The recent (March 2014) judgment by the Norwegian Supreme Court in the case of State v ConocoPhillips, already regarded as the country’s most important tax avoidance decision in ten years, is likely to have a significant impact on the commercial real estate market in Norway.
The Court held that a demerger of a property and the immediate subsequent transfer of the shares in the emerging property company, does not constitute a breach of general anti-tax avoidance principles, even if the main purpose of the transaction is to save tax. The judgment clearly marks a new direction and attitude towards the structuring of real estate divestments compared to what has been regarded as valid law over the last decade.
Background to the case
Since what has become known as the (tax) exemption method was introduced in connection with the tax reforms of 2006, sale of commercial real estate in Norway is normally carried out by way of a transfer of the shares in the property owning company. In short, the exemption method implies that limited companies are exempted from tax on capital gains (and dividends) from the alienation of shares, as opposed to a sale of the company’s assets.
In accordance with previously prevailing administrative and legal practice, this method is also acceptable when it saves the seller from considerable tax liability, provided that the property company was in existence before the purchase agreement was entered into. Since, under Norwegian law, a binding agreement may be deemed to exist at the time where it can be established that the parties had agreed to all the material terms for the transfer (that is, before a signed contract exists), there has also been uncertainty as to how far the owner of a property can go in terms of preparing, marketing and negotiating a sale before the anti-avoidance rules come into play.
Before the Supreme Court’s judgment, the tax authorities had taken the position that if the property is transferred through a demerger to a single purpose property company in connection with the sale, and subsequently the shares in the company are disposed of rather than the property itself, this is regarded as being in breach of the tax provisions. In a number of such cases, the tax authorities have reclassified the transaction as a taxable sale of real estate.
In the case brought before the Supreme Court, the taxpayer had entered into an agreement for the sale of the shares in a property company in 2005. However, the property company had other assets on its balance sheet in addition to the property. The seller and the buyer agreed that these assets were to be demerged from the property company before the share transfer took place.
The Supreme Court was in no doubt that tax saving was the main motivation for the taxpayer’s actions with regard to the demerger and subsequent share transfer. However, the Court held that such a motivation is not sufficient for establishing unlawful tax avoidance. It is also requisite that the transactions are in defiance of the purpose of the tax provisions. This was not the case here, according to the Court.
The Supreme Court attached importance to the fact that legislator has long been aware of the possibilities for tax-motivated restructuring under the exemption method, but nevertheless made an intentional choice not to introduce a statutory anti-tax avoidance rule for the prevention of such transactions.
The Supreme Court concluded that the transaction was neither in conflict with the purpose of the exemption method nor with the provisions on tax exemption for demergers.
Facts of the case
The facts of the case may be outlined as follows:
ConocoPhillips Investment AS, a wholly owned subsidiary of Norske ConocoPhillips (the Company), erected a building on the site of the property, Tangen 7 in Randaberg near Stavanger (the Property). The Property was intended to function as the Company’s headquarters in Norway. In 1989, the Company entered into a ten-year lease of the Property which, in 2000, was extended for an additional ten years. As a result of the merger between the Company’s parent company, Conoco Inc., and Phillips Petroleum Company, the headquarters were however moved to another location in 2001. After an unsuccessful attempt to sublet the Property, it was decided in 2003 that the Property should be sold. In January 2005, an agreement for the sale of the Property was entered into with Havancci AS (the Buyer). In February 2005, the Property owner ConocoPhillips Investment AS was demerged in such a way that the Property remained the single asset in the transferring company, Tangen 7 AS (the Target), while all other assets were transferred to the receiving company, ConocoPhillips Investment AS. The Buyer assumed the shares in the Target with effect from 1 May 2005.
The starting point for the Supreme Court’s evaluation was that a disposal of the shares in a limited company is exempt from taxation pursuant to the Fiscal Act § 2-38 and, in addition, that a demerger of a limited company can take place without incurring tax liability subject to compliance with the conditions in the Fiscal Act § 11-4. Accordingly, the Court held that any taxation of the Company in respect of the sale of the shares in the Target would have to be under the provisions of the general non-statutory anti-tax avoidance rule.
The State acknowledged that the capital gain from the share transfer would have been tax exempt if the Property had from the outset been owned by a single purpose vehicle, but that the Company illegally evaded the tax legislation as it had—after a sale of the Property had been agreed—carried out the demerger and the subsequent transfer of the shares in the Target without taxation.
The Supreme Court stated that the anti-tax avoidance rule—developed through case law and legal theory—consists of a basic condition and a general assessment. The basic condition is that the main purpose of the arrangement is to save tax. In order for the anti-avoidance rule to apply, it is also required that the arrangement, based on a general assessment of its consequences, its characteristic business value, the purpose of the arrangement and other circumstances, should be deemed inconsistent with the objective of the tax provisions. In addition, the Court maintained that such a judgement should be based on an overall assessment of the arrangements constituting a natural whole, in this instance the demerger and subsequent share transfer.
With regard to the basic condition, the Supreme Court court did not question that the overriding motivation for the structure was tax saving. Neither the Buyer’s alleged desire to purchase shares instead of the Property directly nor the argument that the Company saved stamp duty by selling shares was stressed, but it was expressed that there is a strong presumption that the prospect of a considerable tax saving is the paramount purpose of the arrangement for a professional business participant. The Court consequently agreed with the State that the basic condition was fulfilled.
In its general assessment however, the Supreme Court found that the objective of several tax provisions had to be considered. The Court pointed out that it was obviously in defiance of the general principle of taxation of capital gains if the Company’s gain were not taxed, but that this was not relevant here as the intention of the statutory exemption method is precisely to exempt capital gains arising from the sale of shares from taxation. According to the Supreme Court, the purpose of the exemption method is to secure capital mobility and avoid “chain” taxation, and that the transactions in this case did not conflict with this.
The Supreme Court was also of the opinion that the presumption that tax-motivated demergers should not be tax exempt, had to be read in the context of the exemption method adopted subsequently, which has caused a sale of real property to a large degree to be structured by way of share transfers. In the preparatory works for the exemption method, legislation for preventing tax-motivated transactions was considered, but the legislator chose to wait until the situation arose. As the legislator had been aware of the risk and yet did not take any such action, both the tax authorities and the courts should, in the Supreme Court’s view, be careful when applying the non-statutory anti-avoidance rule. The need for predictability in tax matters was underlined.
The Supreme Court’s interpretation was that a taxpayer who is subjected to the exemption method has the option of two alternative transaction models when divesting real estate; either by a sale of the property or by selling shares. If the taxpayer chooses to sell the shares, a demerger will be a necessary first step if the property does not already sit within a single purpose vehicle. According to the Supreme Court, neither the demerger nor the share transfer will, in such cases, be contrary to the purposes of the tax legislation. Nor did the proximity in time between the demerger and share sale lead to any other conclusion. Consequently, the general assessment implied that the Court must give judgment for the Company.
Implications of the decision
Since the Supreme Court handed down its judgment, the tax authorities have expressed their intention to fully adhere to the new principle that the non-statutory anti-tax avoidance rule is not applicable in cases where the taxpayer deploys a tax-exempt demerger in order to be in a position to effect the sale of assets by means of a share transfer.
It thus seems safe to assume that any reversal of this interpretation will have to be made by means of new legislation establishing the opposite rule.
The following general points can be extracted from the Supreme Court’s decision:
- A demerger of real property with a subsequent share sale is not in defiance of the purpose behind the exemption method.
- The general non-statutory anti-tax avoidance rule is not applicable in this type of transaction, even if the principal objective is to save tax.
- The proximity in time between the demerger and the sale is without significance. That is, there is no basis for tax liability even if the share transfer takes place immediately after the demerger. It is also of no consequence if the demerger is decided after the sale and purchase agreement is entered into.
The new state of the law paves the way for a far more flexible and simplified approach with regard to the structuring of real estate divestments than before. To mention but one effect of this, there should no longer be any need, unless appropriate for reasons other than tax, to establish special purpose vehicles for each single property in a portfolio in advance of a sale. Once a transfer is agreed for a particular property, that property may now be demerged separately and the shares divested under the protection of the exemption method.
As the guidelines under the general anti-avoidance rule in this respect were vague and any decision on such matters was to a great extent subject to the tax authorities’ and the courts’ discretion, a significant element of uncertainty has now been removed from the Norwegian real estate market.