Landmark ruling on debt financing. Threat or opportunity?
In a verdict on April 26, 2022, the Supreme Administrative Court ruled that debt financing cost limits do not apply to operating leases. This is good news for the beneficiaries, because even in significantly indebted entities it will not be necessary to exclude financing from tax costs due to exceeding the statutory limit. The problem may arise on the part of the financing entity, for whom – due to the assumption that installment revenues do not increase interest expenses – there may be an excess of debt financing costs.
Since the beginning of 2018, Article 15c has been in effect in the CIT Law, which has revolutionized the rules for accounting for financial expenses. In short, since then it no longer matters from whom funds are borrowed (from related entities or not) or what the debt-to-equity ratio is. The indicator on which the statutory limit is based is the so-called tax EBITDA – that is, income “cleared” of interest (income and expenses) and depreciation. As of January 2022, the limit is 30% of tax EBITDA, or PLN 3 million, while until the end of 2021 the two values summed up. At the same time, it should be remembered that the described limit applies only if the taxpayer has an excess of debt financing costs. That is, if a taxpayer earns, for example, PLN 100 million in interest income and incurs PLN 99 million in interest expenses, then instead of having an excess of costs he has an excess of interest income – at the level of PLN 1 million. In such situation, the statutory limit does not apply to him.
The obligation to exclude interest from tax costs does not apply (among others) to banks, but no longer to leasing companies.
The interest portion of the lease installment proved to be a problematic issue. Why? First, while leasing is certainly a form of financing, the statutory definition of debt financing costs includes only “costs associated with obtaining funds from other entities, including unrelated parties, and with the use of those funds.” In addition, leasing, although it is a financial transaction, does not involve the provision of funds, but of an asset acquired with these funds by the lessor. At the same time, however, the “interest part of the lease installment” is explicitly mentioned in the provision as a cost of debt financing. The clue of the problem is therefore to define the concept of “interest portion of the installment.”.
Supreme Administrative Court: no interest portion in operating lease
The lessee includes the entire net amount of the invoice in tax expenses – both the principal portion of the installment and the interest portion. As a result, in a tax operating lease, the interest portion is not distinguished or even absent – it is simply a part of the installment, constituting income – similar to “ordinary” rent.
Recognizing that income from the interest portion of the installment in a finance lease is not interest income would result in the fact that financing incurred to finance a leasing transaction may be limited – but income from the interest portion of the installment would not increase interest income. In turn, this significantly increases the risk that the leasing company will have excess expenses.
Based on the above, the Regional Administrative Court in Gdańsk in 2019 held that debt financing costs do not exist in operating lease. According to the RAC’s verdict, such costs are recognized only in finance leases, because in the tax sense only in this lease there is a separate interest portion.
This ruling was appealed to the Supreme Administrative Court, which ruled on the case on April 26 (ref. II FSK 2197/19). The court pointed out that the phrase “all kinds of costs” refers only to costs related to obtaining funds from other entities and using these funds, and not to things, as is the case with operating leases. According to the SAC, neither the provisions of the balance sheet law nor the so-called ATAD Directive are relevant to this issue. As a result, the SAC agreed with and upheld the previous decision of the RAC.
An opportunity for lessees?
The ruling is extremely favorable for lessees and may have a positive impact on lease sales. An indebted lessee will find it much more advantageous – in tax terms – to use operating leases than other forms of financing, since the interest portion does not count against the limit on debt financing costs. Even a highly indebted lessee will therefore not have to exclude financing costs from tax expenses.
However, this settlement can be problematic from the perspective of the leasing company’s tax returns.
Interest portion of the installment versus debt financing costs of the leasing company
As mentioned at the beginning, the limit on debt financing costs applies only if the taxpayer has an excess of these costs – that is, if there are more of them than interest expenses. How does this issue relate to operating leases?
Recognizing that income from the interest portion of the installment in a finance lease is not interest income would result in the fact that financing taken out to finance a leasing transaction may be capped – but income from the interest portion of the installment would not increase interest income. In turn, this significantly increases the risk that the leasing company will have excess expenses.
Admittedly, there is Article 15c paragraph 13 in the CIT Law, which states that interest income is also income economically equivalent to interest income. However, we recently described a ruling by the Supreme Administrative Court, which concluded that interest income must be legally equivalent to the cost of debt financing. According to the judgment described earlier, this equivalence does not exist.
So what should leasing companies do in this situation? It is certainly worthwhile for them to carry out a cost simulation on their side, assuming that installment income in operating leases does not increase interest expense. It is not a foregone conclusion that there will be a surplus on the financier’s side, which would have to be excluded from costs. However, if this were to happen, further remedial steps could be considered, such as applying for an interpretation on the interest portion (for the time being, there is a chance of a positive ruling) or changing the form of financing to one that does not generate financing costs for the taxpayer.