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Spain: Supreme Court provides guidance on thin capitalisation rules

Traditionally, the application of thin capitalisation rules has triggered a number of questions which have been extensively debated by tax commentators. Some of them have been clarified by the Spanish courts or the Directorate-General of Taxes in various rulings, but some others have remained open to discussion.

Two Supreme Court judgments, both rendered in the course of 2011 (March 17 and November 2, respectively), have provided interpretation guidelines on two of those controversial issues relating to the application of the thin capitalisation rules, namely:

  • The compatibility of the domestic thin capitalisation regulations and the non-discrimination clause contained in tax treaties; and
  • The delimitation of the concept of indirect indebtedness in cases where the related party is not the lender but the guarantor of the loan.

Thin capitalisation and tax treaties

A previous judgement of the Supreme Court, dated October 1 2009, had already declared the incompatibility of the thin capitalisation rules with the non-discrimination provisions contained in the Spain-Netherlands tax treaty. Based on article 26.4 of that treaty, the court held that a Spanish-resident borrower, the capital of which was owned by a Dutch resident lender, received a more adverse treatment than a Spanish entity in the same situation which received a loan from a Spanish shareholder.

The 2011 judgments follow the same line of reasoning and reach the same conclusion, although they refer to a case involving a Spanish entity that was indebted to its Swiss-resident parent.

From a practical standpoint, the importance of these new judgements could somehow be downplayed due to the Spanish authorities' tendency to negotiate the inclusion of provisions in the new tax treaties expressly establishing the compatibility of the domestic thin capitalisation rules and the non-discrimination principle.

Another remarkable aspect of these judgements is that the Supreme Court seems to take the view that article 9 (associated enterprises) of the tax treaties should prevail over domestic thin capitalisation rules. Hence, the tax authorities could only adjust the profits of a resident company if they proved that its commercial relations with an associated enterprise of the other contracting state were not arm's length.

Indirect indebtedness

Thin capitalisation rules are worded so as to cover situations of both direct and indirect borrowing. Whereas the direct indebtedness is a clear-cut concept, the reference to indirect borrowing has led to technical discussions aimed at delimiting its meaning and scope.

It has generally been accepted that certain types of back-to-back loans could be labelled as indirect borrowing for thin capitalisation purposes.

One situation that has generated certain controversy is where the foreign related party is not the lender in the loan contract but simply provides guarantees in favour of the third-party lender.

In two rulings dated March 30 1998 and June 20 2001, the Spanish Directorate-General of Taxes held that the granting of guarantees by a non-resident related entity and the consequent assumption of the obligation to pay the debt in case of insolvency of the debtor could be construed as a situation of indirect borrowing.

According to those rulings, for the thin capitalisation rules to apply to that indirect borrowing, the specific circumstances of the case must be examined, such as the likelihood of the debtor's being adjudged insolvent or the arm's length nature of the guarantees provided.

Interestingly, the Supreme Court judgment of March 17 2011 went further in the interpretation of indirect borrowing in cases of related-party guarantors. In the court's view, when applying the thin capitalisation rules, regard should be had to their intrinsic nature as an anti-abuse provision aimed at preventing the erosion of the Spanish tax base by transferring taxable profits to a related entity of another jurisdiction.

The Supreme Court held that there was no such transfer of taxable profits from Spain to another country in the case under analysis, since the simple granting of guarantees by the Swiss parent had not resulted in taxable profits being shifted from Spain to Switzerland. On those grounds, the court rejected the application of the thin capitalisation rules.

In summary, the tax authorities should do more than just prove the existence of a guarantee from a non-resident related party to make use of the thin capitalisation mechanisms. Among other aspects to be taken into account, the authorities should prove that the parties have inappropriately (such as on conditions that are not arm's length) eroded the Spanish taxable income by transferring such income to a related party in a foreign jurisdiction.

Francisco Lavandera (

Garrigues is the Spanish member firm of Taxand

: + 34 93 253 37 00

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