As of the 1 February, the Swedish Ministry of Finance launched a memorandum for consultation regarding the implementation of regulations in the EU’s directive against tax avoidance to neutralise the effects of hybrid mismatches.
Since 2013, OECD has worked to prevent tax base erosion and profit shifting in the BEPS project (Base Erosion and Profit Shifting). One of the actions within the BEPS is attributable to international tax planning, where differences in national legislation as regarding the tax treatment of companies and financial instruments (so called hybrid mismatches) are utilised.
A company can be a hybrid if the company is treated as a taxable entity of its own by one country, and at the same time is treated as a partnership taxed by another country. A financial instrument can be a hybrid instrument if it is treated as a liability in one country and as equity in the other country. These differences might lead to double non-taxation in cross-border situations.
In 2016, the EU adopted a directive against tax avoidance, which means that the EU member states coordinate the implementation of certain of OECD’s action points against BEPS, including hybrid mismatches.
On the 1 January, new tax regulations for the business sector in Sweden entered into force. As a step in the implementation of the EU’s directive against tax avoidance, a prohibition of deductions was implemented in certain cross-border situations. The new rules are limited to mismatches with hybrid companies and hybrid financial instruments, and concern only the right of deduction of interest expenditure. The scope is also limited to associated companies.
According to the memorandum, the hybrid regulations should now be extended to include further situations, as well as other expenditure than interest expenditure. The hybrid rules shall be applied (as previously) for associated companies, but also on other procedures leading to a tax benefit.
The new rules are to be implemented in a new chapter of the Income Tax Act. The rules are proposed to enter into force on the 1 January 2010, and to be applied for the first time for fiscal years beginning after the 31 December 2019.
Below are examples of some of the proposed provisions:
Hybrid financial instruments
A company is not allowed to make deductions for fees paid to a company in accordance with a financial instrument, if the receiving company does not recognise the corresponding income for taxation. However, this is only valid provided that the non-taxation is due to the way Sweden and the receiving country legally classify the financial instrument or payment for tax purposes.
Contrary to previous rules, the proposed provision does not imply a limitation to interest expenditure; instead it will be expanded to include expenditure in accordance with financial instruments. In the Income tax Act or the Annual Accounts Act, a definition of the term financial instrument is missing, which means that GAAP will decide if such expenditure is treated as return on investment or equity that the rule concerns. It might, for example, be service fees, rent payments or royalty payments. Normally, depreciation, amortisations or cost for the acquisition of an asset not be included.
Hybrid entities and mismatches with permanent establishments
A company is not allowed to make deductions for expenditure paid to a company if the receiving company does not recognise the corresponding income for taxation. However, this is only valid provided that the non-taxation is due to the way Sweden and the receiving country legally classify the first company for tax purposes.
A company in Sweden might, for example, be regarded as a hybrid entity if the legal order in another country allows the foreign parent company, for tax purposes, to treat the Swedish subsidiary as a disregarded entity. In that case, the Swedish subsidiary is treated, for tax purposes, as a branch of the foreign parent company, and the taxable profit is calculated through the elimination of the transactions between the parent company and the subsidiary.
It shall not be possible to make deductions for expenditure concerning imported mismatches. Imported mismatches mean that the effect of a hybrid mismatching that occurs between two different countries are transferred (imported) to another country.
The following example illustrates an imported mismatch:
A group is comprised of the parent company A and the two other companies, B and C. All entities are domiciled in different countries. Only C is domiciled in the EU and has hybrid rules. A lends money to B through a hybrid instrument, which means that B receives deductible expenditure and A receives dividend exempt from tax. Further, B lends money to C, with the result that C receives deductible interest expenditure and B taxable interest income. The total effect is that the interest expenditure is deducted in C, B receives an interest income that is offset against interest expenditure and A receives a non-taxable dividend.
Companies are not allowed to make deductions for expenditure attributable to a permanent establishment in one country, if deductions for the same expenditure might be done in the country where the permanent establishment is located, to that extent that a deduction is made in the other country is made against an income in another entity.
As an example might be mentioned that a foreign company owns a Swedish limited company. The Swedish limited company has raised an external loan and is allowed to deduct the interest expenditure. The Swedish company is treated as a partnership taxed in the foreign entity, and for that reason the foreign entity might make deductions for the same interest expenditure.
Non-recognised permanent establishment
In accordance with Sweden’s tax conventions with a few countries (Bulgaria, Cyprus and Greece), the exemption method applies to avoid double taxation. The exemption method imply that certain income is exempt from taxation.
As an example might be mentioned that a Swedish company has operations in a permanent establishment in Greece. However, Greece dos not think that there is a permanent establishment in Greece, and does not charge any income tax. In accordance with the tax convention between Sweden and Greece, the income is exempt from tax in Sweden. According to the memorandum, the exemption ruled are not be applied in these cases, which means that Sweden will be able to charge income tax.
Limited tax credits on foreign tax at hybrid transfers
It shall not be allowed to offset foreign tax to the extent that the tax is attributable to an income from the holding of financial instruments to that extent that the taxable entity is allowed deductions for dividend or interest income, due to the terms and conditions of securities lending or repurchase agreements regarding the financial instruments.
The rules are aimed at securities lending and repurchase agreements, where two countries have different views of the question which party that, from a tax perspective, is thought to collect any yield from the transferred financial instruments.
The currently proposed regulations regarding hybrid mismatches fulfil Sweden’s obligation to implement EU’s directive against tax avoidance. The aim of implementing the rules is to strengthen the tax rules in the EU member states, so that it will not be profitable to create structures which utilise the differences in tax regulations in different countries in order to lower tax.
The rules regarding hybrid mismatches are, broadly, implemented already as part of the implementation of rules to limit interest deductions, which is why the proposed changes only will have an impact the few hybrid constructions that are left, and which mainly concerns other expenditure than interest costs.