A recent ruling from the Supreme Administrative Court (“SAC”) (KHO:2024:103) indicates that the pledge of a receivable by a related party as collateral for a bank loan of another related party does not necessarily change the character of the bank loan to a related party loan for tax purposes.
Interest deductibility limitation rules in a nutshell
For Finnish corporate income tax purposes, interest expenses paid on external loans are treated more favourably compared to interest on related party loans. Net interest expenses incurred on external loans are always tax-deductible up to EUR 3m per year, whereas there is a general threshold of EUR 500k for related party loans (including also the 25% EBITD rule).
The interest deductibility limitation regime can be viewed as targeted anti-avoidance rules which aim to discourage debt arrangements designed to minimise taxation. The regime also includes a provision regarding the tainting of external loans with the purpose of preventing companies from circumventing the EUR 500k deductibility threshold via certain back-to-back arrangements. Under this provision, an external loan may become tainted and thus reclassified as a loan taken from a related party in circumstances where such external loan is, for example, secured by a receivable pledged by a related party as collateral for the loan. The definition of receivables includes in this context both intragroup and external receivables such a trade, hedging or insurance receivables, but also bank accounts which are technically receivables from the account bank.
Circumstances of the case
A Finnish real estate company had taken out a bank loan. As per market practice, the company had placed an extensive pool of assets as collateral for the loan. The security package included, among others, the company’s own (directly held) real estate, shares in other real estate companies, loan receivables from real estate companies and the company’s bank account. In addition, the parent company guaranteed the bank loan through various pledge and collateral arrangements. The collateral granted by the parent company included, notably, a receivable owed by the company to the parent company.
The company applied for an advance tax ruling from the Central Tax Board (“CTB”) asking, among others, whether the bank loan could to some extent be viewed as a related party loan for interest tax-deductibility purposes due to being secured by a receivable pledged by a related party as collateral. The company argued that the pledged receivable had no real collateral value given that it was subordinated to the bank loan (i.e., there can be no recovery under the receivable unless the bank is made whole first). The company also argued that it is market practice to include intragroup receivables into the security package due to this facilitating the realisation of the pledged assets upon enforcement, i.e., the intention of such security is not to realise collateral value from the pledged receivables but to make enforcement of other collateral easier. Further, the company also highlighted that the value of other assets in the security package, namely the real estate and the shares in the real estate companies, already provided for full security for the bank loan (with some 50% over-collateralisation).
The CTB accepted the arguments put forward by the company and ruled, in principle against the express wording of the law, that the bank loan should not be viewed (reclassified) as an external loan for interest tax-deductibility purposes. The SAC later agreed with the reasoning of the CTB and upheld its decision.
Current financing practice
The wording of the law regarding the tainting of external loans has created difficulties and challenging negotiation issues regarding security packages for bank loans. These issues have largely been addressed by: (i) not granting security over receivables at all; (ii) having only borrowers grant security over their own receivables to secure their own direct borrowing obligations only; or (iii) having all borrowers and guarantors grant fully cross-collateralised security over all receivables in which case the borrower has taken the tax risk of the bank loan being reclassified as a related party loan.
Impact of SAC’s decision and looking ahead
The decision is significant due to the SAC having deviated from the express wording of the law in favour of a more deemed purpose of the law. Despite the wording of the law, the SAC considered that the bank loan should not be reclassified as a related party loan for interest tax-deductibility purposes when (i) the receivable pledged had no real collateral value; (ii) other assets pledged provided for full collateral value for the bank loan; and (iii) funds were not channelled through a third party in order to benefit from a more favourable interest tax-deductibility regime.
While all cases should be analysed based on their own merits, going forward it should perhaps be a little bit easier for companies to assess their interest tax-deductibility position based on this case. Clearly, borrowings from banks are hardly ever done for the purposes of circumventing the interest deductibility limitation regime and the banks aim to get as broad a security package as possible. The case does, however, still leave room for interpretation especially as regards the extent to which weight should be put on the collateral value of pledged receivables and other assets pledged versus the circumvention consideration. It also needs to be noted that the SAC’s decision did not address security granted by group companies over bank accounts or other external receivables at all.
That said, while the situation still remains unclear, the SAC’s decision can be considered a breath of fresh air as it brings the interpretation of the interest tax-deductibility rules closer to the commercial reality. Time will tell whether the case could shift market practice towards lenders more aggressively requiring that all receivables be part of the security package without any carve-outs.