Pitfalls of debt-to-equity swap in Polish tax law
August 9, 2021
When a loan to a subsidiary becomes problematic?
A newly formed company can be typically financed solely by the share capital or also additionally by loans from shareholders. From a point of view of a parent company, setting up a subsidiary with a large share capital is commonly considered as an investment and for this and other reasons usually not a preferable option. Setting up a subsidiary with a more modest share capital and financing it by loans from shareholders usually seems like a more flexible solution to start with. Depending on business development a loan can be paid back sooner or later, and interest can be treated as deductible cost. But what if the business goes slow and the loan becomes a more permanent fixture rather than a temporary solution. Although, by mutual agreement, a loan can be extended for indefinite time, from a point of view of a parent company it may become problematic over time. Especially if auditors question such loan as an equity a write-off may be necessary.
Debt-to-equity swap as a solution.
A natural solution to this problem is a debt-to-equity swap. By this operation we increase a share capital of a company in exchange for a capital contribution in form of a claim resulting from the loan. The loan amount becomes share capital, and the loan position disappears from accounting ledgers. While such conversion is a relatively simple operation consisting of resolution of shareholders and registration at the business registry, tax implications for involved parties may be severe.
Differentiation between the principal and interest.
The aim of a debt-to-equity operation is to convert the whole loan position into share capital. It typically includes the principal and the interest (also capitalized costs). Polish law provides a different tax treatment of these two components.
Taxable income for a shareholder.
As a rule, an acquisition of shares for an in-kind contribution generates taxable income for the purchaser of new shares. This income is equal to the par value of the shares. It is however possible to deduct the principal loan amount from this income as a deductible expense (Art. 15 point 1j, item 2a CIT). There are two conditions to be met:
• the right to deduct costs is limited to the value of the loan transferred to the company’s bank account. This means that the right to deduct does not apply to interest and capitalized interest;
• the loan amount needs to be transferred to the bank account of the company by the same entity that obtains new shares. This means that deduction of principal amount from taxable income does not apply in situations where a loan was a subject of an assignment agreement.
Shareholder being a foreign entity.
In case of foreign shareholders, potential taxation of income from a debt-to-equity swap needs to respect the rules of double taxation treaties. In a typical treaty, such income can only be taxed in the state in which the person transferring the property is domiciled or has its registered office – the place of residence of a foreign shareholder. For this reason, limitations in deduction of a principal loan amount from income, as outlined in the point above, will not apply in a typical scenario with a foreign shareholder.
Conversion of interest.
The conversion of interest and capitalized interest into share capital has other tax consequences. According to Polish law, the payment of interest to a foreign company is subject to a withholding tax of 20% (according to Art. 21, Point 1, Item 1 of CIT). Despite the fact that there is no actual “payment” of interest a debt-to-equity swap is a subject of this withholding tax in Poland. This results from two circumstances. Firstly, Article 26 point 7 of the Polish CIT states that “payment” means the performance of an obligation in any form, including through the payment, deduction or capitalization of interest. Second, the term “payment” based on the model double taxation treaty should be understood broadly, in line with the guidelines of the Commentary on the OECD Model Tax Convention. In the present case, the interest is converted into shares, which is the same as “payment”.
Polish withholding tax rate on interest to non-residents is 20%. This rate is usually reduced by double taxation treaties.
• A debt-to-equity swap is a practical solution to convert an unpaid loan from a shareholder into share capital.
• Polish tax law provides different taxation rules on the principal amount and the interest.
• Conversion of the principal amount of loan can be tax neutral for the shareholder, provided the loan amount was paid to the company by this very shareholder.
• Interest and capitalized interests are subject to WHT of 20%. The tax rate may be reduced based on double taxation treaties.