Withholding tax issues on Facility Agreements: traps for the unwary
The basic position on withholding taxes in LMA facility agreements is often summarized by saying that the borrower only takes the risk of change of law – i.e. it does not need increase the withholding tax unless the law changes. As a result, it may be tempting for borrowers, when negotiating such clauses, to focus on putting in place standard “LMA-eligible lender” provisions – assuming this is the only protection they need. . However, in our experience, and as the law regarding withholding taxes becomes increasingly complex, there are a number of points that borrowers should bear in mind and where negotiation and/or a clear understanding of the obligations under the facility agreement are essential.
1. Don’t forget to submit your papers! – Procedural requirements
Borrowers must be satisfied that all conditions for exemption from withholding tax are met. In certain situations, a borrower may not be permitted to pay interest to an eligible lender without withholding tax until certain procedural requirements have been met. These procedural requirements vary by jurisdiction and may seem like technicalities. However, failure to complete these steps (or fail to allocate the risk that they are not completed on time) could mean not only that interest payments could be subject to withholding, but that the borrower may also be required to increase.
2. Upcoming Legislative Change – The Unshell Directive
The European Commission has published a proposal aimed at preventing the misuse of fictitious entities for the purposes of tax evasion and evasion (the Shell Directive) and it seems likely that it will be adopted in one form or another this year, with effect from January 1, 2024.
Under facility agreements, the classification of a lender as a “fictitious entity” under these rules may mean that it ceases to be an eligible lender (because it would no longer be entitled to benefits tax treaty or EU exemption) . Since this loss of qualified lender status would result from a “change in law”, if no change is made to the standard “LMA” risk allocation, it would be borrower this entails the risk that the lender will be treated as a fictitious entity under these rules and that the borrower may find itself forced to mark up payments to the fictitious entity.
3. Who is the beneficial owner of interest payments?
To benefit from an exemption from withholding tax (or a reduced rate of withholding tax) under tax treaties or the European Interest and Royalties Directive, a lender must generally be the “beneficial owner”. interest payments. The current climate has led tax authorities to focus more on the identity of the beneficial owner of the interest and “beneficial owner” is interpreted by both courts and tax authorities to have meaning beyond the traditional legal meaning, drawing on the anti- avoidance notions.
Borrowers should carefully consider whether a lender’s structure could mean that its ability to rely on an exemption or treaty could be challenged by a tax authority based on the beneficial ownership requirement. What confirmations does a borrower need to be able to pay without deduction – and what happens if they are wrong? What happens if there is an under-participation? These points are often not clearly dealt with if the provisions of the “LMA standard” are used.
4. Problems created by the Borrower’s group structure
Withholding tax exemption challenges may also arise in the context of borrower group financing structures where third-party financing is provided to a holding company with limited activity and then transferred through intra-group loans to another entity of the borrower’s group located in a different jurisdiction (for example, a parent company located in country A borrowing externally and lending to a subsidiary located in country B).
If a tax authority were to argue that the external lenders were the beneficial owners of the loan to the subsidiary, would the parent be able to obtain information/documentation from the lenders to help mitigate the withholding that would occur otherwise ? Is there a risk that Country B imposes a withholding tax on payments made by the parent company in Country A based on the source of payment? How is this handled in the facility agreement? These are points that require both technical analysis and thoughtful trading to be dealt with effectively.