New tax legislation is being proposed that would limit the right of companies to deduct interest and other financial costs. The aim of the proposed rules is to apply equal tax treatment to equity and debt.Thus a negative “financial net result” would not be deductible. If implemented, the rules would have a serious impact on the financing of real estate companies.
On 12 June 2014 the Swedish Committee on Corporate Taxation outlined its plans for new tax legislation.This consisted of one main proposal as well as one alternative proposal.This article provides a brief summary of the proposed rules.
The salient features of the Committee’s proposed new system of corporate taxation are as follows:
- Deductions for interest and other financial costs will be limited. Deductions will only be allowed against corresponding financial income. No other financial costs will be deductible. Thus deductions will not be denied for all financial costs, but only for net financial costs.
- A general deduction, a “financing allowance” of 25 per cent of the company’s entire taxable profit, will be allowed for all companies.This deduction will be allowed regardless of whether the company has financial costs or not. The effect of this general deduction will be equivalent to reducing the corporate tax rate by 5.5 percentage points (from 22 per cent to 16.5 per cent).
Prohibiting deductions for net financial costs will lead to an equal treatment of equity and debt, from a tax perspective, in companies that have net financial costs.
The proposed rules for limiting deductions and general deductions will apply to legal entities that pay corporate income tax. Special rules will apply to partnerships.The rules will not apply to sole traders.
The prohibition of the deduction of financial costs will include (in addition to interest) foreign exchange effects, taxable profits and losses on financial instruments, taxable dividends and the interest component of certain rents. Certain types of interest payments, such as imputed interest in accounts payable and accounts receivable, will normally not be included, in an effort to maintain simplicity.The interest component in rents for real property and non-residential premises and short-term rents of various kinds will normally not be included either. Certain exemptions will apply to sale and lease-back operations and intra-group leases.
In the Swedish corporate tax system, an activity undertaken by a group of companies, and one undertaken by a single company are, in principle, subject to the same tax liability, although the common definition of a “group” of companies does not apply in this instance as special criteria will apply with respect to ownership, etc.To uphold this principle, companies with net financial income will be allowed to set this off against net financial costs reported by companies in the same group. The rules regarding group contributions will limit rights to implement such set-offs.
Since the proposal entails a significant limitation on the right to deduct financial costs, the Committee has proposed a general deduction in the form of a financing allowance rather than reducing the actual corporate tax rate.
One consequence of financial costs being deductible against financial income is that the rules will not influence the source of financing chosen by companies that have net financial income. In principle, banks always have net financial income.Thus, the proposed model is not particularly suitable for banks. Nevertheless, the Committee proposes that financial companies will receive the general deduction. In order to compensate for this, the banks will have to report taxable standard income based on their liabilities.This will impact the source of financing chosen by banks. Even though complete equality of tax treatment for equity and debt will not be achieved for banks and other financial companies, the tax treatment of financing will be more equal than is currently the case. For the financial sector, the combination of the standard income and the financing allowance is not expected to result in any change in tax liability.
Prohibiting the deduction for net financial costs will remove the tax incentive to report large interest costs in Sweden.This should lead to the abolition of the rules to prevent tax planning by means of intra-group loans between associated companies that Sweden introduced in 2009 and 2013.
The proposed rules will result in higher interest costs for companies with net financial costs. However, the increase in costs is not seen as significant by the Committee. At the current interest rate of about 3 per cent, the prohibition against deducting net financial costs will lead to an after-tax interest cost that is 0.50 percentage points higher than under the current rules. If the interest rate goes up to 5 per cent, the after-tax interest costs will still only be 0.82 percentage points higher than under the current rules.
The effects on a company’s tax position will depend on the leverage of the company’s financing and on the rate of returns on the company’s investments. High interest costs will of course lead to higher taxes. High returns will lead to a larger general deduction and thus lower taxes.
The proposal will mean that companies with large debts and low returns on investments will pay more in corporate tax. Companies with small debts and high returns on investments will pay less tax. In Sweden many real estate companies have significantly leveraged finances and the proposed rules are likely to have a significant impact on the financing in this sector.
The proposed rules are to apply from 1 January 2016.
The Committee has also issued an alternative proposal, which will not lead to any changes in the total taxes paid and will also have similar rules to those applicable to the financial sector. The alternative proposal will apply to the same types of companies as the main proposal and has the same definition of financial costs and income.
Like the main proposal the limitations with respect to financial costs will apply to the net financial costs. However, the alternative proposal does not entail a prohibition on deducting the net financial costs, but limits the deduction to 20 per cent of EBIT (somewhat simplified).
Disallowed deductions will be carried forward for six years, unless there is a change of control.There will be a right to set-off between group companies if group contributions are possible.The current tax avoidance rules with respect to interest payments will still apply under the alternative proposal. Finally, the corporate tax rate will be reduced from 22 to 18.5 per cent.