New Regulation Targets Debt-Equity Classification in Controlled Loan Transactions

Original content provided by BDO

Effective 1 January 2025, Georgia introduced a new regulation governing the proper delineation of loan transactions. This regulation applies exclusively to controlled loan transactions, specifically:

• Loan transactions between Georgian resident entities and non-resident related parties
• Loan transactions between Georgian resident entities and entities registered in jurisdictions with preferential tax treatment.

For purposes of this regulation, a loan includes credit/loan agreements, overdrafts, letters of credit, credit lines, financial guarantees, debt securities, and similar instruments.

Georgia does not have domestic thin capitalization rules. Prior to this regulation, there was no local legislation addressing the balance between debt and equity financing for Georgian entities.

Criteria for Recharacterization of a Loan as Equity

Order №423 of the Minister of Finance of Georgia, which outlines the application of transfer pricing regulations, was amended effective 1 January 2025. The amendment introduces Article 14, which establishes the criteria for delineating controlled loan transactions. The purpose is to determine whether a transaction treated by the parties as a loan -- based on contractual terms and/or factual circumstances --should be fully or partially recharacterized as equity.

The criteria include:

• A fixed repayment schedule
• An obligation to pay interest
• A right to enforce payment of principal and interest
• The funder’s status (e.g., subordination) compared to ordinary corporate creditors
• The existence of financial covenants and security
• The borrower’s ability to fulfil loan obligations
• The borrower’s equity structure (i.e., debt-to-equity ratio)
• The purpose and necessity of the borrowing
• Failure of the borrower to repay the loan on the due date or a request for deferral
• The funder's involvement in the borrower’s management
• Issuance of the loan based on shareholding proportions and/or ownership rights
• The possibility that the funder may convert the loan into equity

These criteria broadly follow the guidance set out in Chapter X of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

A controlled loan transaction may be fully or partially recharacterized as equity if at least three of the above criteria are met, one of which must be either:

• The borrower’s ability to fulfil loan obligations, or
• The borrower’s equity structure.

The regulation does not apply to:

• Exchange rate differences that arise before 1 January 2025
• Interest accrued before 1 January 2025 on loans issued prior to that date --
  regardless of whether payment occurs in the same or a subsequent period.

Accordingly, the regulation applies to interest accrued and exchange rate differences arising on or after 1 January 2025.

Tax implications of New Regulation

To assess the tax implications of the regulation for Georgian entities, it is important to note that Georgia applies the Estonian model of corporate income taxation, under which corporate income tax  is levied only upon distribution, not on an annual basis.

The regulation applies to both situations -- when a Georgian resident entity is the borrower and when it is the lender. However, the Georgian tax authorities are primarily focused on cases involving Georgian resident borrowers, so the potential tax implications for a Georgian borrower are outlined below.

When the Georgian tax authorities fully or partially recharacterize a loan as equity, any interest accrued and paid on the recharacterized portion is treated as a dividend and becomes subject to corporate income tax at a 15% rate, and withholding tax. This risk will materialize only if and when accrued interest is actually paid.

Tax Treatment Before Recharacterization

Interest payments are subject to withholding tax at 5% or 15% (if paid to an offshore jurisdiction). However, the withholding tax rate may be 0% under a potentially applicable income tax treaty.

Tax Treatment After Recharacterization

Payments of interest recharacterized as a dividend is subject to corporate income tax at a 15% rate, and withholding tax at a 5% rate, potentially reduced to 0% under an applicable income tax treaty.

Additionally, if a loan is issued in a foreign currency, the lender is entitled to repayment of the principal in the same currency and nominal amount, without triggering tax. In contrast, equity contributions to Georgian entities are denominated in Georgian lari (GEL), based on the official exchange rate of the National Bank of Georgia on the date of contribution. Such equity contributions may be withdrawn tax-free, but only up to the GEL-denominated value.

Consequently, if the Georgian tax authorities fully or partially recharacterize a loan as equity, the recharacterized portion may be repaid to the funder without incurring any tax, but only up to the GEL-denominated amount. Any excess repayment arising from exchange rate fluctuations will be treated as a dividend distribution and will be subject to corporate income tax at a 15% rate, along with potential withholding tax.