Tax neutrality in corporate financing

• Author: Jakob Bundgaard; Michael Tell
• Pages: 1-24

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1. Introduction

Corporate financing decisions¹ and the tax law effects have played a significant role on the international tax policy agenda in recent years². The overall problem relating to corporate financing in international tax law is basically the different tax treatment of the remuneration on debt and equity. As a general rule the tax treatment of equity financing and debt financing follows the same basic principles around the world³. Especially in a Danish context there has been a massive policy focus on tax neutrality in corporate financing in terms of eliminating tax advantages obtained by private equity funds in leveraged buy-out structures. Moreover, the Danish Government has been eager in combating cross border tax arbitrage possibilities which have also occurred in a corporate finance context.

In this article we analyze the present Danish tax regime with a specific focus on corporate financing. More specifically we shall analyze whether the existing corporate tax system can be considered to be in accordance with an overall policy goal of tax neutrality.

Initially we present the existing Danish tax regime with respect to debt financing and equity financing. This also includes a presentation of the specific interest deduction limitation provisions and anti arbitrage provisions which have been adopted during the last few years. The analysis focuses on cross border financingPage 2 whereby the questions asked concern the taxation of a domestic issuer and a foreign investor or a foreign issuer with a domestic investor. The analysis is not intended to be exhaustive regarding all tax issues raised by the relevant tax legislation and does not go into detail with any technicalities of domestic law nor does it attempt to provide an in depth analysis of the issues of a more general nature relating to issuance of share capital and loan capital. On the basis of this outline we analyze whether the existing regime is in accordance the principle of tax neutrality. In order to carry out this analysis we have defined the tax neutrality concept as applied in this context. Finally, potential EU law infringements of this regime are analyzed.

2. The Present Danish tax regime regarding debt- and equity financing

2.1. Tax Treatment of a Corporation Issuing Equity

Generally corporate earnings from equity are subject to corporation tax in the country of residence of the issuing corporation. Corporate earnings are presently taxed at a rate of 25% in Denmark⁴. As a main rule remuneration on equity (dividends) is not deductible in the calculation of taxable profits. Dividends are not deductible in Danish tax law.

2.2. Tax Treatment of the Investor in a Corporation Issuing Equity

In the country of source of the dividend the shareholder may be subject to a withholding tax on the shareholder's account, which is however frequently reduced as a result of the EU parent/subsidiary directive (PSD)⁵ or tax treaties⁶. In the country of residence of the shareholder, dividends are in principle taxable (possibly with a credit for the withholding tax and/or corporation tax levied at the level ofPage 3 the paying corporation). Under the existence of an international affiliation privilege or participation exemption, they are tax exempt.

In Denmark dividends may also be subject to a withholding tax of 28%⁷ on the shareholders account if the shareholder is a non-resident⁸. Corporate shareholders qualifying as a parent corporation may be exempt from the dividend withholding tax. The requirements that should be fulfilled in order to obtain the exemption are direct ownership of at least 10% of the shares in the corporation paying dividends. The foreign corporate shareholder should be classified to be of a similar nature as a Danish taxable corporation (broadly defined). Another requirement is that the taxation of the dividend should be reduced or eliminated according to the PSD or a tax treaty. Exemption can also be obtained if the corporation do not fulfil the 10% ownership criteria, but qualify to joint taxation with the Danish subsidiary corporation⁹.

The withholding tax will be reduced to 15%, if the corporate shareholder is a resident in a country were the authorities have an agreement with the Danish authorities to exchange information and the corporate shareholder owns less than 10% of the shares¹⁰. The withholding tax of 28% still applies and the shareholder shall therefore contact the Danish authorities to invoke the reduced taxation.

Corporate shareholders resident in Denmark are generally taxable in Denmark regarding dividends¹¹. However, for corporate shareholders meeting the parent corporation test, dividends may be exempt according to the Danish participation exemption regime, which although applicable worldwide is also the Danish implementation of the PSD. Thus, dividends received by Danish parent corporation (specifically mentioned in the wording by reference) are tax exempt if thePage 4 following conditions are met¹²: (1) The parent corporation should directly own at least 10% of the shares in the corporation paying dividends or qualify to a joint taxation with the Danish subsidiary corporation according to Sec. 31or Sec 31 A of the CTA and (2) the dividends are not tax deductible¹³ or subject to a specific tax regime regarding (domestic and foreign) investment corporations as defined in Sec. 19 of the Act on Taxation of Capital Gains and Losses on Shares (GLS).

Dividends received which do not fulfil the participation exemption requirement are taxed at the ordinary corporate tax rate of 25%¹⁴. Dividends received by physical shareholders are taxed as share income at the rates of 28% (income up to DKK 48.600) and 42% in 2010¹⁵.

Capital gains regarding shares in a subsidiary corporation are tax exempt as well as capital losses are non-deductible, if the investor directly owns minimum 10% of the shares in the subsidiary corporation and the taxation of a dividend should be reduced or eliminated according to the PSD or a tax treaty¹⁶. Capital gains are tax exempt and capital losses are non-deductible even though the investor does not meet the 10% requirement, if the investor and the corporation are considered a group according to Sec. 31 C of the Corporation Tax Act.

To date, convertible bonds could be disposed of free of tax if a corporation sold the convertible bond after having owned it for at least three years, and any losses were not deductible. As a result convertible bonds have been used in cross-border financing structures. The benefit could be achieved, for instance, if a Danish lender re-lends by means of an interest-free convertible bond to a borrower who is a foreign corporation domiciled in a country that accounts for convertible bonds as claims. In this situation the Danish corporation would be exempt from tax on any gains from the convertible bond after at least three years' ownership while thePage 5 foreign corporation would be eligible for deduction of any capital losses¹⁷. This type of tax arbitrage was attacked in 2008 by the Danish legislator by way of making gains on convertible bonds generally taxable. This is also the result of the 2009 tax reform¹⁸.

2.3. Tax Treatment of a Corporation Issuing Debt

Internationally, remuneration on debt (interest) is in general considered a deductible expense in the calculation of taxable profits in the country if residence of the debtor/issuing corporation¹⁹. This leads to the conclusion that the interests are effectively free of corporate income tax, whereas the creditor in both the national and international context is the only person likely to suffer tax on interest payments²⁰. However, domestic restrictions on interest deductibility may impose limitations on the deductibility of the interests.

In Denmark interest expenses are tax deductible in the corporate income tax²¹. In general a corporation’s capital loss on debt is also tax deductible²². However capital losses regarding debt in Danish crones (DKK), which are regulated by an index and if the interest is not below the minimum rate set in Sec. 38 of the ACD are not deductible²³. Further, a capital loss on debt is not deductible if the redemption is made to a predetermined premium relative to its value at the original issue date and the debt is issued in Danish crones (DKK) and the interest is not below the minimum rate set in Sec. 38 of the ACD²⁴.

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The deductibility of interest and capital losses may be restricted under three sets of rules for corporate taxpayers: 1) the thin capitalisation test, 2) the asset test and 3) the EBIT test²⁵.

2.3.1. The thin capitalisation test

A corporation is thinly capitalized if the debt-to-equity ratio exceeds 4:1 at the end of an income year²⁶, provided that the controlled debt exceeds DKK 10 million²⁷. If a corporation is considered thinly capitalized, interest expenses and capital losses regarding the controlled debt that should be converted to equity so the dept-to-equity ratio is not exceeded, are not deductible. However, the deductibility of capital losses are carried forward...