Anton Kulakov, Junior Tax Consultant at Tax Compliance, discusses the tax aspects of a loan agreement.

Borrowing relations allow redistributing resources between economic entities in a faster way both within one country and in international transactions. Borrowing money is the most common method of financing in economic turnover. 

The tax consequences of a loan differ significantly from the taxation of other financial and economic transactions (sale and purchase, supply, performance of work, etc.). Therefore, in order to comply with tax legislation, an organization should take a number of key parameters into account before concluding a loan agreement.

Debt financing is the most popular alternative to a bank loan. A loan agreement is concluded both between independent participants and within a group of companies. It should be taken into account that the execution of a loan agreement involves special tax consequences for all parties to the transaction.

What is the tax effect?

As a general rule, a taxpayer may include in profits tax expenses the entire amount of interest on loans received. In certain cases (for example, where the parties are affiliated) the amount of interest expenses/income recognized for tax purposes should be reduced. At the same time, operations involving the issue and return of money loans are exempt from VAT. 

Conclusion and execution of a loan agreement

The Tax Code of the Russian Federation provides for a special procedure for accounting for operations involving the issue/receipt of a loan in respect of the principal debt and accrued interest:

• The giving/receiving of a loan body by a taxpayer is a tax-neutral operation. Thus, a lender does not recognize an expense in tax accounting when transferring funds, and a borrower who receives funds does not recognize income;
• Interest payments should be recognized as income of the lender / expenses of the borrower. Where a loan agreement is valid for more than one reporting period, irrespective of the terms of the loan agreement on the actual timing of interest payments, the parties should recognize interest income/expense in tax accounting at the end of each month of the relevant period.

An important feature of tax accounting for a loan agreement is that interest on loans and credits used for the construction, manufacture or purchase of fixed assets is not capitalized in tax accounting, i.e. is not included in the initial cost of the fixed asset (for example, this position is set out in the Letter of the Ministry of Finance of Russia dated 10.03.2015 N 03-03-10/12339).

Termination of the loan agreement

If the loan agreement is properly executed by the parties, the taxation procedure is similar to the loan: (1) repayment of the principal debt (loan body) does not have tax consequences for the parties; (2) payment/receipt of final interest is included in the income tax base. 

At the same time, if a loan agreement is terminated in a manner other than by proper performance, the tax consequences will depend on the manner in which the obligation was terminated:

Write-off of bad debts

Where a borrower is unable to repay a loan for objective reasons, the lender may recognize losses in the form of the remaining amount of debt as part of the tax base for profits tax. According to the legal position of the Ministry of Finance of Russia (for example, in the Letter of the Ministry of Finance of Russia dated 16.06.2021 N 03-03-06/1/47424) bad debts for profit taxation purposes are recognized, including: 

(1) debts for which the statute of limitations has expired;

(2) debts for which, in accordance with civil law, the obligation has been terminated due to impossibility of fulfillment;

(3) debts for which, in accordance with civil law, the obligation has been terminated by an act of a public authority;

(4) debts for which, in accordance with civil law, the obligation is terminated by liquidation of the organization.

At the same time, with regard to interest, law enforcement practice (for example, Letter of the Ministry of Finance of Russia dated 23.06.2016 N 03-03-06/1/36577) proceeds from the fact that, if the organization is not a bank, the creation of a reserve for doubtful debts for interest recorded as part of expenses for profits tax of organizations is unjustified.

Forgiveness of debt

Tax legislation and law enforcement practice (for example, Letter from the Federal Tax Service of Russia dated 17.08.2022 No. СД-4-3/10775@) proceed from the fact that the amount of principal debt forgiven by a lender to a borrower cannot be recognized as economically justified and, as a consequence, cannot be included in expenses for profits tax purposes. At the same time, interest previously taken into account by a taxpayer is not excluded from the tax base for profits tax.

At the same time, court practice (for example, case A82-7247/2008-99) recognizes that in exceptional cases debt forgiveness may be economically justified. In particular, if the creditor's forgiveness of part of the debt facilitates the debtor's transfer of the remaining part of the debt.

Tax peculiarities of certain loan agreements

In certain cases tax legislation establishes special tax accounting rules in relation to a loan agreement. In particular, such cases include loan agreements with foreign organizations or with interdependent persons. Let us consider in detail the tax consequences of concluding a loan agreement in relation to the above cases.

Withholding tax

Where a foreign organization is the lender, a Russian resident must withhold withholding tax on interest paid on a loan. The above-mentioned income of a foreign organization is subject to withholding tax at the rate of 20%. At the same time, the provisions of an LEDN may provide for the possibility of applying preferential tax rates. 

At the same time, law enforcement practice (e.g., case A40-151147/17-107-1848) proceeds from the fact that forgiveness of a Russian organization's debt under loan agreements to foreign companies is recognized as other income received by foreign companies from sources in the Russian Federation. 

Thin capitalization

Where under a loan agreement (1) a foreign organization is the lender; and (2) the amount of a Russian organization's debt is significantly higher than its net asset value, the provisions of the Tax Code on thin capitalization apply. 

At the same time, thin capitalization rules apply only if the percentage of borrowed funds exceeds the amounts established by law. The Tax Code establishes a ratio of 3 to 1 (12.5 to 1 for banks and leasing companies) of an organization's debt to its net assets for the application of thin capitalization rules to outstanding debt (capitalization ratio). 

A positive difference between accrued interest and marginal interest calculated on the basis of the capitalization ratio should be recharacterized as dividends and cannot be taken into account by a Russian taxpayer as corporate income tax expenses. A Russian organization must withhold withholding tax at source at the rate of 15% or apply the provisions of the relevant SIDN with respect to the reclassified amount of dividends of a foreign lender. 

Transfer pricing

Where a loan transaction is controlled (for example, concluded between interdependent persons [1] or one of the parties is an offshore resident), the parties should include interest in the tax base within the limits established by the Tax Code of the Russian Federation. 

The interest rate ceilings under a debt obligation also depend on the currency of the debt obligation. For example, if the debt obligation is denominated in rubles, the marginal interest rate under the loan agreement depends on the key rate of the Central Bank of the Russian Federation. If the parties stipulate a different currency of contract execution, then €STR (Euro short-term rate); SOFR (Secured Overnight Financing Rate), etc. are used.

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Thus, the above provisions justify a special procedure for the taxation of operations under loan agreements. When obtaining loan financing, an organization should assess a number of parameters for tax accounting purposes, including: (1) the status of the lender (foreign or interdependent person); (2) the amount of financing; (3) the term of the agreement; (4) the currency of the agreement; and (5) the ratio of own assets to borrowed assets.

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[1] If the amount of income from such transactions with one person(s) for the relevant calendar year exceeds 120 million roubles.