When Loan and Bond Costs Become Disallowable Deductions: Lithuanian SACL Ruling

The decisions of the Extended Chamber of Judges of the Supreme Administrative Court of Lithuania (hereinafter referred to as the "SACL") form the Lithuanian taxation practice, which is to be followed by both the tax administration and the courts. Lithuanian companies often classify the costs of loans and bonds as allowable deductions in practice, so let's look at how this may raise taxation risks under the new SACL case law.

Situation and background

The specific circumstances must first be examined in order to clarify the assessment of the judgment and the possible tax consequences.

Most Lithuanian companies classify loan and bond costs as allowable deductions. Some companies also incur tax losses. In general terms, these are limited deductions.

However, the Supreme Administrative Court's decision does disclose what mistakes companies should not make, as the relevant expenses will not reduce corporation tax and the tax authorities will calculate the additional corporation tax payable.

In the following situation, there are two issues (or risks) in the calculation of corporate income tax: the right of UAB Y (i.e. the applicant in the dispute) to deduct (i) interest on loans and (ii) interest on bonds (Art. 17(1) of the ITA) from the taxable income of the disputed periods, as allowable deductions and as limited deductions (Art. 11(1) ITA).

So the circumstances are:

·         Suppose a contract for the sale and purchase of 100% of the shares in UAB M is signed in December 2024. It is concluded between the seller of the company and the buyer, a closed-end real estate investment fund (i.e. an unincorporated real estate collective investment undertaking; hereinafter 'the Fund').

·         Then, in December 2024, UAB Y was registered (declared business activity: consulting business). This company actually acquired the shares of UAB M in question (to which the rights and obligations arising from the aforementioned share purchase agreement were transferred).

·         Then, in December 2024, UAB Y entered into a credit agreement with the bank. Under the agreement, it received a total loan of more than EUR 10 million, more than half of which. was to be used to acquire shares in UAB M. The credit agreement stipulated that (i) UAB Y had to submit to the bank, prior to the disbursement of the credit, documents proving that at least one-third of the purchase price of the shares of UAB M had been transferred to its UAB Y account; (ii) to carry out and complete the reorganisation - the merger of UAB Y into UAB M - no later than 5 months after the date of disbursement of the first instalment of credit.

·         At the end of December 2024, UAB Y entered into a bond subscription agreement with the Fund. As a result, the total amount received for the bonds issued (bond issue) was approximately EUR 6 million (annual interest rate set at 15% at the time of subscription; subsequently reduced to 4%).

·         Then, at the end of December 2024, UAB Y paid almost EUR 12 million for UAB M's shares via bank transfers. The proceeds of the above-mentioned loan and over EUR 5 million received for the above-mentioned bonds (purchased by the Fund) were used for this purpose.

·         Finally, on the last day of December 2024, a reorganisation took place by merging UAB Y into UAB M. This means that the parent company was merged into the subsidiary and the latter (i.e. UAB A, hereafter referred to as 'the applicant in dispute') was renamed UAB X. After the reorganisation, 1 % of the applicant's shares were held by the Fund and 99 % by the applicant itself (UAB X). Consequently, in accordance with the provisions of national law, the applicant's own shares were cancelled and 100 % of its shares were acquired by the management company of the Fund.

·         Thus, after the reorganisation, the applicant started to amortise goodwill (the price paid for the shares in UAB M exceeded the market value of the net assets). This company also included in the allowable deductions the interest paid under the abovementioned credit and bond subscription agreements. These amounts were also included in the allowable deductions for the year 2024 (limited amounts).

Treating interest costs on company loans and bonds as allowable deductions: the interpretation of the Supreme Administrative Court and the tax administrator's practice

The costs of UAB Y, which the tax authorities refused to recognise as allowable deductions (recognised as non-allowable deductions (Article 31(1)(13) of the ITA)), consist primarily of interest. These were paid under a credit agreement concluded between UAB Y and a bank and on bonds issued by UAB Y, i.e. in fulfilment of the applicant's obligations taken over from UAB Y after the reorganisation.

The tax authorities refused to allow the deduction of the interest related to the amounts received from the bank loan and the bond issue used by UAB Y to acquire the shares of UAB M (the applicant).

According to the assessment of the Supreme Administrative Court, the conclusion is that UAB Y, by concluding the transactions which gave rise to the disputed interest payments and by using the (borrowed) funds received under these transactions to acquire shares of UAB M, not only did not seek any economic benefit for itself, but also did not act as an independent entity carrying out commercial or industrial activities aimed at obtaining income or other economic benefit within the meaning of the provisions of the Law on Taxes and Taxes. In simple terms, UAB Y acquired the shares of UAB M not with a view to take over and continue the latter's activity (business) or for economic gain, but with a view to 'optimising' the corporate income tax.

Thus, Lithuanian companies should be aware that in such situations, as analysed in this article, the tax administration and the courts hearing the tax dispute are justified in assessing that the costs in question could not be recognised as allowable deductions reducing the taxable income of UAB Y.

It is necessary to detail the circumstances that led to this assessment in order to understand the criteria (facts) that lead to it and how to avoid making mistakes in the proper planning of one's tax obligations.

So taxation is driven by:

·         The Fund has been seeking to acquire shares in UAB M from the outset. UAB Y was set up exclusively for this purpose, i.e. to take over the applicant's shares from the Fund on the basis of a reorganisation of the companies, which would not only enable the latter to avoid its obligations under the share purchase agreement, but also to secure additional income in the form of interest on the bonds;

·         The Fund entered into a share purchase agreement with the then owner of the shares of UAB M. Meanwhile, UAB Y, which was set up after the conclusion of that contract, was essentially limited to the performance of the obligations (liabilities) arising from that contract;

·         UAB Y was not set up to carry out the same activities as UAB M. The Fund did not intend to invest specifically in the activities of this company (UAB X).  The activities of UAB Y were limited to the intermediate economic operations necessary to achieve the Fund's objective of investing in UAB M. The authorised capital of UAB X amounted to EUR 2 500 and the redemption of the bond issue by the Fund was only necessary to fulfil the terms of the credit agreement concluded with the bank;

·         it was the Fund (its affiliates) that handled the conclusion of the credit agreement. The share purchase agreement was concluded before the incorporation of UAB Y; the high-value credit agreement with the bank was concluded a short time (say, two weeks) after the incorporation of UAB Y; UAB Y's limited financial (minimum static capital) and human resources (1 employee, i.e. the manager), etc.) prove this. The annual interest rate on the bonds redeemed by the Fund for UAB M was as high as 15 %, which, in the present case, reinforces the doubts that this entity actually sought the benefits in question.

·         The Fund acquired the shares of the applicant (UAB Y) essentially for free. Consequently, the Foundation acquired assets by avoiding the obligations arising from the share purchase agreement and ultimately passing on to the applicant the costs of fulfilling those obligations.