Polish equity and debt financing regime in the light of neutrality principle, EC tax law and ECJ case-law

• Author: Włodzimierz Nykiel; Ziemowit Kukulski; Michał Wilk
• Pages: 1-18

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1. Introduction

Shareholders¹ may generally choose between two different methods of company’s financing: equity or debt. As a result, the differences between the taxation of dividends and interest payments rise the question whether or not the Polish legal framework guarantees a sufficient level of internal and external neutrality. Internal neutrality assumes similar tax treatment of equity- and debt-financing whereas external neutrality – equal treatment of domestic and foreign-sourced income of the same type². In addition, this paper will focus on the tax aspects of debt and equity financing relevant to EU primary and secondary law and ECJ case law.

2. General description of the Polish equity and debt financing tax regime

Poland uses a classic system of dividend taxation.

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According to the Corporate Income Tax Act (hereinafter: the CIT Act)³ in purely domestic situations dividend payments are subject to a final withholding tax of 19%.⁴ In contrast, resident companies receiving foreign-sourced dividends are obliged to add them to income from other sources (the worldwide taxation principle). In order to eliminate juridical double taxation in this case, Poland grants an ordinary tax credit on per-country basis.⁵ These rules do not apply to dividend distribution made by subsidiaries which are residents of the EU, the EEA and Switzerland. Under Polish domestic tax regulations implementing the Parent-Subsidiary Directive (hereinafter: the PSD)⁶ Polish resident parent companies receiving dividends from its UE, EEA and Swiss subsidiaries are fully exempt from tax in Poland. The full exemption applies also in cases where the dividend payment is made by a Polish subsidiary to its UE, EEA or Swiss parent company – according to the provisions implementing the PSD, dividends and other profit distributions are fully tax exempt at source if certain conditions are met. In all other situations domestic-sourced dividends paid by a resident company to foreign recipients are subject to a final withholding tax of 19%. Nevertheless, this rate is reduced by virtue of double taxation conventions. Tax treaties concluded by Poland follow the Article 10 of the OECD Model Tax Convention, which means that the rate of withholding tax on outbound dividends may not exceed 5% (in the case of corporate recipients owning at least 25% of shares in the distributing company) or 15% (in all other cases) of the gross income. Under some treaties the single rate of 10% applies instead of two different rates.⁷

Individual resident shareholders receiving domestic and foreign-sourced dividends are subject to a final withholding tax at the rate of 19%. Also Polish-sourced dividends paid to non-resident shareholders are subject to a finalPage 3 withholding tax at the rate of 19%, unless a treaty provides otherwise.⁸ This uniform tax system regarding foreign and domestic capital income was introduced in 2005 as a consequence of the ECJ rulings in the Lenz ⁹ and Weidert-Paulus¹⁰ cases.¹¹ As far as individuals are concerned the juridical double taxation is also relieved by ordinary tax credit granted on per-country basis. Rules concerning the taxation of interest in Poland guarantee both the internal and external neutrality. Interest is subject to a final withholding tax at the rate of 20% in case of corporate recipients¹² and at the rate of 19% in case of individuals¹³. Interest paid to non-residents (both corporate and individuals) may be taxed at a reduced rate if a tax treaty concluded with the country of recipient’s residence provides so. Then the withholding tax on interest would normally not exceed 10% of the gross income. Under some tax treaties this rate is reduced to 5%¹⁴ or even to 0%¹⁵ - provided that certain conditions set by the tax treaty are met. Resident recipients of foreign-sourced interest are entitled to an ordinary tax credit on per-country basis – as in the case of dividends.

Poland as a EU Member State has implemented respective provisions of the EC Interest and Royalties Directive (hereinafter: the IRD)¹⁶. However, according to the Council Directive 2004/76/EC of 29 April 2004 introducing the transitional periods referring to the application of the provisions of IRD¹⁷, within the period ofPage 4 1 July 2005 and 30 June 2009 Poland was entitled to levy a withholding tax on interest at the reduced rate of 10%. From 1 July 2009 to 30 June 2013, this rate is reduced to 5%. Full exemption will be available thereafter. The reduced rate of withholding tax applies to interest paid between two companies regarded as “associated” within the meaning of the IRD.

Contrary to dividends, interest is fully tax deductible from the debtor’s taxable profits. This means that the problem of economic double taxation, which occurs in case of dividends, does not exist if there is an interest payment made by a company to its shareholders. It constitutes a huge advantage of debt financing over equity financing. But the deductibility of interest may be limited in all those cases where domestic thin capitalization rules apply. The impact of these rules will be examined in the subsequent part of this report.

3. Tax consequences of different types of shareholders’ loans and different types of loans made by subjects other than a company’s shareholders

3.1. The limitation of deductibility of interest paid to shareholders

Polish tax system does not provide for any differences in taxation of interest arising from various types of loans granted to the company by resident or non-resident shareholders. There are no regulations concerning hybrid financial instruments which blend the elements of equity and debt financing regimes (hidden profit distribution). Common examples of such instruments cover inter alia profit participating loans, convertible bonds, back-to-back loans, guaranteed loans and perpetual debts¹⁸. These instruments are often used by taxpayers as the way of reducing tax burden (tax avoidance). Polish domestic tax law containsPage 5 no specific rules limiting deductibility of interest arising from such loans or allowing the re-classification of these payments into dividends for tax purposes. In the Test Claimants in the Thin Cap Group Litigation case¹⁹ the ECJ held that domestic rules allowing the re-classification of interest violate the freedom of establishment (Art. 43 of the EC Treaty), especially if they are addressed only to non-residents and the interest-bearing loan was higher than the company’s paid-up capital plus taxed reserves. In this area Polish tax system is in concordance with the EC law and the ECJ case law, because, as mentioned above, there are no rules under which re-classification is allowed. Even domestic thin capitalization rules follow this requirement.

In Poland also the general anti-avoidance clause against circumvention or abuse of tax law has a very limited effect on interest payments from any form of hybrid financial instruments. The introduction of such clause in 2003 was widely criticized by the Polish doctrine and judicature as it implies the possibility of broadening interpretation of tax law provisions.²⁰ For these reasons the general anti-abuse clause was found unconstitutional by the Polish Constitutional Tribunal in the judgment of 11 May 2004 and then abolished²¹. After that ruling the new version of the general anti-abuse clause was introduced into the General Tax Act²² in Art. 199a, according to which tax authorities are no longer entitled to omit the effects of legal actions undertaken by taxpayers; this right is now reserved only to courts. The application of the general anti-abuse clause as an instrument limiting the deductibility of interest from hybrid financial instruments shall be seen only as a potential threat. By and large, the existence of suchPage 6 clause does not violate the freedom of establishment. In its decisions in the Cadbury Schweppes case²³ and the Thin Cap Group Litigation case²⁴, the ECJ emphasized that the need to prevent tax avoidance might justify restrictions concerning the freedom of establishment especially when taxpayers undertake wholly artificial arrangements designed to circumvent the legislation of the respective Member State. In the ECJ’s opinion, the mere fact that a loan is granted to a resident company by a related company resident in another Member State does not mean that a circumvention of the former Member State’s legislation appears. This fact cannot be a basis for a general presumption of an abusive practice and cannot justify the restriction²⁵.

3.2. The conformity of the Polish thin capitalization rules with the EC law and the ECJ case law

When analyzing tax consequences of loans made by shareholders and by subjects other than a company’s shareholders it is important to focus on thin capitalization rules (hereafter: TCR)26...