The capitalisation of interest in convertible loans can create a significant tax issue for both startups and investors: the obligation to apply and remit withholding tax to the Spanish Tax Authorities, even where no actual cash outflow has occurred.
This tax effect can generate cash flow tensions at critical moments, particularly when the funds raised have already been fully deployed into business operations and no liquidity is available to meet the tax obligation.
Convertible loans, one of the most commonly used early-stage financing instruments, allow the loan amount to be converted into shares or equity interests within a defined period. Their flexibility makes them especially useful when uncertainty prevents structuring a traditional equity round.
However, while their corporate mechanics are relatively straightforward, their tax treatment—particularly regarding interest—requires careful technical analysis to avoid unexpected financial consequences.
1. Withholding obligation on capitalised interest
In Spain, interest is classified as income from movable capital and, when paid by a legal entity, may be subject to withholding tax.
Spanish tax regulations establish that the obligation to withhold arises when interest:
- becomes payable, or
- is effectively satisfied
In convertible loans with capitalised interest, this becomes particularly relevant because:
- interest is not paid in cash
- it is incorporated into the conversion into shares or equity
Therefore, withholding tax may accrue at the time of conversion, even in the absence of a cash payment.
2. Dry tax charge: taxation without liquidity
This situation leads to what is commonly known as a “dry tax charge”, i.e. a tax liability without associated liquidity.
In practice:
- the startup must remit withholding tax to the Tax Authorities
- the investor must recognise taxable income
- but no cash flow has occurred
This is particularly problematic because interest capitalisation is designed precisely to preserve the company’s liquidity during growth stages.
Additionally, the startup must comply with its reporting obligations through Form 123, within the applicable deadlines. Failure to do so may result in:
- late payment interest
- tax penalties
- increased effective cost of the transaction
3. Tax and corporate implications
If the agreement does not expressly regulate the withholding mechanism, additional uncertainties may arise:
- adjustments to the number of shares or equity interests delivered
- alteration of the agreed economic balance
- potential friction between the parties
From the investor’s perspective:
- capitalised interest constitutes taxable income for Personal Income Tax or Corporate Income Tax purposes
- the number of shares received may be reduced if adjusted for withholding
All of this may directly impact the expected return and the legal certainty of the transaction.
4. Importance of proper structuring of convertible loans
The drafting of the convertible loan agreement is crucial to mitigate tax risks associated with interest capitalisation.
Proper structuring should clearly address:
- how withholding tax will be handled upon conversion
- who bears the economic burden
- how compliance with the Spanish Tax Authorities will be ensured
- what the actual cash flow impact will be for the company
Without this, conversion may trigger an unexpected liquidity requirement, turning a tool designed to protect cash into a source of financial risk.
5. Conclusion: key tax considerations in convertible loans
The capitalisation of interest in convertible loans follows a clear financial rationale: preserving company liquidity.
However, under Spanish tax rules, it may result in:
- withholding obligations without cash payment
- taxable income for the investor
- direct impact on cash flow
This risk, although not always immediately apparent, can affect regulatory compliance, financial structuring and the relationship between the parties.
Therefore, anticipating and contractually regulating withholding obligations is essential to ensure a sound and efficient transaction.
At Across Legal, we combine legal rigour with strategic insight to structure financing transactions securely and efficiently.
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