In the annual assessment and at the Board of Adjustment, a hybrid instrument was treated as equity and the related interest expense was treated as non-deductible. The company won its case in the Court of Appeal and in the Supreme Administrative Court.
As a consequence, the Ministry of Finance issued a draft for a parliament proposal in January 2015 to allow re-characterisation under Section 31 of the Fiscal Assessment Act (“VML”) which currently closely follows Article 9 of the OECD Model Tax Treaty. The proposed section would allow re-characterisation based on tax avoidance and violation of arm’s length conditions. The proposal raised strong objections (except from the Tax Administration) in the public hearing which ended in February 2015.
Facts of the case
A Finnish company had obtained a loan of 15 MEUR from its parent company in Luxembourg in 2009. The company claimed a tax deduction for the interest incurred in 2009. The Luxembourg parent company had granted the financing based on the requirements of the banks that had financed the Finnish operative entity. According to the decision, the banks required the intra-group financing to be subordinated. In addition, they required that the hybrid instrument in question should be treated as equity for IFRS purposes. The loan did not have a maturity date or collateral. The fixed annual interest rate was 30% and the accrued interest was added to the capital. The loan could only be repaid at the initiative of the debtor. The Tax Administration claimed non-deductibility based on a characterisation as equity under section 31 VML. They did not refer to or try to establish tax avoidance under section 28 VML.
The decision of the Supreme Administrative Court confirmed the debt equity characterisation of the hybrid instrument and whether or not section 31 VML allowed the re-characterisation for tax purposes. Section 31 closely resembles Article 9 of the OECD Model Tax Treaty and the Tax Administration had claimed that Article 9 and the OECD Transfer Pricing Guidelines supported such a re-characterisation. The majority of the Supreme Administrative Court ruled that taking into account the severity of the outcome for the taxpayer, ie the non-deductibility of interest expense, section 31 VML did not allow for such a re-characterisation. The court determined that Article 9 of the income tax treaty between Finland and Luxembourg did not expand Finland’s domestic taxation right and hence was irrelevant. The OECD Transfer Pricing Guidelines, which the Tax Administration had relied upon, could only be used to assess the arm’s length character of the transaction within the scope of section 31 VML, and not to disregard the loan for which section 28 VML would have been required. The decision was unanimous concerning the outcome, but there was a vote 3-2 concerning the reasoning. A concurring judge left in the minority pointed out that the Tax Administration had failed to support its case by analysing the debt equity criteria of the hybrid instrument.
The Supreme Administrative Court rejected the appeal of the Tax Recipients’ Legal Services Unit and returned the case to the Tax Administration for an assessment of the arm’s length level of the interest.
Impact of parliamentary elections
It is likely that the President will nominate a conservative Government where the Prime Minister will be Juha Sipilä. Due to his background as an entrepreneur and hard business lobby it is not likely that the draft proposal will be passed by the new Government during the next four years. However, because of the BEPS and current budget deficit there will be pressure to take some action. The budget process in autumn 2015 may consider this.