The question of whether a particular instrument should qualify as debt or capital under Belgian (tax) law is sometimes a heavily debated issue. Since the 1950s Belgian courts have rendered numerous decisions on the qualification of hybrid instruments as the Belgian tax administration disagreed on the legal qualification given to instruments by its issuers and investors. As a growing number of innovative financing instruments are continuously unleashed to the market, the debate on the debt or capital nature of hybrid instruments remains unsettled.
Like most jurisdictions, Belgian law provides for a different tax treatment of debt and capital. The most essential distinct features are:
- While dividends paid by companies subject to Belgian income tax are not tax deductible, at-arm's-length interest payments on debt instruments such as loans constitute tax-deductible expenses;
- While 95% of dividends received by companies subject to Belgian income tax is upon certain conditions exempt from corporate income tax, received interest payments shall be fully subject to corporate income tax;
- While interest is subject to a 15% domestic withholding tax, dividends will usually benefit from the 0% withholding tax rate provided that they are distributed to another EU company (the Belgian domestic withholding tax rate on dividends is currently at 25%); and
- While a contribution into the share capital of a Belgian company will in principle entail a 0.5% capital tax (exemptions apply within the EU), no such tax is levied on loans granted to Belgian companies.
In order to benefit from the tax deductibility of interest payments, borrowing entities have an interest in qualifying instruments as debt rather than capital. As a general principle in Belgium, civil and accounting law determines the legal qualification of an instrument as loan or capital. The Belgian tax administration will be bound by such qualification unless the Belgian tax law provides for an explicitly deviating definition or if the tax administration succeeds in demonstrating simulation.
To prove that a loan is simulated, the tax administration will need to demonstrate that the parties did not have the intention to accept all legal particulars of a loan and that the underlying features of the transaction correspond to the constitutive elements of capital, rather than a loan.
The Belgian tax administration traditionally challenges the qualification of an instrument as a loan if the creditor is perceived to have had the intention to participate not only in the profits but also in the losses of its debtor. In the past, the following features were referred to in demonstrating the capital nature of the loan:
- Absence of any maturity date for reimbursement of the funds;
- The loan's subordinated character;
- Exercise of a certain degree of control by the creditor over the debtor (voting rights, direct shareholding between creditor or debtor);
- Insufficient capitalization of the debtor to pursue its corporate objects;
- The funds were provided to the debtor without any guarantees or security;
- Payments to the lender were subject to the availability of net profits; and
- Involvement of the lender in the borrower's core business.
Even though the position of the tax administration cannot be dismissed as entirely unsustainable, the Belgian Supreme Court has at several occasions proven very reluctant to re-characterize loans as capital. This is despite the apparent demonstration by the tax administration of several of the above features, as is also demonstrated by two rather recent court cases.
In the case of Société Anonyme D versus the Belgian Minister of Finance (Brussels, May 25 2001) a Bfr 6 million loan bearing interest at an annual rate of 10% was granted by the debtor's eight shareholders only seven days after the incorporation of that debtor. Interest payments were due annually. However, if the debtor did not generate sufficient profits in a given year to cover the interest, it could defer the payment of interest due for that year until sufficient profits were generated by the debtor. If, upon repayment, the debtor's profits would not be sufficient to pay the aggregated outstanding interest, the interest rate would be decreased to match the shortfall. The debtor's share capital amounted to Bfr 1,280,000.
About six months after incorporation, the debtor acquired real estate for the amount of Bfr 6 million. During the third year after incorporation, the real estate was sold for Bfr 9,800,000 and an interest payment of Bfr 1,800,000 was made to the eight shareholders.
The tax authorities argued subsequently that the debtor's share capital was not sufficient for it to pursue its corporate objects (the acquisition of the real estate) and that therefore the loan was to be considered as capital. However, the court denied re-characterization as the tax authorities did not succeed in demonstrating that the parties had never had the intent to accept all legal particulars of a loan and that the transaction did feature the constitutive elements of a capital contribution. Additionally, the court confirmed the principle that, provided no legal obligations are breached, taxpayers may endeavor to reduce the tax burden using their contractual freedom to enter into transactions of which they accept all legal consequences.
In a second case (Brussels, June 13 2001), a German parent company contributed DM 50,000 to the share capital of its newly incorporated German subsidiary, which was engaged in managing real estate. A few days after the German subsidiary's incorporation, the parent company granted a DM 20 million loan to the subsidiary to buy real estate in Belgium. The terms of the loan were not conclusively documented and no specific guarantees were issued. In addition, the subsidiary had not paid interest during the term of the loan. Three years after the incorporation of the subsidiary, the total amount of the loan (outstanding interest included) was contributed to the subsidiary's share capital.
As the Belgian real estate constituted a Belgian permanent establishment of the German subsidiary, the rental income generated was subject to taxation in Belgium. Consequently, the subsidiary would be entitled to offset the rental income from the real estate with the interest payable under the loan (based on the allocation of the loan to the Belgian permanent establishment). The tax administration denied, however, the interest deductions, arguing that the loan was in fact a simulated capital contribution as of the onset. According to the tax administration, the loan structure was only set up for the purposes of reducing the (taxable) profit generated by the real estate.
In this case, the court also concluded that the tax administration did not demonstrate that the loan was simulated. As before, it confirmed the principle that taxpayers are free to organize their activities in the most tax-efficient way, as long as they do not breach any legal or contractual provisions.
The principles confirmed by the above court decisions are in line with previous Belgian jurisprudence on this matter and may lead to the conclusion that the chances for a successful re-characterization of a loan into capital on the basis of simulation under Belgian law are remote. The reluctance of the courts to re-characterize a loan into capital, however, does not entail a license for market practitioners to freely denominate, at their discretion, the nature of the transaction. Creditors and debtors will need to carefully consider whether the particular financing transaction does not meet the above conditions of simulation.
Enrico Schoonvliet, Loyens Brussels and Jan Van Gompel, Loyens New York