A review of RTF 03265-3-2022 reveals the Tax Court’s position regarding the classification of various financing mechanisms (capital contributions or loans) carried out between related parties.
Background
A company domiciled in Chile that reported losses in the previous fiscal year decided to increase its capital by issuing preferred and common shares. Its related party (the appellant) made the capital contribution in exchange for the preferred shares, which were repaid the following year in the same amount.
The Appellant’s Position
The appellant argues that a capital contribution through the subscription of preferred shares is a valid investment transaction and constitutes one of the three financing options available to a company[1]. In this type of financing, both parties benefit, as the shareholder receives a return through profits, while the issuing company obtains financing without losing control of the corporation.
On the other hand, the appellant notes that the Tax Administration disputes the validity of the transaction due to the existence of an economic relationship between the parties.
Position of the Tax Administration
The Tax Administration states that, through the accumulation of non-cumulative preferred shares, the company does not ensure a return on the money invested via the capital contribution. Furthermore, it was not demonstrated through the corresponding financial analyses that the investment transaction qualifies as a “capital contribution,” but rather as a continuation of the loans that the appellant had already granted (an economic fact that actually occurred). This is the criterion for raising the objection, not the existence of an economic relationship between the parties.
Finally, the Tax Administration determines that the transaction subject to objection does not constitute a capital contribution but rather a cash loan. Therefore, the adjustment must be applied in accordance with transfer pricing rules, and it was considered appropriate to use the interquartile range reported by the appellant in its EPT technical study for other loans granted to the same company.
Tax Court Ruling
It upholds the reclassification of the capital contribution as a “loan,” due (among other reasons) to the fact that the documentation (financial analyses, among others) did not demonstrate an expectation of return on investment. Therefore, since it has been reclassified as a loan transaction between related parties, the adjustment must be applied in accordance with transfer pricing rules. However, it notes that, when making this adjustment, the Administration used, for the calculation of interest, an average of the rates applicable to a different period, which were taken from the appellant’s 2010 EPT for its loan transactions. Consequently, the objection regarding the transfer pricing adjustment is not properly substantiated.
Conclusions
The appellant failed to provide evidence that its transaction with a related party generated expectations of a return on investment sufficient to qualify as a capital contribution.
The tax authority reclassifies the “capital contribution” transaction between related parties as a loan.
The Tax Administration did not perform an adequate comparability analysis (in this case, considering the timing of the transaction) and applied an interest rate corresponding to an interquartile range of transactions from a different period.
The concept of “burden of proof” ultimately proves decisive in resolving the case. If the Tax Authority proposes a transfer pricing adjustment, it is incumbent upon the Authority to demonstrate that it complies with all the requirements set forth in the regulations (in this case, the comparability analysis). If it fails to do so, the proposed adjustment will be rejected.