Sweden’s drive for tax competitivenessJanuary 17, 2013
Although their announcements were separated by some months, Sweden recently unveiled a pair of tax proposals that reflect a trend being seen in many countries elsewhere: that of a significant reduction in headline corporate income tax rates (from 26.3% to 22%, effective 1 January 2013), with a corresponding limit on the tax deductibility of interest payments that will cover roughly half the cost of the rate reduction.
This article was first published in the Ernst & Young Global Tax Policy and Controversy Briefing, Issue 11, December 2012 (pdf, 4.26 MB)
Interest limitation — background
The Swedish government is currently proposing the tightening of Swedish tax rules limiting the tax deductibility of interest payments on loans. The objective of the proposal is to counteract certain types of tax planning using loans and interest payments, an approach that has been used in Sweden for some time and that the government feels has been eroding the Swedish tax base.
The current proposal contains some radical changes to the rules currently in place since 2009. The proposed changes should also be seen in context of other changes to the Swedish Income Tax Act that the Swedish government would like to accomplish in coming years, including the proposed corporate income tax rate cut.
Government view of the Swedish corporate tax system
In an initiative to carry out a broad review of the Swedish corporate tax system, the government in 2011 appointed a special committee for this purpose. In the guidance to the committee, the Swedish government recognizes taxation of companies as being of central importance for both inbound and domestic investment, Swedish tax revenue growth and for competitiveness of companies.
A dynamic and innovative business environment that is based on predictable rules, sound competition and development capability is widely seen as important for Sweden in order to support future economic development. The purpose of the review is, therefore, that the taxation of companies should be designed to favor entrepreneurship, investment and increased employment.
Special attention shall be given to changes in tax legislation that can improve Sweden’s global competitiveness while protecting the tax base from erosion that has arisen from certain cross-border transactions.
During the 1990s the Swedish corporate income tax system went through significant reform with the introduction of a much broader tax base and a reduction of the headline corporate income tax rate from 57% to 28% in just a few short years. From tax year 2009, the tax rate stands at 26.3%. The reform contributed to a more neutral tax system where investment in different types of assets and where different means of financing and investment were treated more uniformly.
As a result, Sweden was viewed as having one of the most competitive corporate tax systems within OECD; in 1995 the Swedish corporate tax rate was 28% while the average income tax rate of 27 EU Member States was 37.5%. Thereafter the income tax rate has decreased in many countries, and the average corporate tax rate within the EU is now 25.9% and for Euro countries, 23.5%.
Despite the further reduction in 2009 to 26.3%, Sweden’s headline rate today is still above the average EU rate, and the country has consequently lost a significant competitive advantage compared with earlier years. The rate cut to 22% mirrors that of a number of other European economies, all seemingly targeting a corporate income tax rate in the low-twenties.
With all countries now driving these higher levels of tax competition, the Swedish Government now sees the need to carry out broader reform of the Swedish corporate tax system. Contributing to this is that in a more and more globalized economy, it is important that a corporate tax system is competitively neutral and contributes to a high level of investment and a quick development of productivity that will benefit the Swedish GDP.
The Swedish government is consequently looking to create long-term changes to the tax system that promote investment and productivity, but at the same time introduce changes to the tax system that protect the Swedish tax base and prevent possible erosion of Swedish corporate income tax revenue.
Current areas of concern
In the current tax system there are some areas that are viewed as specific areas of concern by the Government, and the financing of investment is one key concern. In the current Swedish corporate tax system, there is what can be described as a “double asymmetry.”
- The first asymmetry comes from the fact that revenue from investment in certain kinds of assets, as for example business-related share investments, are tax free while interest expense on loans (that could be used to finance such an investment) are tax deductible.
- The second asymmetry comes from the diverging treatment of different sources of financing, where cost for borrowed capital (interest) may be deducted while cost of equity (dividend and value increase) is non-deductible.
The asymmetries represent more and more of an issue as the world economy has become more and more globalized.
Other areas of concern and focus are:
- The lack of withholding tax (WHT) on interest payments made outside Sweden (while most other countries apply WHT), which may facilitate tax evasion attempts
- The lack of competitive research and development incentives, while other countries are introducing or reforming such systems
- Swedish rules on group contributions (the Swedish method of tax consolidation) that were designed to work in a closed economy (i.e., on a domestic level)
All of these areas will be addressed by the Government-appointed committee, and we will most likely see proposed changes to Swedish tax legislation. The more pressing concern, however, to the Government seems to be the Swedish rules on a tax deduction for interest costs. Despite that, rules governing interest deductibility are part of the broader review of the Swedish corporate tax system the Government has already now, in addition, proposed changes to the current rules effective already as from 1 January 2013.
Current legislation on interest deductibility
The Swedish Income Tax Act contains rules limiting the deductibility of interest expense on intra-group loans that have been used for intra-group acquisitions of shares or share-based instruments. Further, the rules apply to certain external financing related to internal acquisitions of shares, primarily with respect to so-called back-to-back financing.
Deductions are, however, allowed if the interest income corresponding to the expense would be taxed at a rate of at least 10% in the hands of the beneficial owner had the interest been the only income of the recipient/beneficial owner (the “10% rule”). Further, deductions are allowed if both the intra-group acquisition in question and the debt related to the interest expense are predominantly (approximately 75%) motivated by business reasons other than tax savings (the business reasons exemption).
The proposed legislation limits the deductibility of interest expense relating to all loans between related parties. Consequently, the application of the rules will no longer be limited to loans put into place as a result of an acquisition of shares between affiliated companies, but will apply to all inter-company loans — that is to say, it will be indifferent to the purpose of the loan.
As an example, the rules will in the future apply also to loans put in place for the acquisition of assets such as machinery and equipment, or for the acquisition of intellectual property, as well as to loans resulting from group internal cash pool arrangements. Two entities are considered to be related if one of the entities has a substantial influence (through ownership or by other means) in the other entity, or if the entities are essentially under the same management.
Exemptions to limitation
The proposed business reasons exemption provides that interest expense shall be deductible if the debt relationship related to the interest in question is predominantly motivated by business reasons. The exemption is applicable only if the beneficial owner of the income corresponding to the expense is resident in a state within the European Economic Area (EEA) or, under certain conditions, in a state with which Sweden has a tax treaty.
If the debt relates to an acquisition of shares or share-based instruments from a related company, or to an acquisition of shares or share-based instruments in a company that becomes related after the acquisition, it is also required that the acquisition is motivated mainly by business reasons.
A specific rule is introduced providing that special consideration shall be paid to whether financing through contributions from either the lender or a company with a substantial influence over the borrower would have been possible instead of debt.
The 10% exemption provides that deductions for interest payments shall be allowed if the corresponding interest income would hypothetically be taxed at a rate of at least 10% in the hands of the beneficial owner had the interest been the only income of the recipient/beneficial owner. However, a further requirement is that the debt relationship has not been created mainly to provide the group with a substantial tax advantage.
The interest limitation changes are proposed to come into force on 1 January 2013. The proposal has been referred for consideration to interested parties in a first round of consultation, and to the Council on Legislation in a second round, without undergoing any major changes.
The proposal has also been accepted in the main by the Council on Legislation, although the Council has indicated that the rule providing that deductions shall not be allowed in situations where the 10% test is met if the debt has been put in place mainly for tax reasons, should not be applied by the Tax Agency at first instance.
Instead, the Council indicates that the Tax Agency should apply to the first tier administrative court and request that the court tries whether the provision can be applied in a particular case. The reason for this is that the rule in fact is formulated as a general anti-avoidance rule.
The proposal has already been substantially criticized on a number of points. Introducing limitations to the interest deductibility in 2009, new restrictions in 2013 and the possibility for additional reform of the rules with potential effect from 2015 can of course in itself be argued to be in conflict with the Government’s own intention of creating a business environment that is based on predictable rules. The high pace of legislative change in itself creates uncertainty.
Further, once rules are introduced, business would typically like to see rules that are clear and objective in their nature and where the tax effects of a transaction can easily be predicted. The proposed rules, however, open for uncertainty how some of the key definitions may be interpreted and also creates a situation where subjective assessments may be made by the tax authority and by the courts.
As an example, the newly proposed definition of affiliated companies makes it uncertain which companies will in fact be covered by the legislation. It will most likely be very difficult for the Swedish Tax Agency to assess whether a transaction is made for valid business reasons or not, as well as whether a loan from a company subject to at least 10% corporate income tax has been put in place mainly to provide the group with a substantial tax advantage.
It is, further, not clear what weight should be attributed to the possibilities of choosing to finance a company with contributions instead of debt, or how the concept “substantial tax advantage” relates to interest payments to group companies that can offset interest income against tax losses carried forward from previous financial years. It has been argued that this creates a legally uncertain position for all companies having internal debt relationships.
Further, the rules, if implemented, will apply to interest payments made as from 1 January, but actually have a degree of retroactive effect considering they will apply to debt relationships that may have been put in place before the rules came into force. Consequently, the Tax Agency may go back in time to examine and determine if, in their opinion, a loan agreement was put in place for valid business reasons or not.
Further, it can be noted that the rules will restrict interest deduction for interest payments to a related entity located outside the EEA and in a country with which Sweden has no tax treaty, which is taxed below 10% even if there are valid business reasons behind the loan that can also be substantiated by the company. Consequently, even if there are valid business reasons for the loan, the interest deduction will still be restricted in these situations.
Corporate rate reduction
On 13 September 2012, the Swedish government, as part of the 2013 financial bill, presented a proposal for a reduction of the Swedish corporate income tax rate from 26.3% to 22% (a 16% reduction) effective from 1 January 2013. As noted, during the 1990s, the Swedish corporate income tax system went through significant reform with the introduction of a much broader tax base and a reduction of the headline corporate income tax rate from 57% to 28% in just a few short years.
While a further reduction in 2009 to 26.3% was welcomed by business, it remains around three percentage points ahead of the average for countries that have adopted the euro. With the downward pressure on headline corporate income tax rates remaining, and taking into account other recent moves by other countries, the government has decided that a significant reduction of 4.3 percentage points is necessary.
The proposal for the rate reduction is presented in the Government budget bill for 2013 and has an estimated cost of SEK16 billion (about US$2.44 billion) per year. The Government estimates that the proposed tightening of the Swedish interest limitation will result in SEK8.8 billion (US$1.34 billion) in revenue for the state.
For corporations it is important to consider that if the proposed reduction of the corporate income tax rate is implemented, it will have a direct effect on potential deferred tax asset or liabilities booked on the balance sheet of the company.
What happens next?
At the time this article was published, the final form of the interest limitation proposal was still unclear. It is likely, however, that new rules will be adopted and that these new rules will have a significant impact on both existing and future internal debt relationships where Swedish entities are involved.
Most likely we will see a final proposal during autumn 2012, and companies with arrangements in place that may be impacted are recommended to carry out impact assessments on the information known thus far.
Questions or comments? Contact T Magazine and Ernst & Young