Thin cap rules demystified
"Neither borrower nor a lender be"
- W. Shakespeare, Hamlet
Aware that not all readers can afford to heed Polonius' words of advice, this week's Tax Eye ambitiously aims to disperse the cloud of mystery surrounding Polish 'thin cap' rules. If this does not immediately ring a bell, try to overcome the temptation of turning to the next page. Otherwise, you will only have yourself to blame for paying too high a price for financing. And who isn't struggling with cash flow nowadays?
You will hear about thin capitalization or 'thin cap' in reference to debt. Let's imagine that a parent (company A) has succumbed to its daughter's (company B) nagging for extra cash and has decided to lend her money. In a healthy family, the child (company B) would get a better deal than can be found out on the streets, in other words - longer grace periods and repayment terms as well as cheaper interest than the bank around the corner has to offer.
Prior to January 1, 1999, it was a good deal indeed for children, as there was nothing to stop them from taking advantage of full tax deductions for the interest on the cheaply borrowed funds. It all changed after that date when thin capitalization rules were introduced to the Polish Corporate Income Tax (CIT) Act.
Under these rules, the interest on loans could not be expensed or deducted in full from certain companies' taxable incomes. The restrictions applied to family relations defined as parent(s) holding over 25 percent of the daughter's or the sisters' voting power, where parents extended loans to their children, or sister companies borrowed from each other. The tax deduction for interest on such loans was limited to a debt-to-equity ratio of 3:1.
When determining the amount of equity, the borrower's paid-in equity capital was taken into account, excluding debt converted into equity and less contributions in kind of intangible non-depreciable assets (e.g. know-how).
The gist of the situation may be illustrated using our previous example. If parent company A extends a loan to its fully owned subsidiary company B, the related interest expense will be fully tax deductible at the level of B as long as B's debts to A do not exceed three times its equity gauged at the time of each interest payment. Interest on loans which tip the leverage ratio would not be allowed as an expense against B's taxable income.
Thin capitalization rules have evolved since 1999. Under the current legislation, they only apply to loans extended by foreign companies (i.e. entities based outside Poland) and by Polish companies on tax holiday operating in special economic zones. Therefore, genuine Polish families can benefit from tax efficient financing, whereas cross-border relations between Polish subsidiaries and their foreign parents are usually more expensive. As in 1999, the law still makes parental relations (single or multiple parents) contingent on holding more than 25 percent of the daughter company's voting power or that of the sister companies who have the same parent(s).
Moreover, whereas previously the term 'loan' for thin capitalization purposes was not specifically defined, the amended 2004 CIT Act has introduced a rather broad definition, which encompasses deposits and debt securities, including bills and bonds. Coming back to our example, parent company A subscribes for company B's bond issue, the coupon will be subject to thin cap restrictions in the hands of B.
Over the last five years, the Polish thin cap rules have evolved and the scope of their application narrowed down to foreign lenders and Polish companies which carry out business in special economic zones. As the tax deductibility of loan interest is contingent on the origin/nationality of the lender rather than on more objective criteria such as economic merit, investors are effectively discouraged from setting up subsidiaries in Poland. In the case of EU companies looking to invest in post-accession Poland, it could be argued that such fiscal favoritism goes against fundamental freedoms.
Thanks to the establishment of the European Union and its institutions, such as the European Court of Justice (ECJ), the EU member states have means available to tackle such restraints on the freedom of establishment, free movement of capital and other such rudimentary freedoms on which the EU has been founded.
The role of the European Court of Justice (ECJ) in building a truly common European market cannot be emphasized enough. In December 2002, the ECJ ruled on the Lankhorst-Hohorst case which concerned the German provision on shareholder debt financing or 'thin capitalization'.
The plaintiff, Lankhorst-Hohorst GmbH, engaged in trade with accessories for ships and other hardware, had borrowed zł.1.7 million (DM 3 million) at very favorable terms from a Dutch grandparent company and used the funds almost exclusively for the repayment of a more expensive bank credit taken up earlier. Problems arose when the German company claimed a tax deduction for the interest payments made on the loan. The German tax authorities came to the conclusion that a 'thin cap' situation was at hand. Consequently, the interest was classified as a dividend (taxable at 30 percent corporate income tax) and the interest expense was disallowed for tax purposes.
However, the ECJ ruled that the German tax thin capitalization provisions violate European law and more specifically infringe the application of the fundamental freedom of establishment provided for under Art. 43 of the EC Treaty. More specifically, where the tax treatment of interest is differentiated according to the lender's tax residency (German resident vs. German non-resident), it influences investor decisions to carry out business in jurisdictions which appear less attractive as a result.
The above ruling should provide food for thought for the Polish Tax Man and investors alike. As mentioned above, currently the Polish thin capitalization rules only apply to loans received from non-resident lenders or certain Polish companies. Hence, the question: Is that compatible with EC law requirements? remains open.
Donka Darpatova is a tax manager in the Warsaw office of Ernst & Young.
- W. Shakespeare, Hamlet
Aware that not all readers can afford to heed Polonius' words of advice, this week's Tax Eye ambitiously aims to disperse the cloud of mystery surrounding Polish 'thin cap' rules. If this does not immediately ring a bell, try to overcome the temptation of turning to the next page. Otherwise, you will only have yourself to blame for paying too high a price for financing. And who isn't struggling with cash flow nowadays?
You will hear about thin capitalization or 'thin cap' in reference to debt. Let's imagine that a parent (company A) has succumbed to its daughter's (company B) nagging for extra cash and has decided to lend her money. In a healthy family, the child (company B) would get a better deal than can be found out on the streets, in other words - longer grace periods and repayment terms as well as cheaper interest than the bank around the corner has to offer.
Prior to January 1, 1999, it was a good deal indeed for children, as there was nothing to stop them from taking advantage of full tax deductions for the interest on the cheaply borrowed funds. It all changed after that date when thin capitalization rules were introduced to the Polish Corporate Income Tax (CIT) Act.
Under these rules, the interest on loans could not be expensed or deducted in full from certain companies' taxable incomes. The restrictions applied to family relations defined as parent(s) holding over 25 percent of the daughter's or the sisters' voting power, where parents extended loans to their children, or sister companies borrowed from each other. The tax deduction for interest on such loans was limited to a debt-to-equity ratio of 3:1.
When determining the amount of equity, the borrower's paid-in equity capital was taken into account, excluding debt converted into equity and less contributions in kind of intangible non-depreciable assets (e.g. know-how).
The gist of the situation may be illustrated using our previous example. If parent company A extends a loan to its fully owned subsidiary company B, the related interest expense will be fully tax deductible at the level of B as long as B's debts to A do not exceed three times its equity gauged at the time of each interest payment. Interest on loans which tip the leverage ratio would not be allowed as an expense against B's taxable income.
Thin capitalization rules have evolved since 1999. Under the current legislation, they only apply to loans extended by foreign companies (i.e. entities based outside Poland) and by Polish companies on tax holiday operating in special economic zones. Therefore, genuine Polish families can benefit from tax efficient financing, whereas cross-border relations between Polish subsidiaries and their foreign parents are usually more expensive. As in 1999, the law still makes parental relations (single or multiple parents) contingent on holding more than 25 percent of the daughter company's voting power or that of the sister companies who have the same parent(s).
Moreover, whereas previously the term 'loan' for thin capitalization purposes was not specifically defined, the amended 2004 CIT Act has introduced a rather broad definition, which encompasses deposits and debt securities, including bills and bonds. Coming back to our example, parent company A subscribes for company B's bond issue, the coupon will be subject to thin cap restrictions in the hands of B.
Over the last five years, the Polish thin cap rules have evolved and the scope of their application narrowed down to foreign lenders and Polish companies which carry out business in special economic zones. As the tax deductibility of loan interest is contingent on the origin/nationality of the lender rather than on more objective criteria such as economic merit, investors are effectively discouraged from setting up subsidiaries in Poland. In the case of EU companies looking to invest in post-accession Poland, it could be argued that such fiscal favoritism goes against fundamental freedoms.
Thanks to the establishment of the European Union and its institutions, such as the European Court of Justice (ECJ), the EU member states have means available to tackle such restraints on the freedom of establishment, free movement of capital and other such rudimentary freedoms on which the EU has been founded.
The role of the European Court of Justice (ECJ) in building a truly common European market cannot be emphasized enough. In December 2002, the ECJ ruled on the Lankhorst-Hohorst case which concerned the German provision on shareholder debt financing or 'thin capitalization'.
The plaintiff, Lankhorst-Hohorst GmbH, engaged in trade with accessories for ships and other hardware, had borrowed zł.1.7 million (DM 3 million) at very favorable terms from a Dutch grandparent company and used the funds almost exclusively for the repayment of a more expensive bank credit taken up earlier. Problems arose when the German company claimed a tax deduction for the interest payments made on the loan. The German tax authorities came to the conclusion that a 'thin cap' situation was at hand. Consequently, the interest was classified as a dividend (taxable at 30 percent corporate income tax) and the interest expense was disallowed for tax purposes.
However, the ECJ ruled that the German tax thin capitalization provisions violate European law and more specifically infringe the application of the fundamental freedom of establishment provided for under Art. 43 of the EC Treaty. More specifically, where the tax treatment of interest is differentiated according to the lender's tax residency (German resident vs. German non-resident), it influences investor decisions to carry out business in jurisdictions which appear less attractive as a result.
The above ruling should provide food for thought for the Polish Tax Man and investors alike. As mentioned above, currently the Polish thin capitalization rules only apply to loans received from non-resident lenders or certain Polish companies. Hence, the question: Is that compatible with EC law requirements? remains open.
Donka Darpatova is a tax manager in the Warsaw office of Ernst & Young.
