Economic motivation in corporate merger transactions

The reason for the corporate reorganisation is debatable if the absorbed company is inactive.

Today we bring you a resolution of the Economic Administrative Court of Cataluña, dated 12 February 2018, due to its importance in mergers when a company is absorbed that is not active at the time of the absorption, although it may have been active shortly before.

This ruling, number 08/09472/2015 of the TEAR of Cataluña, analyses whether there were valid economic reasons for rationalisation or restructuring of the economic activity that were sufficient to be able to apply the special tax deferral regime in the corporate merger operation.

The case:

The case is that we have: (i) a company (A), constituted in 2005 that had been providing personal assistance services for guests (belonging to a hotel group); and (ii) a company (B) constitued in 2006, whose corporate purpose is the design, creation and marketing of websites, as well as the sale of computer hardware and software.

In February 2010, both companies merged through the absorption of A (absorbed or transferring company) by B (absorbing or acquiring company), the operation being covered by the special regime of Chapter VIII of Title VII of the Companies Act at the time. The accounting retroaction of the operation was also set at 31/07/2009, i.e. from this date is when all the operations of the absorbed company are actually considered to have been carried out in the absorbing company.

Note that the absorbing entity only increased its capital by 64 euros as a result of the merger by absorption and at the same time was subrogated to the right to offset tax losses for more than 955.000 euros, which were applied to the compensation at the headquarters of the absorbing entity to offset positive results from the financial years 2010 to 2013.

Tax Inspection

This operation was subsequently reviewed by the tax authorities via the Tax Inspectorate on the basis that there was no real valid economic reason, since in the inspector’s opinion the only reason was to take advantage of the absorbed company’s negative tax bases. To make matters worse, the absorbed company had ceased to have any commercial activity, so it would be difficult for it to take advantage of these negative tax bases.

Therefore, the inspector considered that the operation should be governed by the application of article 15 of the Corporate Income Tax.

To make matters worse, the inspector opened a penalty file in addition to the liquidation.

The TEAR’s ruling

The taxpayer appealed as a matter of course, arguing that there were valid economic reasons for business reorganisation and restructuring that justified the application of the special regime, however, the TEAR, in its Fundamentos de Derecho, replied as follows:

FD5: On the economic motivation of the merger operation, the Inspectorate concludes, as already stated in the precedents of this ruling, that the safeguard clause provided for in Article 96. 2 of Chapter VIII of Title VII of the TRIS, which states that the special regime shall not apply when the main purpose of the operation carried out is tax evasion or avoidance and that, in particular, the regime shall not apply when the operation is not carried out for valid economic reasons, such as restructuring or rationalisation of the activities of the entities participating in the operation, but merely for the purpose of obtaining a tax advantage. The latter is what, in the opinion of the tax authority, has happened in the present case, as it considers that the main purpose of the transaction was to enable the absorbing company to compensate, at the absorbing company’s headquarters, the tax losses generated by the absorbed company, which it would be difficult for the latter to compensate in the future.

The TEAR adds that determining whether or not such valid economic reasons exist is strictly a question of fact, which must be decided in the light of each specific case, it being very difficult to establish a priori rules, although of course the evidence must be assessed as a whole, i.e. before and after the merger took place. The objective is to ensure that operations can be carried out without taxation becoming an obstacle to decisions on company restructuring.

It concludes by indicating that, in the case at hand, two circumstances are relevant:

1. The absorbed entity was an inactive company at the time of the merger.
2. The absorbed company had hardly any valuable assets that could be transferred to the acquiring company (with the exception of tax claims against the tax authorities).

It is true that, at the time of the merger, the acquired company had one employee on its payroll, but in 2005 it had 43 employees, in 2006 it had 55 employees and in 2007 and 2008 it had 37, so having one in 2009 is significant. Moreover, company B had only one client (the hotel group) which terminated its contract in 2008, i.e. B had de facto ceased to have any activity, consequently, B did not have a business to transfer nor was there, therefore, any ongoing economic activity that could be subject to reorganisation, restructuring or rationalisation that could benefit from the special tax regime,

“the question is not whether or not B, in view of its lack of activity, should merge with other companies or otherwise transfer its assets, but whether or not such a transaction would merit the special tax regime for the reorganisation and restructuring of businesses and, again, in this case, the business no longer existed”.

As for the assets, B had no valuable assets at the time of the merger or, at least, none of the alleged intangible assets pointed out by the claimant, except for the negative bases, in fact, having taken advantage of the negative bases immediately afterwards reveals to be the only reason for the merger, which provided a tax saving of almost 200.000 euros, i.e., such saving was not a mere expectation, but a reality that occurred in the following years from 2010 to 2013.

For all of the above reasons, it was concluded that there were no valid economic reasons to allow the operation to benefit from the special tax neutrality regime and the tax assessment proposed by the inspector was confirmed, as well as the penalty proceedings.

In other words, the TEAR interpreted that the whole thing was staged to take advantage of the losses of the inactive company. Thus, once again, the need for an in-depth study prior to the merger and acquisition operations is clear.