finance expenses related to the acquisition of a holding: can the expenses be considered as connected to the activity?

Under article 15.e) of Law 27/2014, dated 27 November, on Corporate Income Tax, gifts and donations are not considered tax deductible. The article includes various expenses, which should not be considered as a gift or an expense and, therefore, should be deductible. This list of tax deductible expenses concludes with a reference to those expenses which are correlated to income generation.

The main disadvantage with the way Spanish Corporate Income Tax ("CIT”) Law requires that an expanse be related to income generation as a condition for its tax deductibility, is that it imposes such condition under paragraph e) of article 15. Such paragraph relates to the deductibility of gifts and donations. An general requirement, designed to apply to all expenses, located in this paragraph may therefore give rise to interpretation issues.

On the one hand, the nature itself of an expense deemed to be a gift or a donation requires that there be no consideration and that there be a will to make a gift ("animus donandi”). Therefore and as a general rule, classifying an expenses within article 15.e) should imply that the expenses fulfils the above two requirements.

However, under different reading of the article, one could argue that since gifts and donations are not deductible and since expenses correlated to income generation would not be considered to amount to a gift or a donation, any accounting expense not correlated to income could be classified as a non-deductible gift or donation. This extensive approach has allowed Spanish Tax Authorities to resort frequently to this article in order to reject the tax deductibility of expenses borne by companies.

This was precisely the case for Cupire Padesa, S.L. (the "Company”), parent of the Cupa Group. Regional Tax Authorities rejected the deductibility of various financial expenses which arose in 2006 and 2007. Although such expenses cannot be considered as gifts or donations, the lack of correlation with a specific income stream was the decisive factor which led to their classification within article 14.1.e) of the previous Spanish Corporate Income Tax Law, the wording of which is identical to the current article 15.e).

The Tax Authorities analysed the Company's decision-making and operative in relation to its acceptance of debt: the Company had entered into a bank loan to finance the acquisition of its own shares, in an amount of up to 40% of its share capital. Such shares were subsequently amortised in a share capital reduction with refund of contributions to shareholders. In the opinion of the Tax Authorities, the transaction could have been more simply designed as a share purchase among of the shareholders. A more complicated transaction was chosen in order to benefit from the deductibility of the interest expenses, thereby allowing the Company to derive a tax benefit.

The Tax Authorities also considered that the aim of the whole transaction was to refund contributions to some of the shareholders. Such a transaction can therefore impact a Company net equity, but cannot generate income subject to Corporate Income Tax. Tax Authorities relied on this lack of income generation to determine that the transaction was not linked to the Company's business operations. The financial expenses could therefore be deemed to fall within the non-deductible gifts and donations provision (article 14.1.e)).

The debate around this provision of the Spanish Corporate Income Tax Law and its application has reached the Spanish Supreme Court. The Supreme Court, in its order dated 28 October 2019 (Appeal num. 3454/2019), has allowed the appeal since it considers that this matter may affect a significant number of cases and there is no precedent in this matter. In this regard, two issues are put forward for the Supreme Court to rule on:

• Whether any accounting expense not correlated to the generation of income can be deemed to amount to a gift or donation or whether it is necessary to determine first whether there is an absence of consideration and "animus donandi”.
• Whether the principle of correlation requires that expenses be directly and immediately related to income, in order for such expenses to be deductible. In other words, whether it would be necessary for such expenses and income to have a simultaneous and joint effect in the same tax base, as the Tax Authorities are requiring, or whether it is sufficient that the corresponding expenses be generally directed at the generation of income.

A requirement that the expense be directly and immediately related to the income of the Company would be especially burdensome in the context of financial expenses, given that article 16 of the Spanish Corporate Income Tax Law already limits the deductibility of the net amount of such expenses to 30% of EBITDA. Should the Supreme Court rule that these expenses are also required to be directly and immediately related to income, the resulting situation would be one of a double limitation which would make the deductibility of such expenses particularly difficult.

So far, the Courts have considered that, absent a case of evident disproportion, the taxpayer is not bound to prove the correlation of expenses with income, beyond what results from its accounting or its filings – see for instance the Superior Tribunal of Catalonia in its ruling dated 15 June 2017 (Ruling num. 464/2017 and Appeal num. 50/2014. Therefore, it would be up to the Tax Authorities to prove the lack of correlation between expense and income. In the case before the Superior Tribunal of Catalonia, both the Tax Authorities and the Regional Administrative Tribunal had rejected the tax deductibility of expenses related to the purchase of lottery tickets and gift vouchers. Since the recipients had not been identified, it was not possible to prove that these purchases had aimed at furthering the business activity of the taxpayer.

The ruling from the Supreme Court has created a sense of expectancy in light of the opposing views held by the Courts and the Tax Authorities and of its potential far reaching implications. Finally, it is worth noting that the precedent which the Supreme Court will establish will be directly applicable to the interpretation of the current Corporate Income Tax, since the wording of article 14.1.e) of the previous Spanish Corporate Income Tax Law is identical to the current article 15.e).