International Tax Review - Capital Markets

This article first appeared in International Tax Review: Capital Markets Supplement - Tax Reference Library

Although the general level of activity in the capital markets has slowed down compared to the situation a few years ago, Finland continues to be one of the jurisdictions where optimism prevails and where transactions and investment activities continue, albeit not quite on the same level as before and with a slightly different emphasis.

Due to the rather general wording of tax laws and the substance-over-form approach of Finnish tax courts, Finland may not be the ideal jurisdiction for very aggressive tax planning and purely tax driven structures. This said, the Finnish tax system is generally perceived as investor friendly and the level of corporate tax as competitive. While Finland is often described as a high-tax jurisdiction, this primarily applies to the taxation of resident individuals. Foreign investors have usually appreciated the absence of withholding tax on interest and formal thincapitalization rules. Finland and the Baltic region have generally been viewed as an attractive market for investment including private equity and venture capital funds.

In the following article we will review the fiscal framework for inbound investment into Finland. As private equity and venture capital funds tend to be structured as limited partnerships, we will also discuss briefly the tax treatment of such vehicles in Finland and in particular developments relating to a foreign silent partner’s tax liability to Finnish income tax.

Interest paid on loans taken from abroad is normally exempt under Finnish domestic tax law from Finnish withholding tax. This applies also in cases where the relevant tax treaty would allow the levying of withholding tax. In order to prevent this rule from being used to circumvent the withholding tax levied on for example, dividends, it is expressly provided that the exemption does not apply to interest paid on loans representing investments comparable to equity. This carve-out, which is as close to a thin-capitalization provision as can be found in the Finnish Income Tax Act, has, to our knowledge, never been applied and does not specify in which situations a re-characterization could take place. An obvious risk exists, however, where a loan is clearly not intended to be repaid.

Interest expenses are generally deductible in the taxation of the borrower provided that the interest rate is arms length and the loan is taken for business purposes.

The absence of withholding tax often makes convertible debt instruments an attractive alternative to foreign investors. While a convertible instrument may be structured so as to entitle the lender to a profit-based interest, such a convertible bond could, in certain situations, be susceptible to the application of anti-avoidance provision.

There are no formal thin-capitalization provisions in Finland, that is, no provisions limiting the deductibility of interest paid on foreign loans primarily to related parties in certain situations. Certain attempts have been made to challenge deductibility in typical thin-capitalization situations based on general principles of tax law but in a recent case (SCA 1999:19) deductibility was confirmed by the Supreme Administrative Court in a case where the debt to equity ratio was as low as 1:15.

It is expected that thin-capitalization rules will be introduced in Finland in the future. Any such rules will, however, have to pass all relevant anti-discrimination tests.

There is no fiscal unity or consolidated tax return procedure in Finland. This means that using a Finnish special purpose vehicle (SPV) to acquire a Finnish company will not automatically allow the deduction of interest on the acquisition debt from the income of the target company. However, Finland does apply a group contribution regime that in certain situations will allow the target company to make tax-deductible contributions to the SPV to cover the interest expenses. The contribution need not be paid in cash, but can be recorded as a liability and receivable in the books of the companies. In order for the group contribution regime to be available, certain rather strict requirements will have to be satisfied.

In brief the requirements are as follows:

• at least 90% of the share capital in one of the companies has to be owned by the other directly or indirectly;
• the companies must have belonged to the same group of companies throughout the entire tax year;
• the fiscal year of both companies must end on the same date;
• both companies must carry on business activities;
• the group contribution must be intended to be used in the business activities of the receiving company;
• the contribution must be openly recorded in the accounts of both companies before the end of the relevant fiscal year;
• appropriate decisions must be made in both companies; and
• the contribution may not exceed the taxable profit for the relevant fiscal year of the granting company.

In the case of an acquisition SPV, the critical issues are often the unavailability of the regime for the acquisition year and the need to ensure a sufficient level of business activity in the SPV as well as the use of the contribution for business purposes. Artificial structures are not accepted for tax purposes.

Provided that the SPV is loss making and that all requirements listed above are met, the use of group contributions can reduce the total tax cost of the Finnish group.

While the group contribution regime only applies to domestic groups, the Supreme Administrative Court has held that it will be available also where two Finnish companies have a common foreign parent in a jurisdiction with which Finland has a tax treaty with a qualifying non-discrimination article.

Another commonly used method designed to make the interest expense from the acquisition debt deductible from the income generated by the target is merging the SPV with the target company. The tax implications of such a merger should, however, be considered carefully. The merger could in certain situations be construed as tax avoidance and in a merger all tax attributes of the target, that is, tax losses carried forward from previous years and imputation system (avoir fiscal) related items will be forfeited without any exemption being available.

While there is extensive tax practice and case law on group contributions, it is important to note that group contributions are recognized solely for tax purposes. The company law implications of granting a group contribution, such as the need to ensure availability of distributable equity and fair treatment of minority shareholders, will have to be reviewed separately on the basis of the rules laid down in the Companies Act.

Finnish private equity and venture capital funds are frequently structured as Finnish limited partnerships with foreign investors as limited partners. Finnish partnerships, such as limited partnerships (kommandiittiyhtiö, Ky) and general partnerships (avoin yhtiö, Ay) are transparent for Finnish tax purposes, that is, no income tax is levied on partnerships. Instead, the partnership is treated as an accounting unit whose net profit is calculated separately, just like any other legal entity, after which the profit is allocated among the partners on the basis of the partnership agreement and taxed as their income.

In a recent Supreme Administrative Court ruling (SAC 2002:34), a non-resident limited partner was held liable to pay Finnish income tax on its share of the income of the partnership. In the ruling it was established that the tax liability of the foreign partner could not be determined by examining whether the activities carried out by the foreign partner in Finland qualify as a permanent establishment in Finland, as this would lead to part of the income of the Finnish business activities of the partnership not being taxed in Finland. Further it was held that the Nordic double tax treaty should not be construed as meaning that Finland has agreed to waive the right to tax income generated in Finnish partnerships. The question whether the relevant foreign partners were members of the investment board of the fund was held not to be decisive. In the same ruling, it was also established that a Finnish resident investor investing through a Swedish partnership is not entitled to Finnish imputation tax credit on his share of the Finnish dividends received by the partnership (if the same investment had been made through a Finnish partnership, the imputation tax credit would not have been granted to the partnership but directly to the Finnish investors on the basis of their share of the dividends).

The ruling referred to above as well as the fact that the partnership and the general partner are jointly and severally responsible for any income tax payable by a limited partner are likely to somewhat dampen the enthusiasm to use Finnish limited partnerships as investment vehicles. That said, it continues to be more tax efficient in most situations for Finnish investors to invest in Finnish targets through a Finnish partnership (because of the imputation system) than through a foreign partnership. This has lead to the establishment of twin-headed structures where Finnish investors invest through a Finnish partnership and foreign investors through a foreign partnership. Many of these structures have not been tested in tax practice yet.

The Finnish imputation system for dividend taxation has been held to be discriminating, in that it provides for the payment of imputation tax credit to Finnish resident shareholders and to Finnish permanent establishments (PE) of foreign shareholders. This, in combination with the fact that the number of European countries using the imputation system is diminishing, led to a working group being established by the Ministry of Finance in June 2001 to assess the viability of the imputation system and to propose alternative solutions.

In November 2002, the working group published its report in which they proposed that the imputation system be replaced by a classical system for dividend taxation with double taxation of a company’s distributed profits. The working group further proposed that the corporate tax rate would be reduced from the current level of 29% to 25%. This would result in an aggregate tax burden on distributed profits of 43.75%. The granting of a tax exemption to the receiving company would abolish double taxation of corporations.

Some jurisdictions have abolished capital gains taxation in respect of shares transferred by companies. A similar solution was considered by the working group but rejected. Nevertheless, it proposed that the taxation of transfers of shares within a group of companies would be deferred until the shares are transferred outside the group.

The introduction of thin capitalization rules in the form of a general provision restricting deductibility of interest paid on a foreign loan considered as a capital investment comparable to equity was proposed. No safe havens in the form of set thresholds are proposed to be introduced.

Finland had a parliamentary election on March 16 2003 and one of the most important matters for the new government to resolve after its appointment will be to decide what action should be taken in respect of the proposed tax reform, which has been widely criticized, in particular by the Finnish business community. While the proposed reform could, in theory, be implemented so as to be effective as of the beginning of next year, it is in practice unlikely that any major legislative changes will be implemented before the beginning of 2005.

www.internationaltaxreview.com