The so-called sound economic reason as a requirement for tax relief in corporate reorganisations (M&A)

01.2012

On a regular basis companies undertake changes in the manner in which they conduct their business, aimed at optimising internal organisation, increasing operational efficiency, reducing costs, or enhancing the market position of their products or services. Additionally, these changes may be intended to prepare the business for a potential transfer of ownership, including succession within a family context.

To facilitate such operations, the Spanish Corporate Income Tax system provides significant tax advantages, primarily designed to prevent taxation of capital gains arising from the transfer of assets and rights between companies within a reorganisation process. In this way, such operations are shielded from both Corporate Income Tax and other taxes, such as the Property Transfer Tax, resulting in substantial fiscal savings for the companies involved.

The special tax regime requires, as an indispensable condition, that the reorganisation is carried out for a “sound economic reason” or “valid economic reason”, a concept whose interpretation is complex, as it is not explicitly defined in tax legislation. Consequently, it is essential to analyse binding rulings issued by the Spanish tax authorities, as well as relevant case law, which is inherently case-specific and occasionally contradictory. Nevertheless, some conclusions can be drawn regarding the criteria considered acceptable.

A valid economic reason must be based on genuine business considerations rather than solely on tax advantages, although the reorganisation may also yield fiscal benefits, such as reducing the overall tax burden of the group. Recognised valid reasons include: improving the management of the company or group by strengthening financial structure and simplifying administrative processes to reduce costs; enhancing market position by consolidating companies under a single brand; utilising tax losses within the group; separating or integrating, as appropriate, the ownership and exploitation of business assets, such as real estate; and reducing cross-holdings between companies.

Operations primarily aimed at distributing company assets among shareholders or at preparing future shareholder benefits will never constitute a valid economic reason. Therefore, when designing a reorganisation strategy, it is essential to consider subsequent events, since it may be difficult to justify an operation if one or more shareholders sell their holdings shortly thereafter. In short, valid economic reasons must serve the interests of the company and not those of individual shareholders, strengthening the economic resilience of the business and ensuring greater future stability through improved profit expectations.

When a reorganisation involves the separation of assets, it is essential that the segregated assets or rights constitute a “business branch.” Spanish Corporate Income Tax law defines a business branch as an economic unit capable of being operated independently, with autonomous management of personnel and resources. Consequently, the mere management of shareholdings in other companies does not constitute a business branch and cannot be segregated in the reorganisation.

With regard to real estate, the Spanish tax authorities adopt a highly restrictive approach. The special regime will only apply where the segregated properties can be operated autonomously, with dedicated personnel, marketing strategy, and independent organisation. The simple leasing of property does not qualify as a business branch. Only where all properties of a company, previously managed as a single unit, are segregated and their independent operation continues after the transaction, can the exit of a business branch be recognised.

Given the complexity and case-specific nature of these operations, it is advisable to obtain a prior audit or business valuation report. Such a report allows the taxpayer to substantiate the existence of a valid economic reason or a business branch in the event that the tax authorities challenge the operation years later. EU case law also serves as a safeguard against unilateral interpretations by the Spanish authorities that could adversely affect reorganisations within the European market, bearing in mind that these concepts originate from the EU Mergers Directive.

The interpretation of the law and the principle of anti-abuse generate ongoing debate regarding the limits of the regime. A paradigmatic example is the judgment of the Spanish National Court of 16 February 2011, which, regrettably, held the special merger regime inapplicable by excessively broadening anti-abuse rules, effectively nullifying legitimate tax planning protected under Article 38 of the Spanish Constitution, which guarantees freedom of enterprise within a market economy.

In conclusion, the concept of a “sound economic reason” constitutes a central requirement for accessing the tax benefits of corporate reorganisations in Spain. Its correct interpretation requires a thorough analysis of the business rationale, the nature of the assets and rights involved, and the coherence between the operation’s objectives and subsequent effects. Only through a detailed and well-founded approach can it be ensured that the reorganisation complies with legal requirements and maximises the economic and fiscal efficiency of the corporate group.

++ Article originally published in German in the magazine “Economía” in 2011, issued by the German Chamber of Commerce in Spain ++