New Criterias for Reclassifying Loans into Capital in International Controlled Transactions
Tax Risk in the Reclassification of Loans into Capital
From October 2, 2024, new criteria came into force in Georgia for qualifying loans received by a Georgian company from a related non-resident entity as contributions to capital. The Minister of Finance of Georgia issued Order No. 331, specifying circumstances under which tax authorities have the right to reclassify an international controlled transaction, recognizing a loan from a related non-resident entity as capital. This approach may affect the tax burden of companies engaged in controlled transactions.
How Will Taxation Change?
The main change introduced by the reclassification of a loan into capital concerns the tax treatment of accrued interest. In the case of a traditional loan, interest paid to a related non-resident entity is subject to a 5% withholding tax at the source, which may be reduced if there is a double taxation avoidance agreement with the relevant country. However, if the loan is reclassified as capital, the accrued interest on the loan will be treated as dividends. Consequently, instead of 5%, there will be an obligation to pay corporate income tax at a rate of 15%. Additionally, a further 5% dividend tax may apply.
What Influences the Tax Authority’s Decision?
The Order lists criterias that are considered when classifying a transaction initially regarded as a loan as a capital contribution, either wholly or partially:
Fixed Repayment Schedule: Whether a fixed schedule for the repayment of the principal loan amount/interest is provided and whether it aligns with market conditions and the loan's intended purpose.
Obligations to Pay Interest: Whether interest accrual/payment is provided and whether the accrual/payment of interest is actually carried out.
Enforcement of Loan Recovery: Whether measures for enforcement in case of a breach of obligation are provided and whether the lender exercises such rights upon the occurrence of relevant conditions.
Subordination Status of the Lender: Whether the lender’s claims are subordinated to those of other creditors of the borrower.
Contractual Restrictions and Protective Mechanisms: Whether contractual restrictions on the borrower are provided in case of a breach of agreement terms, including penalties and/or other means of securing claims, and whether the lender exercises such means upon the occurrence of relevant conditions.
Ability to Fulfill Loan Obligations: Whether the borrower has a real financial capacity to repay the loan principal/interest from its operating income in relation to the transaction treated as a loan.
Borrower’s Capital Structure: Whether the financial indicators of the borrower correspond to market ranges concerning the transaction treated as a loan.
Need for a Loan and Its Purpose: Whether the borrower has a real need for the loan and whether the received financing is intended for or used to acquire long-term (capitalizable) assets or to provide funds for a startup.
Postponement of Loan Obligations: Whether there is a non-payment of the principal loan amount/interest within the specified period and/or repeated extension of the repayment term.
Participation in Borrower’s Management: Whether the lender is granted rights to participate in the strategic/operational management of the borrower and whether the lender exercises these rights.
Provision of a Loan Proportionate to Ownership or with Ownership Conditions: Whether the lender is granted rights related to the borrower’s ownership shares and whether the lender exercises these rights.
Possibility of Loan Conversion into Capital: Whether the loan conversion into capital is provided and whether the lender exercises this possibility.
Reclassification of the transaction or its part is possible if grounds are identified under at least three criteria, one of which must include either the “Ability to Fulfill Loan Obligations” or the “Borrower’s Capital Structure.”
Example Calculation of Loan Reclassification into Capital
Let’s examine how taxation might change if a transaction is reclassified. For instance, a loan of 1 million USD was issued at an exchange rate of 2.5 GEL per dollar, but by the time of repayment, the rate had increased to 3 GEL per dollar. If the transaction’s classification remains unchanged and is treated as a loan, the repayment of the principal loan amount is not taxed. However, if the loan is reclassified as capital, the difference of 500,000 GEL (3 million - 2.5 million) will be treated as income distribution and subject to taxation.
How to Mitigate Tax Risks?
To minimize tax risks, it is important to assess the structure and terms of the transaction in advance. For example, the tax authority may reclassify a loan as capital in cases of prolonged repayment periods, insufficient financial resources of the company to repay it, or an excessive loan-to-capital ratio. In this context, the advice of a tax consultant specializing in transfer pricing can be invaluable for a preliminary risk assessment.
Thus, the new criteria provide taxpayers with certain guidelines; however, the risk of subjective evaluation of loan conditions remains. Any company attracting loans from related non-residents must be prepared for potential tax consequences and ensure closer control over the compliance of its transactions with market conditions.