The Spanish National Court rules on the deductibility of directors’ compensation one year after the controversial ruling from the Supreme Court

Written on 21 Jun 2019

In its ruling dated 28 February 2019, the Spanish National Court ("Audiencia Nacional") confirms that directors' compensation, in order to be tax deductible, must strictly comply with corporate law requirements, regardless of the possibility of considering such compensation as a gift. However, the ruling declares, in an innovative pronouncement, that this same interpretation should apply to the Spanish Corporate Income Tax Act current wording, (Act 27/2014). Therefore, such an expense may not be deductible under articles 10.3 and 15.f); the provisions of article 15.e) would not be deemed relevant in this discussion.

It is worth recalling that, in a ruling dated 26 February 2018, the Spanish Supreme Court reopened the controversy, that many taxpayers had considered as over both in terms of its corporate and its tax implications. Thus, the Supreme Court declared that rules on directors' compensation, provided for under  article 217 of the Spanish Act on corporations, should apply to all directors. Therefore, all compensation paid to directors should comply, in accordance with this ruling, with corporate law requirements (namely, inclusion in the company's byelaws and approval of the maximum amounts by the shareholders meeting).

The Tax Authorities had exploited the failure to comply with such corporate requirements to argue that directors' compensation should be seen as a gift and thus non-deductible (since, absent a provision in the byelaws to the contrary, the position of director would not be remunerated). It was thought that this interpretation was obsolete, given that Courts and some instances of the Spanish Administration were adopting a "dualist view" of directors compensation, whereby there should be a distinction between directors with executive (senior management) and non-executive functions. As a very broad statement, only compensation paid to directors with non-executive functions should comply with the corporate law requirements mentioned above. The tax aspect of the controversy was also considered as over with the enactment of a new Corporate Income Tax Law (Act 27/2014, dated 27 of November). This Act, applicable to tax periods as from 1 January 2015, includes a specific mention in its article 15.e), according to which directors' compensation should not be treated as a gift.

For taxpayers, the Spanish Supreme Court ruling, mentioned above, results in a return to a situation of uncertainty with respect to the tax deductibility of directors compensation. This Spanish National Court  has broached on this issue in its ruling dated 28 February 2019. Thus, the National Court review the tax deductibility of several executives, who were members of the company's board of directors.

Note that the company also engaged in the discussion as to when an a labour law relationship should rightly be considered as "senior management". In this context, the company alleged that its labour law relationship with these executives should not be considered as a "senior management relationship" (a specific relationship under Spanish labour law), since such executives had roles with specificities, that were different to that of senior management; such as for example finance functions… Moreover, these executives were under direct orders from the executives of the parent company; a situation which limited significantly their role as directors. The Spanish National Court, however, refers to the positions of these executives ("managing director" or "director of finance") and considers that no proof has been advanced of these executives carrying out functions other than management. Therefore, there can be no doubt as to their consideration as "senior management". The direct consequence of this reasoning is that, as a result of their inclusion in the board of directors, their labour law senior management relationship with the company should be deemed to have been replaced by a corporate law relationship (as company directors).

Then, the Court confirms the reasoning of the Spanish Tax Authorities as regards the tax deductibility of directors' compensation. In this context, the Court refers to two rulings from the Spanish Supreme Court: ruling from 2 January 2014 (Rec. 4269/2012) and 5 February 2015 (Rec. 2795/2013). Both establish the need for compensation paid to directors to comply with legal requirements.

According to the Tax Authorities and the Court, the need to strictly comply with legal requirements entails that the deductibility of directors' compensation will hinge on a "two-pronged" test. Firstly, corporate legal provisions must be observed, in accordance with article 10.3 of the Corporate Income Tax Act (Royal Decree 4/2004, dated 5 March – applicable to the facts of the case at hand). Secondly, it would be necessary to analyse whether article 14.1.e) has been observed, to determine whether such compensation amounts to a gift and, as such and despite the fact that it may be included in the company's byelaws, such compensation should not be deductible, since it would amount to a gift or an expense not related to income.

Such a view is by no means new. The rulings from the Spanish Supreme Court mentioned above were pointing to the same conclusion, although the wording was not so clear. There is a novel aspect, however, in the fact that the Tax Authorities hold the view that such interpretation should also apply to the current Corporate Income Tax Act and the Court does not oppose this view. Thus the new wording of Article 15.e) should also be considered once the requirements of Article 10.3 have been complied with. Therefore, only when directors' compensation complies with corporate law, will it then be necessary to determine whether such compensation also complies with other provisions of the Corporate Income Tax Act, in order to assess its deductibility.

This reading of Article 10.3 is, at the very least, contrived (note that article 10.3 is worded in the same manner in the current Corporate Income Tax Act). This article only refers to the general principles applicable to the direct method of calculation on the corporate income tax base. Moreover, the Court does not mention of Article 15.f) of the current Corporate Income Tax Act, under which expenses deemed in contravention of the legal order are not deductible. This Article 15.f) would offer Tax Authorities an additional tool, since it would provide an alternative to question the deductibility of directors' compensation not fully compliant with corporate legal provisions.

As a conclusion, it would seem that the Tax Authorities and the National Court hold the position that, for tax periods starting from 2015 onwards, compensation paid to directors or to senior executives also holding positions in the board of directors would only be deductible provided all legal requirements established under Spanish corporate law are strictly observed. In this analysis, the drafting of Article 15.e) of the Spanish Corporate Income Tax would not be relevant.