Stockholm Tax Alert: Deduction for interest on mandatory convertibles denied
On 14 February 2014, the Swedish Supreme Administrative Court rendered a judgement regarding the classification of a convertible debt instrument. The questions raised in this case ties very much in to the questions that we have discussed in relation to CRD IV. Below is an executive summary and then an outline.
In short, the Court found that there is no obvious answer to the question of how financial statements should be classified from a tax point of view, but it must be decided on a case by case basis. Our conclusion from this case is in line with what we have previously discussed with you, namely that where instrument are recorded as equity in the books, the tax treatment generally follows the accounting classification.
The circumstances in the case were the following: A company planned to issue convertible bonds maturing in 20 years. The loan had a term that gave the company the right to choose if the loan should be repaid in cash or exchanged for shares. The loan had an 8.5 percent annual interest that was payable quarterly. However, the company had a right to decide that the interest should not be paid when due, but instead be capitalised and added to the loan amount. In such case, penalty interest was also due. Also the interest, including penalty interest, may be paid in shares instead of cash.
The company had stated that the loan constituted a debt obligation (convertible) under the Swedish Companies Act. In accordance with GAAP, the loan would be reported as equity in the financial statements. The interest expenses would therefore not be recognised in the income statement. The compensation to the holders of the convertible bonds would instead be accounted for under equity.
The case concerned whether the company was entitled to deduct the interest expenses on the loan and, if so, at what point in time.
In its decision, the Supreme Administrative Court did not question the fact that the loan fell under the definition of a convertible bond in the Company’s Act, nor did it question the fact that it should be recorded as equity under IAS 32.
The Court concluded that there are no tax rules stating how the classification should be made for tax purposes (such as debt or equity). A natural starting point, where there are no specific tax rules, is the taxpayer’s accounts, provided that they are prepared in accordance with GAAP.
The Court found that international developments in the field of financial instruments is very fast and that new instruments are often designed in a way that makes it difficult to classify the instrument as debt or equity. The Court further stated that it is debatable to what extent the accounting framework is an appropriate basis for corporate taxation.
The Court stated that there is no obvious answer to the question of how financial statements should be classified from a tax point of view, but it must be decided on a case by case basis. The Court found that the tax classification of this particular instrument should follow the accounting classification and thus be regarded as equity. The company was therefore not entitled to deduct the interest expenses.
In its reasoning the Court stated that the loan’s characteristics differ from what normally characterises debt. It particularly mentions the fact that there was no obligation on the company to repay the loan with funds from its own wealth, but the company may unilaterally elect to convert the loan into shares. It further concluded that the tax treatment of the loan as debt would mean that non-deductible distributions of profits may be deducted as interest expenses for tax purposes.