Taxation in Sweden of cross-border interest payments of corporations.

Last September 11 the Swedish IFA (International Fiscal Association) Branch arranged a meeting to discuss the draft national reports for the 2008 IFA Congress in Brussels. This type of meeting is held every year shortly before the deadline for submission of the reports with the purpose of giving the reporters an opportunity to discuss their work and to obtain comments and further input from other members of the Swedish branch.

One of the main subjects (number II) deals with the international tax aspects of interest payments under the title “New tendencies in tax treatment of cross-border interest of corporations”. The two national reporters for Sweden are Lars Jonsson senior tax partner of Linklaters, Stockholm and Peter Melz, professor of Fiscal Law at the University of Stockholm.

After a presentation of the report (covering 8 pages) by Messrs Jonsson and Melz, professor Robert Påhlsson at the University of Gothenburg, who had been assigned the task of giving a first introductory comment hereto, raised no substantial or serious objections.

Like professor Påhlsson I had no problems either about what was in the report but rather about what was missing therein! This had even prompted me to prepare a written memo thereon which was sent out to the branch members in advance of the meeting.

My main concern was that the report made no reference whatsoever to the situation in Sweden regarding thin capitalization and, more specifically, the fact that Sweden is a country that has no such rules. This, in combination with other features of our treatment of cross-border interest payments, justifies a further discussion and policy considerations. Also, there is at present  in our country an on-going and very exited debate  regarding the widespread use in the recent past of so called “interest spinners” leading to enormous corporate tax base losses in Sweden. More hereinafter.

Under section 3 of the final directives for the subject the General Reporter (Prof. Pascal Hinny) had advised branch reporters to restrict their reports to a description of the basic principles on thin capitalization and to focus primarily on any new tendencies experienced in the last decade, foreseeable future developments in this field and problematic aspects thereof. Branch reporters had also been requested to answer 13 questions on thin capitalization. These questions and answers, however, are not part of the national report.

The Swedish draft report which systematically coordinates with the structure of the directives of the general reporter and is numbered in accordance therewith indicates (under section 3) only that the thin capitalization issue is not applicable (“N/A”) in Sweden. And the term thin capitalization as such does not appear anywhere in the draft report. This, as will be explained below, will give a foreign  tax analyst a very limited possibility to fully comprehend the full implications of our international regime on cross-border taxation of interest and the quite extraordinary tax strategies that can be engineered as a result hereof.

At the branch meeting I got the impression that my considerations only had a limited impact and would not lead to any substantial changes of the national report. This, however, remains to be seen when the Cahiers for the congress and the final national reports are published in June of this year.

The purpose of this paper is therefore to convey to a broader readership both in Sweden and abroad the ideas put forth by me at the branch meeting and to facilitate, as I see it, the understanding of the Swedish tax regime regarding cross-border interest of corporations.

Thin capitalization

As already mentioned there are no formal tax rules limiting debt to equity ratios on the financing of a Swedish company. The minimum equity requirement is 100 000 SEK (app. 15 000 USD).

In the late 80s the tax authorities challenged this situation suggesting under our arm’s length provisions that it would be out of the question between non-related parties that a Swedish company with an equity of 5000 SEK, (which at the time was the minimum statutory capital requirement), would be able secure debt financing running into maybe tens of millions of SEK. Therefore the deduction for the interest payments by a Swedish subsidiary to its foreign parent company should be substantially reduced. (There was, however, no claim that the non-deductible payments be classified as dividends and thus subject to withholding tax). The Supreme Administrative Court, however, in what has become a landmark decision (RÅ 1990 ref. 34, Mobil Oil Corporation) flatly rejected the fiscal suit. (A more substantial analysis of the case is provided in the Swedish national report for the 1996 IFA congress in Geneva on “International Aspects of Thin Capitalisation” by Sture Bergström and Leif Gäwerth.)

The outcome of the case prompted the National Tax Administration (RSV 1990:1) in a report of about 150 pages, to call for the introduction of formal Swedish rules on thin capitalization. This request, however, in a ceremonious declaration (Fi 90/3410, Dossier 30) over some ten lines of text (!), and without much fuss (!!) was dismissed by the Swedish government almost five years later (!!!).

Deduction of interest expense.

As noted in the Swedish draft national report there are no restrictions for Swedish companies to deduct arm’s length interest expense. There is, however, a specific rule (Income Tax Act (ITA) chapter 9, section 5) which prevents the deduction for any costs, including interest expense, attributable to income which is exempted from taxation under a Swedish double taxation treaty. This rule was introduced in the wake of the Supreme Administrative Court ruling RÅ84 1:27 where a Swedish bank receiving treaty exempted interest payments from Argentina nevertheless was granted a deduction for costs relating thereto.

Interest expense (and other costs) attributable to the financing of a foreign company the profits of which may be received by the investor as a dividend are, however, deductible if the dividend receipt had been exempted from taxation if the foreign payee company had been Swedish, (which invariably is the case).

Further very important to note is that a deduction for interest expense is granted irrespective of the residence of the (foreign) lender. Nor is there any requirement that the interest is defined as such in the state of the recipient or that it has been effectively subjected to tax in that state. This has recently, and after the presentation of the draft national report, been confirmed by the Supreme Administrative Court in its ruling regarding the so called interest spinners. See below.

In his national report to the 1994 congress subject on “Deductibility of interest and other financing charges in computing income” professor Melz, who was national reporter then too, stated that interest payments received by foreign lenders were usually taxable in their domicile countries (thus preventing any interest tax arbitrage opportunities). Such a remark, in a world of cold and calculating international tax planning where the interest more often than not may wind up in a tax haven financing company, a tax exempt (Swiss) branch, a foreign trust or in the bank account of an individual in Monaco or a Saudi company, must frankly be considered quite innocent.

In various discussions regarding our CFC tax rules the idea was broached on and off, but not really seriously, that instead of such rules Sweden should limit interest deductions on the financing of foreign investments in order to prevent tax arbitrage.

Swedish tax on outgoing interest payments.

There are no taxes whatsoever, neither ordinary nor withholding, on any interest paid by Swedish corporations (or individuals) to non-resident lenders - period. However, if paid to a related company abroad, the amount of interest must of course be at arm’s length.

In the early 60s a government committee, Dubbelbeskattningssakkunniga, submitted a comprehensive report (SOU 1962:59) on a number of international tax issues, including a suggestion that Sweden introduce a 25% withholding tax on outgoing interest payments. This, however, was rejected on the grounds that it would only raise the interest level for Swedish debtors.

Messr Jonsson and Melz have noted that the absence of source taxation on interest is “unconventional” and remain doubtful to the alleged risk that this, today, would jack up the level of interest to foreign lenders. Their reason herefor, they suggest, is that interest income is usually taxed in the jurisdiction of the lender and credit granted for source taxes. Further, one may add, the very competitive and sophisticated financial markets of the globalized world of today are very different from those in the 1960s.

Practical effects of the Swedish tax treatment of cross-border interest payments.

The situation in Sweden regarding the taxation of cross-border interest payments, i.e.

a)      the absence of thin capitalization

b)      the full deduction of interest expense and

c)      the lack of withholding taxes on interest payments

and the combined effects thereof is probably not unique but nevertheless quite exceptional in a comprehensive and modern tax system of an economically developed country such as Sweden’s and also, for that matter, a country with an outspoken ambition to protect its tax base.

The main advantages of our international tax regime concerning interest payments as far as foreign investors are concerned are that the deduction of interest expense together with – many times – the (foreign) non-taxation of interest receipts greatly facilitates take-overs of Swedish companies, particularly those requiring large capital input and that consequently these foreign investors, both corporate and individual pay very little or at least much less corporate tax than their Swedish competitors. Also, together with a number of other tax factors, it has made Sweden the number one tax location and stepping-stone jurisdiction for third state investments. Sweden, in this sense, can be characterized for tax purposes as a veritable “swing-door” for international holding company investments.

An informative description hereof can be found in an article titled “A break with tradition” by Carl Pihlgren (Ernst & Young, Stockholm) in International Tax Review, June 2007. Also, in KPMGs “Magasinet” no 3/03 in the wake of the introduction of our new participation exemption regime, an article was authored by Inger Paulin and Johanna Lidell  under the title “Sweden supports holding companies”, (“Sverige håller för holdingbolag”). Below a color picture of three big appetizing cakes appeared the somewhat guileful and rhetorical question: “Is there a country where you can both eat cake and keep it?”

In order to counteract the interest tax arbitrage that follows from unrestricted deduction for interest expense by Swedish companies and full participation exemption with regard to both dividend receipts and capital gains on foreign investments Sweden in 2004 introduced a new CFC-legislation allowing the (current) income of low-taxed foreign holdings to be subjected to taxation in Sweden in the hands of the Swedish holding company. This taxation kicks in at a level of shareholding or voting power of 25% or more if the tax of the CFC is less than 15.4% on a tax base assessed under Swedish rules. Also, a very generous white list exempts many foreign companies from CFC tax treatment altogether. Also, as explained above, if the Swedish company is highly debt leveraged its CFC income may be offset by the deductible interest payments thus effectively “immunizing” the company from the CFC taxation. In addition, the underlying tax paid by the CFC may be credited against the Swedish tax.

Consequently, this CFC taxation regime must be held in mind when discussing the tax treatment of interest in Sweden.

“Interest spinners”

Under section 5 (Effective taxation of interest income) of the directives, the Swedish draft national report has highlighted the situation where also Swedish international groups, by means of a technique labeled “interest spinners”, can take advantage too of the absence of thin capitalization and our international tax regime regarding interest payments. These “interest spinners” are described in the report as an arrangement where a foreign parent company (normally located in a tax haven) of a Swedish operating subsidiary “has sold the shares in the subsidiary to a newly established Swedish company against an interest-bearing promissory note. The promissory note so received has thereafter been transferred to another subsidiary of the foreign parent company as an unconditional shareholder’s contribution. The transactions have incurred interest expenses for the newly established company which has been able to receive group contributions (taxable for the recipient and tax deductible for the provider) from its operating subsidiary”. [1]

The role of the newly established (holding) company is normally only to receive group contributions from its operating subsidiary to be offset – or spun off - against the interest expense paid to the foreign tax haven group company or any other recipient exempted from Swedish tax such as an investment company[2] or a municipality.

Somewhat off-handedly the national reporters have remarked that the tax authorities have “questioned” the deductibility of interest in some of these cases. This, however, completely fails to reflect the intensity of the discussion which has taken place in Sweden regarding interest spinners! [3] The general theme in the articles published so far, mainly written by tax practitioners, is a vociferous rejection of the idea that interest spinners could be subject to our general anti-tax-avoidance rule (GAAR).

Also, at a recent seminar arranged by the Institute of Taxation and Legal Security (Institutet för Skatter och Rättssäkerhet (www.isr.org) ) the National Tax Administration, because of its intention to challenge the interest spinners, was fiercely accused for overstepping its constitutional powers on the grounds that the Supreme Administrative Court had already granted deductions in similar cases and that the conduct of the authorities was thus giving rise to legal insecurity in this field.

Further, in an article in Dagens Industri (15 December 2006) our tax minister Ingemar Hansson was fuming over the “tax abuse” involved in the “fictitious” interest deductions in the operation of interest spinners leaving the tax treasury wanting of something like 10 billion SEK! If the court actions by the tax authorities would be unsuccessful Mr. Hansson was threatening new tax legislation.

The national reporters, discussing the international tax arbitrage involved in interest spinners, have also come to the conclusion that our GAAR is ineffective in these cases. It would, however, have been appropriate in that context to at least have mentioned that the Stockholm Appeals Court  had considered otherwise, disqualifying interest spinners as tax avoidance, a decision which had been appealed by the tax payer to the Supreme Administrative (Tax) Court, Regeringsrätten, (SAC).

In a ruling of 6 December 2007 regarding Industrivärden AB (and consequently made  subsequent to the submission of the national report) the SAC has, however, in accordance with the opinion of the national reporters, overturned the ruling of the Stockholm Appeals Court concluding that tax spinners are not covered by the GAAR.

The Tax Administration in a recent statement has concluded that the SAC ruling will render the payments of Swedish corporation tax “voluntary” estimating treasury losses to SEK 60 billion annually.[4] Certain members of the ruling political parties in the Swedish Parliament have made statements to the effect that new legislation in these matters should be put in place.

The interest spinner issue thus represents a highly contentious area of international taxation at the moment in Sweden justifying a more in depth discussion in the Swedish national report.

Tax sparing on cross-border interest payments.

In my memo to the branch meeting I also brought up the topic of tax sparing on interest payments in our tax treaties.

Sweden in the past has been quite generous in providing such benefits in its treaties, especially those with developing countries. However, since the publication of OECDs alarming report on this issue in 1998 (“Tax Sparing, a Reconsideration”)[5] warning contracting states to take note of the wide-spread abuse encountered in this field , especially with regard to interest payments, Sweden has stopped providing tax sparings on interest payments in its treaties.

This, in my view, is a development with regard to the taxation of cross-border interest payments which is also worth mentioning in the Swedish national report.

Conclusions and recommendations

In one of the very first sentences of the draft national report a reference is made to the fact that (as late as) in 1989 our exchange controls were abolished: “These exchange controls mainly applied to portfolio investments. In this “protected” situation Sweden had less reason to design tax rules specifically for international financial transactions. The Swedish tax system may still not have fully adapted to the new international situation after the exchange controls were abolished and then when Sweden entered the European Union”.

The remark that our tax system has not “fully adapted to the new international situation” is a sweet euphemism!  Indeed, in an environment where foreign borrowing was strictly curtailed one could of course indulge in the luxury of allowing unrestricted interest deductibility and a zero-rated tax on outgoing interest payments!

Professor Brian Arnold in his general report to IFAs aforementioned congress in 1994 on cross-border interest payments also put up a surprised face to the fact that Sweden had no thin capitalization rules, diplomatically concluding that this may have had something to do with the exchange controls which had been given up just a few years earlier.

But this was all in 1994! Today in 2008, a further nineteen years down the road since 1989, we now have completely deregulated and digitalized financial markets, a desperate “(tax) race for the bottom” in many states, EU membership, the internet and God knows what. And our international tax legislator, seemingly still under the lingering sedation of exchange controls and while international tax payers are laughing all the way to their banks, is still fast asleep! Also, it is ironic that Sweden, rhetorically maintaining a stiff defense against tax arbitrage on interest payments as far as Swedish investments abroad are concerned – our CFC-legislation bears clear evidence hereof – is so generous in this regard to foreign investments in Sweden! Moreover, it is quite anomalous that, where we uphold strict arm’s length principles with regard to foreign interest payments, we  put no cap on the amount of inter-company debt that may be incurred! (It has even been evidenced that high debt to equity financing, allegedly bearing a higher risk element, has driven up the arm’s length price level on interest payments!) Surprising too is this contradictory Swedish attitude with respect to the most volatile and sensitive of all tax bases, namely that which concerns pure international financial operations and loan transactions!

Sweden’s general international tax policies - to the extent that they are at all possible to detect - are reactive not strategic, leading to a hotchpotch of disunited rules. This applies especially to our treatment of interest payments. Sweden is consequently in sore need of a new and comprehensive system in this regard that stands up to the realities of today.

In such a process one should seriously consider the introduction of a withholding tax on interest in order to prevent abusive treaty-shopping opportunities by foreign tax havens of our treaty net-work. The purpose of our treaties, based on bilateral tax sacrifices, is to provide business opportunities and benefits to tax payers in Sweden and the other contracting state and should not be doled out indiscriminately to third (and non-treaty) state citizens. At the branch meeting I used the quite vulgar metaphor, (for which I, however, immediately apologized,) that our treaty network should not be “prostituted” in such a manner! It should be noted too, that the OECD Model considers a source tax of 10 percent as being reasonable.

Sweden should also reconsider its position on thin capitalization. At least one should submit the problem to an official inquest for expert analysis.

Moreover, in order to put a stop to interest tax arbitrage and to bolster the competitiveness of Swedish enterprises, one should also consider the requirement that interest payments, that have been granted deductibility in Sweden, shall be subject to tax by a foreign recipient. For the purposes of treaty application the OECD Model (section 10 of the Commentaries to article 11) suggests that relief in the state of source be conditional upon the interest being subject to tax in the state of residence.

Ulf Tivéus, in his recent article in Skattenytt, see footnote 3, has also considered several possibilities for curtailing the effects of interest spinners.

At the branch meeting I concluded that the draft national report, by completely ignoring our position on thin capitalization and not sufficiently “bottom-lining” the combined – and I repeat the combined - effects of our tax regime on cross-border interest of corporations, did not give a fair picture hereof. The report in my opinion has also overlooked other important tax developments and trends in the recent past regarding international interest payments well worth mentioning in our national report.

Anticipating further that the thin capitalization issue will surely play a dominant role at the congress and that the “Swedish experience” in this field would no doubt be of interest to the congress participants, I even suggested that Sweden should claim a seat on one of the discussion panels on this subject in Brussels. Unblushingly I volunteered to be nominated hereto myself! (This offer, however, has not been encouraged by the Swedish IFA Branch. And my proposal to put this article on the website of the Swedish IFA Branch (by a decision of the board of directors) has also been declined.)

peter@sundgren.net