Participating loans in Spain were regulated in general with Royal Decree 7/1996 of 7 June 1996 on urgent fiscal measures and liberalization of economic activity ("RD 7/1996"), in a context of deep economic crisis in which the Government exceptionally allowed balance sheet asset revaluation by companies with accumulated losses in orderto strengthen solvency positions, in exchange for a one-time tax of 3% and the obligation to keep a non-distributable reserve for amount of asset revaluation. With the same objective, the same RD 7/1996 also provided an alternative mechanism to strengthen equity: the use of the participating loan (that in origin was hither to used residually by public-owned industry finance entities when granting "soft loans" in which their remuneration was conditional on the performance of the company, the results and the results of the loan), as a hybrid debt/ equity finance tool.  As of to date the participating loans have been widely used as a legal instrument by companies in financial difficulties while allowing the lender to retain the entitlement to repayment wihtout the the filters of the return on the share capital (dividend, sale of shares, liquidation).

As a drawback, the RD 7/1996 postpones aparticipating loan entitlement to rank below, behind common creditors.

Likewise, since the reform of the Corporate Income Tax Law in 2014, interestsaccrued on these loans are not tax-deductible, thus treated as remuneration ofequity taxwise. Additionally the generally applicable the limitation to the deductibility of the net financial costs to 30% of each fiscal year’s operating profit -although, according to the Spanish Tax Directorate, interest not deductible by special rule are not computed for these purposes, as is the case of participative loans.

Nowadays, companies need look for sources of financing and cash, and lenders seek to get repayment -and interests, where possible.- In this context, it is advisable to review the possibilities offered by the participating loans they have in their balance sheets and, to this end, re-read the legal provisions:

"Article 20 Participating loans.- One. Loans shall be considered as Participating  Loans provided that they have the following characteristics:

(a) The lender must be entitlted to a variable interest rate according to the development of the busines activity of the borrower. The criterion for determining this may be: net profits, total sales, total equity or any other that as freely agreed upon by the parties. In addition, they may agree on a fixed interest rate regardless of the business activity development.

(b) The parties may agree on a penalty clause in the event of early repayment. In any case, the borrower may only repay the participating loan early if such repayment is offset by an increase of its equity by the same amount repaid and provided that this increase is not due to asset revaluation

(c ) Participating loans, shall rank after common creditors.

d) Participating loans shall be considered equity for the purposes of mandatory capital reduction and liquidation of companies as provided for in Companies Act. “ [ [Inaccordance with the current Companies Act (Royal Legislative Decree 1/2010 of 2July, the current ratio is that equity must be at least 2/3 of the sharecapital to avoid mandatory reduction, and 1/2 of the share capital to avoid mandatory dissolution] .

To sum up:

-      Loans,credit facilities: The latest interpretation is that the rule includes both loans and the amounts borrowed from credit lines or facilities,which is common in inter-group company financing. Likewise, commercial credits -as are frequently the case in inter-group companies-, can become participating loan, through the adequate documentation of the appropriate agreements.

-      Interests deductibility. Variable interest linked to the development of business activity, also allowing fixed interest:  Participating loans- related interests are not tax deductible. The legislator intends that the conditional remuneration, linked to the development of results, closest to a dividend, does not enjoy tax deductibility in the borrower, but it does not seem logical that this regime should also be extended to that part of financing granted under afixed interest,  if it is in line with market rates and conditions and where lender and borrower are not related parties. The reason for penalizing interests in cases they are in line with market rate interests in the case of participating loans is often challenged, the most immediate answer being that the purpose of the financing is to "strengthen equity", when in similar circumstances it represents similar terms as those a bank would set to obtain financing to alleviate any need for cash orsecurity.  

 -      Early repayment unless there is an increase of the same amount in equity (for reasonsother than asset updates):  

This provision made sense in the economic context in which it was enacted, i.e. an exceptional revaluation of assets in a context requiring the protection of companies' equity and to prevent them from entering into legal grounds for dissolution, the reserve of which would not be available for dividend distribution. As this concept was extended to participating loans as an alternative to asset revaluation, it seems to be subject to the same limitation, in this case on availability for repayment.

The regulation does not set a period of "retention" or unavailability of the participating loans for early repayment.

Considering that the requirement, the limitation on early repayment lies in its function of reinforcing equity and in accordance with the commercial standard, Companies Act, setting the mandatory ratio of equity at, at least. 2/3 of the sharecapital, it can be concluded that when, as a result of the total or partial early repayment of a participating loan, the equity fulfils the legally required level, there does not appear to be grounds to consider that any rule is being breached with an early repayment: it makes no sense to oblige a reinforcement of the level of equity when it is already fulfilled, according to borrower regulatory law, in Spain, the Companies Act.

Therefore, it would be possible to defend such early repayment provided for in the contract, or the grounds that the parties may modify or renew, by agreement, all or part of a participative loan in this regard, or convert it into an ordinary loan without forfeiting the advantages used to the extent that as a result of it the Company equity fulfils the required levels. As regards formalization, given that these decisions affect the equity situation of the Company, as it works as a kind of "reserve" for these legal purposes, it would be advisable – if not necessary, based on article 160 LSC – that it be approved by the shareholders.

A different matter will arise, if in the future the company falls into losses again and its ratio is reduced below the legal level, in which case the rules on mandatory capital reduction, dissolution and the use of a participating loan (new one or recharacterizing existing financial or commercial loans) as one of the mechanisms to avoid it will apply again.

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