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Supreme Court judgement on Loan Interest
Recently the Swedish Supreme Administrative Court ("Regeringsr?tten") issued a judgement, where it stated that the credit risk of a lender which is also a 100 % shareholder in the borrower is lower than that of an external lender. This meant, according to the Court, that all things alike, such an internal loan should carry a lower interest than an external loan. The case concerned a loan between Swedish entities, but the Swedish Tax Agency has recently issued a note stating that it should apply also to interest related to a loan with a foreign (100 %) parent company, ie the arm's length interest resulting from a benchmark should be adjusted if the lending company is the 100 % shareholder of the borrower. Taxand Sweden analyses the effect the judgement will have on resident and non-resident companies in Sweden.
There are no thin capitalisation rules in Swedish tax law. If there is an internal loan between two Swedish affiliated companies, with no possibility to consolidate their income (through group contributions), it is however of importance to make sure that the interest rate is set at an arm's length rate. If interest is not levied on arm's length rate, a Swedish borrower may be subject to reassessment.
In the judgement the Swedish borrowing subsidiary initially had external loans, in order to finance real estate investments, with an interest charged of 4.5 %. In connection with a change of ownership of the borrowing subsidiary, the loans were replaced with internal loans with ten years duration, from the new parent company holding 100 % of the shares. The interest levied amounted to 9.5 % and no security was provided.
The Supreme Administrative Court concluded that when deciding the deductible arm's length interest rate it is important to take into consideration the credit risk at hand and subsequently the necessity of providing security. A parent company giving a loan to a wholly owned subsidiary has, through the ownership, the control of the borrowing company. This is in comparison to an external lender with only limited insight in the activity of the borrowing company. It was also considered that an external lender could not be certain of a parent company's intention and willingness of financially supporting the subsidiary. Given this background the Supreme Administrative Court further stated that the credit risk in a situation where the lending company is a 100 % shareholder of the borrowing company is generally lower than that of an external lender.
This meant, according to the Supreme Administrative Court, such an internal loan agreement should carry a lower interest under arm's length considerations than an external loan. The court admitted an interest deduction of 6.5 %. It could be noted that the way the case was submitted, the question for the Court to answer was if an arm's length interest would be higher than 6.5 %. This means that it is possible that the Court actually considered that the arm's length rate was lower than 6.5 % however this was not under trial in the case.
The case concerned a loan between Swedish entities. On 28 September 2010 the Swedish Tax Agency however issued a note stating that the approach taken by the Supreme Administrative Court should be applicable also on interest paid from a Swedish company to its foreign parent company, holding 100 % of the shares. The Tax Agency however stressed that it cannot be concluded that in all cases the full control of a subsidiary should result in a lower arm's length interest rate. The creditworthiness of the borrowing company should also be taken into consideration.
In Sweden there are similar trends pointing in the same direction, such as the generally increased focus on transfer pricing. The Swedish Tax Agency has been and is still increasing its resources dedicated to transfer pricing, and the trend (to some extent also in court) seems to be focusing on substance rather than on form.
The judgement from the Supreme Administrative Court is to an extent an in casu judgement. However, the statement that the credit risk and therefore also the arm's length interest rate is lower when the lender is also a 100 % shareholder in the borrowing entity, is a general statement.
This and the subsequent note from the Swedish Tax Agency indicates that the deductible (arm's length) interest rate paid by Swedish subsidiaries to its (Swedish or foreign) parent company should be lower than an interest levied in an external loan situation, all other things comparable. We believe that especially if the borrowing entity is a generally "solid lender" with possibilities to provide security for the loan, but where it has been chosen to provide unsecured internal loans, the difference may be dramatic between external benchmarks and the arm's length level accepted by Swedish authorities.
For Swedish and international company groups, in order to avoid a partly denied interest deduction and tax penalties, it is important to be aware of this recent judgement and the current trends, when deciding interest rates on intra group loans to Swedish entities.
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