December 19 2008
Large projects usually require high levels of financing in order to be satisfactorily developed. Institutional lenders usually face legal lending limits and cannot handle very large loans by themselves. Therefore, they may seek alternative financial structures as a means to ensure the required financing levels for large project developers.
As an alternative to syndicated loans - where banks agree to make loans on common terms governed by a single agreement among all parties - participation loans grant financial institutions the opportunity to participate in a loan or other credit facility already entered into by a lead bank, which is generally the party originating the loan and dealing directly with the borrower. The lead bank may then recruit other financial institutions to participate in the loan under different methods or structures (eg, assignment or sub-participation). Therefore, funds finally lent to the borrower may originate either from available lending funds of the lead bank or funds contributed by the participants.
These transactions give rise to queries regarding the tax treatment applicable to interest paid by borrowers to the lead bank when funds have been partially provided by other participants. Should the borrower take a ‘look-through’ approach and look to the ultimate provider of the funds (ie, participant) as the beneficial owner of the interest payments?
In particular, it is uncertain whether a loan agreement concluded with a lead bank residing in a treaty country would be entitled to the interest benefits provided for in the applicable double taxation treaty even if the funds were partly contributed under a participation loan structure by a party residing in a third state. Should the beneficial ownership requirement be fulfilled at the lead bank level and the reduced withholding tax rate be available to the full interest payments? This issue is exacerbated by the lack of a clear definition of the term ‘beneficial owner’ provided in Article 11 of most of the Argentine double taxation treaties.
In addition, a 'look-through' approach as applied to a participation loan structure in a treaty context may lead to the disregard of special exemptions provided for under the treaties’ interest clauses whenever an official bank of any of the contracting states acts as lead financial institution.
In the absence of any treaty or domestic rule specifically addressing the tax treatment of interest paid to lead banks under participation loans, it is not easy to predict what position the Argentine tax authorities would assume in a particular case. In this regard, a former opinion of the attorney general issued in the 1960s sheds some light on the issue.
Attorney general’s viewpoint
The case analyzed by the attorney general involved not the application of a double taxation treaty, but rather the tax immunity to which the International Finance Corporation (IFC), a member of the World Bank Group, was entitled under its articles of agreement as signed by Argentina and regarding its investments into the country. The question was whether a tax exemption was available in cases where funds were provided by third parties under participation loans.
In order to preserve the exemption, the attorney general distinguished two different scenarios, mainly based on the contractual characteristics agreed upon by the parties involved. The attorney general concluded that when a direct legal relationship was established between IFC (as lender of record) and the Argentine debtor, such investments and the profits derived therefrom were entitled to the tax exemption even if the funds were previously provided by third parties, pursuant to a participation agreement with IFC, not evidencing any legal relationship with the Argentine debtor.
Conversely, the attorney general considered that third parties providing funds to IFC and having a direct legal relationship with the Argentine debtor would not be entitled to the exemption that otherwise would have been available to IFC, even if the loan facility were structured and arranged through the intervention of IFC.
So in the attorney general’s opinion, in order to ascertain whether the benefits of IFC’s articles of agreement and the tax exemption deriving therefrom applied in a particular case, the analysis should focus on whether IFC was the actual lender under the transaction and held a legal relationship with the borrower, bearing all the business risks, rather than on the identity of the party initially providing the funds.
Tax authority’s viewpoint
Notwithstanding that the attorney general’s opinion should prevail since it derives from a reasonable interpretation of the legal structure of a participation loan transaction, it has emerged that the Argentine competent authority on treaty interpretation in Argentina would uphold a different (more restrictive) criterion on the matter.
In connection with participation loans, the competent authority would be inclined to ignore treaty benefits on interest paid to a lead bank whenever the funds lent were provided by the participants. Under this understanding, lead banks would always be deemed to be mere collectors of interest rather than actual lenders and beneficial owners of the interest corresponding to the participating portions of the loan. In order to conclude so, the competent authority would not analyze the methods used to grant participation (eg, assignment or sub-participation) and consequently disregard the fact that under certain structures beneficial ownership of the loan is not transferred to the intervening participants and borrowers remain unaware of the identity of the participants and have no legal relationship with them. In those cases, the legal relationship is established only between the borrower and the lead bank.
If this position is accepted, domestic borrowers will be faced with uncertainty when making interest payments since the ultimate provider of the funds may remain unknown. This uncertainty would impact not only on the withholding tax rate to be applied on interest payments, but also on the application of exemptions provided for under certain double taxation treaties when the lead bank is a qualifying official bank.
The possible assumption of this restrictive opinion and the idea of considering the lead bank to be a mere conduit (collection agent) resurrects the debate surrounding back-to-back loans and beneficial ownership when an intermediate company is deemed to exist. In that debate the economic substance of the intermediary entities was significant. Following those discussions and under analogical reasoning, the economic substance of the lead bank could also be regarded when considering its entitlement to treaty benefits. If the existence of economic substance is duly evidenced - for example, by making a profit of its own via an interest margin or bearing the risks of the borrower’s default - the lead bank should be recognized as a lender and beneficial owner of interest under tax treaties irrespective of whether the funds are provided by third parties.
This issue remains unclear because no court opinions have been pronounced and ‘beneficial owner’ is not a precise concept in the context of Argentine double tax treaties.
The supposed application of a restrictive criterion by the tax authorities would lead taxpayers to an unfavourable situation. It is questionable why taxpayers should enquire into the existence and nature of the participants involved in a loan structure when making interest payments if the loan facility has been agreed upon solely with a specific lead bank. In practice, the Argentine debtor may have no information on who the participants of a participation loan really are, since no direct legal relationship is established with them.
A more precise definition of ‘beneficial owner’ in the context of Argentine tax treaties would be required as a means to determine the precise economic impact of a participation loan transaction, especially at present as credit facilities are extremely scarce.
For further information on this topic please contact Guillermo O Teijeiro or Ana Lucía Ferreyra at Negri & Teijeiro Abogados by telephone (+54 11 5556 8000) or by fax (+54 11 4328 5628) or by email (firstname.lastname@example.org or email@example.com).
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Guillermo Orlando Teijeiro
Ana Lucía Ferreyra