Talking tax

  • 2005-11-02
  • By Luc Nijs [ Sorainen Law Offices ]
Income mutation or ordinary sale of shares

I was confronted recently with one of the basics in taxation 's one of the first things I was subjected to by my professor while in law school. It deals with the relevance in tax matters between the source of income and the income flow out of the source. Although you can tax both the mutation of the source (as a capital gain) or the income flow (employment income, interest, dividends, etc), there still is this remarkable difference that we obey when taxing those type of events.

The story reads like this. A group of foreign investors set up a joint venture with a local party in Lithuania. The JV is partly capitalized but also highly debt-financed. Interest on these loans is due under normal conditions. Looking good so far. However, there is an arrangement between the foreign investors and the local party that the latter has the opportunity ("right") to buy the investors out of the JV after a certain minimum period of time. This was agreed upon at the moment the JV started, and it was determined at that point in time at what price these shares could be bought by the local party.

The pricing clause contained the following remodeled mechanism. The price will be equal to the proportionate share capital at the moment of the sale of the shares increased with a percentage of the value of the investments made by the foreign investors in the JV (including the debt). In addition it was agreed that, at the moment of the sale, the debt (which was substantial) would be repaid, including accrued interest to the foreign investors. So far so good.

The rub comes in when we analyze the sale agreement of the shares to the local party. The tax authorities' initial belief is that such a pricing structure actually includes a portion that should qualify as interest (like with a convertible bond) and be taxed accordingly, whereas a capital-gain would be exempt from tax. Initially I didn't know what to think, but I got my feet back on the ground after remembering what my professor told me so long ago: Interest is a compensation for an sum put at the disposal of someone else under the condition that he needs to pay back both the principal and the interest, and that you are prioritized in repayment before shareholders. Alternative-ly, equity is subject to entrepreneurial risk: There are no guarantees that you will ever see dividends or even get your money back in full.

I'm particularly interested to learn how the authorities ended up with the possible qualification as an interest component, since the income flow out of equity can only qualify as dividends. Unless there would be a fiction written into the tax law that under certain circumstances the nature of income mutates, which I'm not aware of.

I wonder if next time it would not be better for the JV's advisors to include a put option for the buyer at a certain price, as the discussion arose exclusively based on the description of the price structure in the agreement. After all, when valuing stocks of an unlisted company, a rule of thumb tells us that the market value could be determined by the book value of the company or the current P&L result multiplied with a factor reflecting future earnings potential, excess capacity or a correction for discounted cash flow levels in the future. Nobody would doubt that reflecting that idea as a percentage on invested capital is in itself not a strange thing to do (financial accounting uses "return on equity" as a sound parameter for performance). Unfortunately, I still don't see that interest component.