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Dividends as debt capital?

Dividends as debt capital?

It is well known that a loan granted by shareholders to a corporation can be converted into equity under certain circumstances. New to Austrian case law is the fact that a dividend distributed by a corporation to a shareholder may be converted into interest. 

The Federal Finance Court (Bundesfinanzgericht, BFG) ruled on this issue earlier this year (RV/4100371/2017), based on the following facts: the subsidiary PLC issued preference shares to its parent company as part of a capital increase. The parent company in turn sold these shares to the complainant, an Austrian limited liability company (“Bf”). The contractual situation between the subsidiary PLC, the parent PLC and Bf was structured so that the economic risk of the complainant with regard to the preference shares was minimised. For example, the parent company assured the complainant that it would always provide the subsidiary with sufficient financial resources to enable it to duly pay the special dividend promised to the complainant. However, the complainant was also entitled to dividends in excess of the special dividend. Similarly, the complainant granted the parent PLC a call option regarding the preference shares. Because the parent PLC in turn granted the complainant a put option, the complainant could sell the preference shares to the parent PLC at an agreed price within a certain time window in accordance with the option terms. Finally, in the event of the liquidation of the subsidiary company, the complainant’s claims would be satisfied ahead of its ordinary shareholders. The dividends distributed by the subsidiary PLC to the complainant were classified as tax-free investment income, while at the subsidiary company the dividends were treated as a profit-neutral use of income. 

In the course of a tax audit it was found, however, that the preferred shares at issue in the proceedings were not to be regarded as profit participations, since “from an overall assessment of the contracts with the ancillary agreements regarding the agreed redemption guarantees or the put options granted, it emerges from an economic point of view pursuant to section 21 of the Federal Fiscal Code (Bundesabgabenordnung, BAO) that this is not equity capital but debt capital. From a true economic point of view, the respective investor was assured fixed interest income (without participation in hidden reserves or goodwill) on the basis of the redemption guarantees or the put option. But the concept of profit participation is thereby entirely lost.” The tax audit thus concluded that interest paid under the title of dividends constituted interest income or income equivalent to interest for the recipients. This view was also shared by the adjudicating authority. 

The essential question was whether the reinterpretation of the dividend payments as interest was justified on the basis of the economic approach. If so, the interest would in principle be taxable income from capital assets for the complainant (section 27 (2) 2 Income Tax Act (Einkommensteuergesetz, EStG). The aim of the “economic approach” is to focus on the true economic content of the facts and not on their formal legal form when assessing questions under tax law. Because this is intended to take account of the principle of uniformity of taxation, the content, not the chosen form or designation, of a legal relationship is thus essential. 

In the case in question, the authority concluded that from a formal point of view the complainant held an interest in the subsidiary’s equity capital in the form of preference shares. Debt capital was deemed to exist by the authority from an economic point of view, because the risks typically associated with equity capital were excluded in favour of the complainant by agreements. Despite the corresponding tax and accounting treatment of the distributions as “dividends”, they were to be treated as interest according to their true economic content. 

However, the Federal Finance Court did not agree with this view. Although the court recognised the minimisation of risk from preference shares in favour of the complainant, this was an agreement made under private autonomy, which was neither an abuse of rights nor a violation of the principle of equal taxation. The “preferential position” of the complainant compared to the ordinary shareholders in the event of a liquidation was a clear sign of outside capital (for example, in the event of a company’s insolvency, creditors have priority over capital holders). Participation in the dividends exceeding the special dividend was given particular weight when the case was viewed as a whole. 

The put option (as well as the other repurchase obligations of the parent company) was not decisive for the Federal Finance Court. Even if the complainant was allowed to sell the shares to the parent company via the put option, this only changed the ownership of the shares, but not their legal status. Since there is no legal precedent from the highest courts on the central question of whether a reinterpretation of dividend payments as interest is permissible from an economic perspective, the Federal Finance Court agreed to allow an ordinary appeal to the Administrative Court. It appears, however, that the tax authority did not file an appeal. 

Summary 

The Federal Finance Court’s decision is welcome from a practical point of view. This is because the Stock Corporation Act (Bundesgesetz über Aktiengesellschaften, AktG) expressly permits the issue of non-voting preference shares. One of the main advantages of preference shares is a higher dividend. Contractually guaranteed special dividends coupled with obligations to pay such special dividends are not uncommon in practice. A qualification of such preference shares as debt capital and thus of the dividend payments as interest would be accompanied by increased legal uncertainty. 

Nevertheless, the tax component must not be disregarded when structuring agreements regarding preference shares (or similar equity instruments). This is because the Federal Finance Court also arrived at its ruling only after conducting an overall assessment of the circumstances. Conversely, it can be assumed that under certain circumstances equity instruments such as preference shares could be reinterpreted as debt capital. 


AUTHOR:

Mag. Daniel Kocab, LL.M., Attorney-at-Law at LGP

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