How may the proposed EBITDA rule under ATAD 1 affect your financial covenants?
In February the Dutch Ministry of Finance published details on the implementation of new EU rules (further) limiting the deduction of interest for tax purposes. These rules may affect the financial covenants borrowing taxpayers may have agreed in loan agreement(s).
Under the EU Anti Tax Avoidance Directive of 17 June 2016 (ATAD 1), EU Member States are obligated to introduce a general interest deduction limitation in the form of an earnings stripping rule.
Earnings stripping rule
Under ATAD 1, the deduction of net borrowing costs is limited to the highest of (i) 30% of the earnings before interest, taxes, depreciation and amortization (EBITDA) and (ii) a threshold amount of EUR 3 million. By letter of 23 February 2018, the Dutch State Secretary of Finance has stated that instead of applying a EUR 3 million threshold, the Dutch government will apply a (stricter) threshold of EUR 1 million (per taxpayer). The Dutch government will also not implement a group escape rule or a grandfathering rule for existing loans (as allowed under ATAD 1).
The new Dutch earnings stripping rules are supposed to enter into force on 1 January 2019. Furthermore, for banks and insurance companies the Dutch government aims to introduce a thin capitalization rule to prevent banks and insurance companies from deducting interest if their debt exceeds 92% of the commercial balance sheet total.
The new earnings stripping rule applies to all categories of debt (related and unrelated party debt). The implementation of these new rules may affect financial covenants agreed on in loan agreement(s), as interest deduction may be further limited.
If assets (real estate, other tangible assets, shares or otherwise) held by a taxpayer are financed with third party debt, it is likely that certain financial covenants are included in the loan agreement under which the loan was provided.
If tax expenses are taken into account when calculating a certain financial covenant (e.g. under a cash flow cover ratio, a debt service cover ratio or an interest cover ratio where taxes are deducted from the gross income to calculate the net income), any additional tax payable due to the restrictions on deductible interest may adversely affect the applicable financial covenant ratio of the taxpayer.
If (i) a minimal amount of net cash flow is available due to extensive leveraging, or (ii) the thresholds for the financial covenants are barely met prior to the implementation of the abovementioned earnings stripping rule, this could mean that the borrowing taxpayer fails to meet the thresholds of its financial covenants on the next date the financial covenants are tested. The breach will act as a signal informing the debt provider about deterioration of the borrower’s condition based on which they will then decide on follow-up action to be taken. It is likely that a default or so called “Event of Default” will occur under the loan agreement. This would generally trigger the accrual of default interest and enables the lender to (a) cancel undrawn commitment, (b) refuse to advance further (revolving) loans, (c) refuse to roll-over existing revolving loans, (d) declare all loans due and payable, or (e) enforce any security interest granted to the lender.
A taxpayer would be forced to cooperate with the lender to ensure cash flow will be sufficient to service the obligations under the loan agreement and to remedy the financial covenants to prevent enforcement of the applicable security interests and eventually insolvency.
To ensure ongoing compliance with the agreed financial covenants in loan agreements entered into with third party debt providers, we advise taxpayers to recalculate whether they would be able to meet the financial covenants after implementation of the earnings stripping rule. Care should be taken when defining the financial covenants to be used in loan agreements in order to avoid complications during the term of such loan agreements.
About the authors:
Pieter-Paul van Rhijn | Tax
Jack Schrijver | Banking & Finance