Tax Leverage: Shareholder's Loans Under Surveillance

• Published date: 27 November 2020
• Subject Matter: Corporate/Commercial Law, Tax, Tax Authorities, Shareholders
• Law Firm: Mayer Brown
• Author: Mr Benjamin Homo and Nicolas Vergnet

1. Introduction

For several years now, the French tax administration has been paying growing attention to intragroup financing strategies. Numerous litigations arose around the issue of the tax deduction of interest charges paid to related parties, with particularly acute impacts for companies involved in leveraged buy-out transactions. Indeed, in such debt-financed deals, the junior financing raised by the acquisition vehicle is often borrowed at least in part from the shareholders and investors. Furthermore, the very nature of this financing is to bear interest at a rate higher than bank loans, since it is specifically designed to supplement these loans, pushing the leverage level beyond what financial institutions have granted.

In light of the ever-growing number of disputes, setting up strong supporting documentation to secure interest rates applied on shareholders' loans has become a key requirement. Indeed, as a reminder, the tax deductibility of intragroup financial expenses incurred by French corporate taxpayers is in principle capped to a rate set by tax regulations (ca. 1.2% in 2020), unless the group can evidence that the interest rate effectively applied matches the rate that would have been obtained from an independent financial institution or entity in similar circumstances.

2. Initial Litigations: The "impossible proof" quandary

The burden of proof laid on taxpayers was initially made an ordeal by a number of tax audit departments, who demanded that companies provide a firm and binding financing offer from a bank, contemporaneous to the shareholder's loan implementation. According to these audit services, this was the only way by which a taxpayer could prove that the interest rate applied on the loan indeed matched the rate it would have obtained from a financial institution. Yet in most instances no such offer is sought at the time of the transaction, partly because the junior financing under consideration is precisely used to supplement the bank loans and increase the financial leverage beyond what the financial institutions have agreed to fund, but also - and mainly - because seeking such an offer would involve negotiations and efforts too onerous to be carried out solely to support an intragroup financing decision.

Lacking such binding offers from financial institutions, taxpayers usually resorted to financial experts to provide studies allowing to identify the rates applied on the financing market for borrowers with similar risk...