“When we talk about
attracting investments, economic growth and developing new projects, we usually
discuss the availability of financing. However, we pay less attention to the
question of what happens where businesses make initial investments with their
own funds.
Paradoxically, in
Lithuania, an investor financing a new project with their own funds often faces
barriers created not even by the market, but by the legal and tax system.
This is especially
clearly seen when applying the rules of thin capitalization.
How are new projects
financed?
In practice, a new
project is usually financed by the shareholder himself. Be it a residential
block, a commercial building, a new factory, a logistics center, or another
capital-intensive project.
The usual scheme is
simple: the shareholder provides a loan, and when the project reaches a certain
stage, bank or other external financing appears, which refinances this loan.
The shareholder recovers part of the invested funds and can to direct them to
other projects. That is why a loan for a new company starting a project is
often the most rational form of financing.
An alternative would
be to increase the share (authorized) capital, but in Lithuania, capital
investment often means that funds are locked up for a long time and bound by
legal restrictions. Their recovery depends on complex procedures, creditor
protection mechanisms and formal requirements, the economic logic and legal
validity of which are not always obvious.
It seems that our
Law on Joint Stock Companies is still based on the assumption that formally
recorded authorized capital - a specific special line in the balance sheet - in
itself says something about the company's financial capacity or provides
significant protection for creditors. Practice has long shown that the real
stability and solvency of a company are determined and shown by completely
different factors and indicators.
The interest rate
paradox
Another problem
arises when choosing a shareholder loan. Economically, a shareholder invests in
the hope of a return on capital: dividends, growth in the company's value or a
successful sale of the business in the future. Most often, his goal is is not earned
from interest.
However, tax logic
requires us to look at such financing as a loan. And not just any loan.
Usually, a loan
granted to a company starting its operations, which even has a small authorized
capital, is objectively extremely risky. The project is not yet completed,
assets are often absent or insufficient, and cash flows are not yet available.
Therefore, market principles (which are not relevant for the sole shareholder
in this case) dictate that the interest rate for such external financing should
be with a significant risk premium.
Let's also add the
obligation arising from the corporate income tax law to carry out transactions
between related parties under market conditions and we get a situation where
the shareholder actually has to accrue significant interest on such an initial investment.
He usually does not actually receive this interest, because the company
developing the project does not yet have anything to pay for it. Therefore,
such interest only accumulates in accounting, but from a tax point of view, it
becomes taxable income (profit) of the shareholder.
In short, the
investor already has to pay taxes on returns that have not yet been received.
When the same income
is taxed twice
The problem of
interest does not end there.
Interest accrued in
the company developing the project increases costs, reduces equity and
increases accounting losses. However, the recognition of these costs for tax
purposes usually faces additional restrictions: both the 30% EBITDA rule (which
has its own logic and is certainly not the biggest problem) [1], and (at the
same time) thin capitalization rules, which additionally limit the deduction of
interest paid to related parties from taxable profit.
The result is often
paradoxical:
• the shareholder
must recognize the interest as income and tax it;
• he does not
receive real money;
• the company
developing the project cannot fully recognize this interest as allowed
deductions;
• in the future, the
profit earned by the company implementing the project is taxed again, without
assessing all the real costs it would have.
From an economic
point of view, this is simply a double taxation of the same income flow
taxation. And all this happens before the investment actually starts to pay
off.
Do such rules really
achieve their goal?
The thin
capitalization rules were created for a reason. Their goal is to limit possible
manipulations of the capital structure of companies, artificial reduction of
profits through loan financing (when interest is paid to foreign shareholders,
especially those operating in preferential tax territories), etc.
However, the
question arises whether these goals are achieved when the rules are fully
applied to imaginary interest calculated only due to legal requirements (which
the borrower does not want to pay, and the creditor does not even want to
receive), to intermediary financing companies (I borrow in order to lend on),
financing is not intended for operating costs, for long-term investments, or
simply when the interest is received by the shareholder who pays corporate tax
on them in Lithuania.
In such cases, the
system begins to fight not against abuse, but against the investment itself.
What could be
changed?
First of all, it
would be worth reviewing the thin capitalization rules themselves. The
possibility that exists today to prove that “the same loan under the same loan
conditions would be provided between independent (unrelated) persons” seems
logical in theory. In practice, it often becomes almost unfeasible, because the
justification requires things that do not exist “in nature”.
The situation in
which there is a shareholder financing a business project initiated by
him/herself, and the situation in which there is a bank or an investor who does
not assume business risks and does not claim the return on the project, are
absolutely different. The investor’s interest (and therefore the costs) for a
project at such a stage would often be significantly higher if external
financing were provided at all. However, on the other hand, when a shareholder
(who does not want to receive interest) is still required to declare interest
income in accordance with the “arm’s length” principle for the funds provided,
we forget that circumstance – the form prevails. The assumption that this is
essentially a shareholder’s capital investment (for which interest should not
be calculated), only it is formalized as an interest-free loan, is often not
even considered: interest must be declared even if the same loan would not be
provided under the same loan conditions between independent (unrelated)
persons.
Therefore, if
self-awareness or will to review the application of transfer pricing
requirements is not yet sufficient, it would be worth considering at least
clear and actually effective exceptions to the thin capitalization rules, for
example:
• allow the
deduction of interest paid to a direct shareholder of a legal entity (or at
least – assumedly charged by it) without restrictions, if it is effectively
taxed at the recipient (creditor) level;
• not to apply
restrictions on interest on borrowed and re-borrowed funds that themselves
generate interest income;
• to expand the list
of exceptions in other identified cases where it is obvious that there is no
risk of tax base erosion.
Such changes would
not eliminate protective mechanisms, but would allow them to be applied where
they are really needed.
It is time to
modernize capital regulation as well
Another problem (the
current solution?) lies not even in taxes, but in corporate law itself.
In many countries,
various forms of informal shareholder contributions have long existed, which
are recorded and accounted for as equity (shareholder investment), but can be
contributed and returned much more flexibly than authorized capital. Meanwhile,
in Lithuania, a model is still dominant, in which capital increases and
decreases often become a procedural project in themselves.
Perhaps it would be
worth asking ourselves again whether the concept of authorized capital is the
most appropriate and basic legal way to assess a company's financial capacity
in the 21st century. Does a notarized and registered number really tell you more
about a company's solvency than its real assets, cash flows and financial
capacity? What does it still tell you about a company and what additional
security and clarity do those legal requirements and formalities actually
provide (if at all)?
In conclusion
Today, Lithuania
needs more investment, more risk capital and more businesses ready to start new
projects, and greater turnover of capital itself.
Therefore, it is
worth critically assessing whether the current thin capitalization rules and
the corporate capital regulation model still serve their original purpose or
have already become an obstacle to those who create new economic value.
The fight against
abuse and risk management are necessary, but it is no less important that those
who invest and want to create are not punished at the same time.
The author of the
insight is Dr. Mindaugas Lukas, partner at the law firm "Sorainen"."
1. The 30% EBITDA
rule (interest deduction limitation) is a procedure established in the Income
Tax Law, according to which a company's allowed interest expenses (in excess of
interest income) from income may not exceed 30 percent of taxable EBITDA or EUR
3,000,000.
Basic principles
• Upper limit: The
amount allowed for deduction may not exceed the higher of the two alternatives:
30% of the company's taxable EBITDA or EUR 3 million. [1]
• Excess: Interest
expenses that exceed this limit do not reduce the taxable profit of the current
period, but they can be carried forward to other tax periods indefinitely.
• Scope: The
limitation applies to all interest expenses (paid to banks, related or
unrelated persons), not only internal transactions.
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