The Finnish Supreme Administrative Court (SAC) has on 3 July 2014 in its ruling confirmed that the tax authorities were not allowed to deny the deduction of interest payments made on a hybrid loan by a Finnish subsidiary to its Luxembourg parent by re-characterizing the hybrid loan to equity for Finnish tax purposes.
In the case at hand, the Finnish subsidiary was facing financial distress and was in need of additional funding. In order to obtain third party financing and given the importance of safeguarding such creditors, the distressed Finnish subsidiary received a hybrid loan of 15M EUR from its Luxembourg parent. According to the terms of the hybrid loan, the loan was unsecured and subordinated to all other debt, could not be repaid before the full repayment of the senior bank loans, was without a maturity date and did not grant any voting rights or dividend entitlements. An annual interest of 30% was capitalized to the loan balance and the Finnish subsidiary had obtained a benchmark analysis to support the arm’s length nature of the interest rate applied. The Finnish subsidiary prepared IFRS accounts, under which the hybrid loan was treated as equity.
The tax authorities had earlier denied the Finnish subsidiary interest deductions of some 1.35M EUR. The tax authorities claimed that, when interpreting the arm’s length principle in Section 31 of the Act on Assessment Procedure jointly with the OECD Transfer Pricing Guidelines, the hybrid loan should for tax purposes be treated as an equity investment rather than a loan and any interest payments should therefore be non-deductible. According to the tax authorities, unrelated parties would not have entered into the same hybrid loan arrangement and the terms and conditions were clearly different from those which would have been reached in an arm’s length dealing. Based on this, the tax authorities considered that a re-characterization of the hybrid loan to equity by means of transfer pricing adjustment was justified.
The SAC overruled the tax authorities’ decision and stated that Section 31 of the Act on Assessment Procedure on transfer pricing adjustments did not contain a clear authorization for the tax authorities to re-characterize any related party transactions without specific support from the general anti-avoidance rule in Section 28 of the Act on Assessment Procedure. Further, the SAC stated that despite the fact that the OECD Transfer Pricing Guidelines to some extent allow the re-characterization of transactions (especially if the economic substance of a transaction differs from its form), the OECD Transfer Pricing Guidelines cannot expand the scope of domestic Finnish tax legislation, but only affect its interpretation. The SAC then deemed that the OECD Transfer Pricing Guidelines did not provide any interpreting support for re-characterization in the case at hand. The SAC did not, however, take a decision on whether the interest rate of 30% was set at arm’s length, but this issue was returned to the tax authorities.
The ruling of the SAC is welcome by a number of companies that have suffered from the denial of interest deductions in similar circumstances, but naturally also provides for more certainty in cross-border tax planning.
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