CJEU: The tax authority can charge tax on non-existent interest

The Court of Justice of the European Union (CJEU), in its judgment of 24 February this year, case C-257/20, ruled that Article 1(1) of Directive 2003/49 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States, in conjunction with Article 4(1)(d) of that Directive, Article 5 of Directive 2011/96 on a common system of taxation applicable to parent companies and subsidiaries of different Member States, Articles 3 and 5 of Directive 2008/7 concerning indirect taxes on the raising of capital, and Article 63 of the Treaty on the Functioning of the European Union (TFEU), read in light of the principle of proportionality, must be interpreted as not precluding national legislation which provides for the taxation by way of withholding tax of fictitious interest that a resident subsidiary company, which has benefited from an interest-free loan granted by a non-resident parent company, would be obliged to pay to that parent company on an arm’s length basis.

In its judgment of 24 February this year, case C-257/20, the CJEU confirmed that tax authorities have the right to demand the payment of withholding tax on interest which should have been due on an interest-free loan but was not paid. According to the CJEU, the tax authorities may also determine the amount of such interest on an arm’s length basis.

Facts of the Case

In the case at hand, a company based in Bulgaria received an interest-free loan from a foreign shareholder. The loan agreement provided for a 60-year repayment term and extinguishment of the obligation if the company’s share capital was increased by the equivalent amount of the loan.

After establishing that at the time of the tax audit the loan had not been converted into share capital, and that the borrower neither repaid the loan nor paid interest, the tax authority found the existence of a transaction resulting in tax avoidance within the meaning of Article 16(2)(3) of the Bulgarian Corporate Income Tax Act (CITA). The tax authority determined the market interest rate, on the basis of which the unpaid interest was calculated, and subsequently imposed a 10% withholding tax on that amount.

The company appealed against this decision, and on 20 December 2017, the defendant in the main proceedings dismissed the appeal.

By judgment of 29 March 2019, the Sofia Administrative Court, to which the company brought a complaint challenging the legality of the decision dated 16 October 2017, dismissed the complaint, holding that the disputed loan constituted a financial asset of the company generating a gain due to non-payment of interest, whereas the lender incurred a financial loss due to non-receipt of interest. According to this court, the loan amount was used to repay certain financial liabilities of the borrower referred to in the loan agreement and therefore did not constitute equity capital.

The company lodged a cassation appeal before the referring court, the Varhoven administrativen sad (Supreme Administrative Court of Bulgaria), seeking to annul that judgment.

Reasoning of the CJEU

The CJEU found that the national regulation does not constitute a restriction on the free movement of capital guaranteed by Article 63 TFEU. The Court noted that a distinction must be made between differential treatment permitted under Article 65(1)(a) TFEU and arbitrary discrimination prohibited under Article 65(3) TFEU. Case law of the Court shows that for national tax provisions such as those at issue to be compatible with the provisions of the TFEU on free movement of capital, the differential treatment must relate to situations which are not objectively comparable or be justified by overriding reasons of general interest [see similarly judgment of 18 March 2021, Autoridade Tributária e Aduaneira (Capital Gains Tax on Real Estate), C-388/19, EU:C:2021:212, para. 35].

According to the Court, in the present case, Bulgaria chose, by way of the disputed national rules in the main proceedings, to exercise its tax competence in respect of interest-free loans between borrower companies resident in Bulgaria and lending companies not resident in Bulgaria, and consequently, non-resident companies must be considered, for costs directly connected with such loans, to be in a comparable situation to resident companies.

Furthermore, the Court held that resident companies granting interest-free loans obtain a financial benefit compared to non-resident companies granting such loans, arising from the different timing at which they may deduct costs directly associated with that loan. The extent of this benefit is determined by the duration of the refund procedure established by the disputed national regulation, enabling non-resident companies to apply for a recalculation of withholding tax levied on the gross amount of fictitious interest on the interest-free loan, so that that withholding corresponds to the corporate income tax that would have been paid by the resident company granting the loan.

In these circumstances, the Court concluded that the differential treatment regarding the taxation of fictitious interest on interest-free loans depending on whether the loan is granted by a resident or non-resident company is not limited to the method of tax collection. Accordingly, such differential treatment concerns objectively comparable situations.

The Court agreed with the defendant that, pursuant to the territoriality principle, Member States have the right to tax income generated on their territory in order to ensure a balanced allocation of taxing powers. In particular, in the absence of harmonising provisions adopted by the Union, Member States retain the power to determine criteria for allocating their taxing powers. The objective of the national rules is to combat tax avoidance.

The Court concluded that the provisions providing for withholding tax on fictitious interest on interest-free loans granted by non-resident companies to resident companies are appropriate to ensure a balanced allocation of taxing powers between Member States and to guarantee the effectiveness of tax collection aimed at preventing tax avoidance.