The freedom of cross-border funding in multinational groups and European Union law

The free choice of the financing instrument is a key factor economically and in business life. In principle, companies are free to finance their operations with equity, debt, or mezzanine capital. Besides business aspects and flexibility considerations, financing instruments can also be used for tax planning, especially in multinational groups. For instance, against the background to the financing theory as an instrument of internal financing, namely by saving tax payments (tax-induced debt financing). Accordingly, multinational companies (MNCs) have the possibility to utilize intra-group financing. By way of example, using an internal financing company. By using internal debt financing strategies, MNCs are able to lower their group tax rate significantly (Cooper and Quyen, 2020). The principle of tax optimization via intra-group financing is internationally recognized and, in principle, not abusive. This can be demonstrated by the introduction of uniform regulations at the European Union (EU) secondary law level (ATAD)

Especially, the interest limitation rule (Art. 4 ATAD) and the CFC taxation rule (Art. 7, 8 ATAD). Council Directive (EU) 2016/1164 of July 12, 2016, L 193/1 [ATAD/Anti-Tax-Avoidance-Directive].

The present Swedish/French CJEU case of Lexel AB, C-484/19 deals with such a suspected anti-abuse law that denies a Swedish stock corporation (Lexel AB) the tax-effective interest deduction for internal interest payments to a French group financing company (BF SNC). This restricts the freedom of the multinational group of companies at hand to finance and prevents the reduction of the group tax rate. On the other hand, if the same intra-group interest payment had been made between two Swedish group companies that form a Swedish „tax group“ (so-called intragroup transfers), the interest deduction limitation rules would not apply. From a European law perspective, the question arises whether the Swedish law, restricting the tax deduction of interest payments made to foreign group members, infringes the freedom of establishment and thus ultimately cannot be applied due to the primacy of EU law. The Swedish Supreme Administrative Court (Högsta förvaltningsdomstolen) submitted this question to the CJEU in a preliminary ruling after the Swedish Tax Administration (Skatteverket) and the Swedish Administrative Court of Appeal (Kammarrätten i Stockholm) rejected Lexel AB’s allegation that the Swedish interest deduction restriction on intra-group debt financing was unlawful under Union law. Now, the question arises whether Sweden was allowed to refuse the tax-effective deduction of the interest payment at the level of Lexel AB, taking EU law into account? Are Paragraphs 10a to 10f of the Swedish Law on income tax in line with the freedom of establishment (Art. 49 TFEU)? These regulations are applied in the present case C-484/19 and up to December 31, 2018. Exceeding the Lexel AB case, the higher-level question is: how national interest deduction limitation rules must be legally shaped in relation to intra-group financing in order to be in line with EU law? Moreover, the influence of EU law, in particular the freedom of establishment, on the restriction of group interest payment is analyzed.

This article critically examines the Swedish interest deduction limitation rules on intra-group debt financing

Chapter 24, Paragraphs 10a to 10f of the Swedish Law on Income Tax.

This article is on EU law. The Swedish law on interest limitation in affiliated groups in the pending case Lexel AB (C-484/19) is analyzed against the background of the freedom of establishment (Article 49 TFEU). First, the objective content of the legal sources must be examined (analysis of primary sources). Therefore, an interpretation in light of EU primary law will be carried out. In that respect, the methods of judicial interpretation will be used. From a methodological perspective, the examination scheme of the CJEU is applied: restriction, justification, proportionality. Regarding the analysis of primary sources, the existing case law has to be examined, applied and, if possible, transferred to the present case and its unsolved questions. However, because Lexel AB, C-484/19 is a pending case, there is no CJEU case law that directly deals with such a situation. Accordingly, transferable case law can only be found to a limited extent.

Moreover, an analysis of secondary sources is made. Especially the existing literature will be examined. However, the literature on taxation does not (especially) deal with the Swedish provisions at hand in C-484/19. The recent case law on intra-group financing has not been examined at all in this context: especially X BV, C-398/16 of the year 2018. In the literature, the interest limitation rules have never been analyzed from the background of loss situations of the lending subsidiary, which is, however, the case in the request for a preliminary ruling in C-484/19. Furthermore, the current academic literature has not yet examined the arguments of the parties in the request for a preliminary ruling of June 5, 2019, in case C-484/19. Moreover, the literature has not yet analyzed whether secondary advantages of group taxation may be denied in cross-border situations. However, that is a relevant topic in the pending case C-484/19. Only the older literature (up to 2015) had been dealing in general aspects with the compatibility of the Swedish interest limitation rule at hand.

There is some older literature adressing the Swedish interest deduction limitation rules applicable to intra-group debt that are at issue in Lexel AB. This literature, however, provides no consistent picture of whether these rules may be in breach of the fundamental freedoms. Johannsson (2011) shares the view that the rules lack justification

See. J. Johansson, Ränteavdragsbegränsningar – med anledning av att kapital är fungibelt, SN 2011/9, p. 609 (2011).

Another unsolved question under primary law is whether an internal loan can be treated as non-tax motivated if the lender is a domestic subsidiary, but tax motivated if the lender is a foreign affiliate. More importantly, in Lexel AB, the financing group company had deductible loss carry-forwards. Assuming all other factors are equal, Sweden waives the taxation of profits in the amount of the interest in the comparable domestic situation. Actually, in loss situations, that is, where the lending subsidiary has losses to offset against the interest income, the controversial regulations clearly do not pursue the goal of maintaining a balanced allocation of taxing rights. These aspects have never been discussed in the literature on taxation.

From Sofina, case C-575/17

See. CJEU, Judgment of November 22, 2018, C-575/17, Sofina, ECLI:EU:C:2018:943. To that judgment in general G. Kofler, Foreign Losses and Territoriality, in CFE Tax Advisers Europe: 60th Anniversary, pp. 147–168.

Moreover, the more recent literature on taxation does not specifically deal with the Swedish provisions at hand in Lexel AB. The recent case law on intra-group financing has not been examined at all in this context (X BV, C-398/16). Furthermore, the current academic literature has not yet examined the arguments of the parties in the request for the preliminary ruling in Lexel AB, the main issue being whether secondary advantages of group taxation may be denied in cross-border situations. The following article addresses this question in the context of interest deduction limitation rules for intra-group financing. Is it compatible with the freedom of establishment to refuse a Swedish company a deduction for interest paid to an affiliate company in a different member state in circumstances in which the interest deduction would not be restricted if the lender was a Swedish subsidiary and the lender and borrower had the possibility to use a domestic group tax regime?

The Swedish company Lexel AB is part of a multinational group of companies. The applicable Swedish corporate tax rate was 22%. The ultimate parent company of that group is a French SE. The group also includes a Belgian company (SESI), which was 85% owned by a French group company (SEISAS) and 15% by a Spanish group company (SEE). In December 2011, Lexel AB acquired 15% of the shares in the Belgian company (SESI) from the Spanish group company (SEE). To finance this internal share deal, Lexel AB received an interest-bearing loan from the French company (SNC BF), which operates as an intra-group financing company. The French financing company BF has economic substance. It handles the group’s cash pool and has granted loans to around 100 different affiliates. The French financing company BF is fully subject to French corporate income tax, the tax rate was 34.43%, and it was also part in a French group taxation. Because the French financing company BF had negative income in France (deficit) in the years receiving the interest payment from Lexel AB, the interest income was principally not subject to taxation. Lexel AB claimed tax-effective interest deduction in Sweden.

Figure 1

The Swedish Tax Administration (Skatteverket) and the Swedish Administrative Court of Appeal (Kammarrätten i Stockholm) refused tax deductions for the interest expenses on the loan from BF at the level of Lexel AB (borrower). The reason is that Lexel AB and BF were both in a group of associated enterprises, and in such circumstances and according to Chapter 24, Paragraph 10 b, of the Swedish Law on income tax, the interest expense is principally not deductible. Exceptionally, the aforesaid interest expense is deductible if the corresponding interest income is subject to taxation in the hands of the recipient and the applicable tax rate is at least 10% (so-called 10% rule

First subparagraph of Paragraph 10 d Swedish Law on income tax.

Overall, The Swedish Tax Administration (Skatteverket) and the Swedish Administrative Court of Appeal (Kammarrätten i Stockholm) argued that the internal debt financing between the French BF (creditor) and the Swedish Lexel AB (borrower) was mainly tax-motivated. Moreover, both aimed to receive cross-border tax consolidation by shifting income from Lexel to the loss-bearing BF. Intra-group debt can be arranged to circumvent the rules on intra-group transfers, which is what the interest deduction rules seek to prevent (Skatteverket, 2019a). The interest deduction limitation rules in affiliated groups should prevent the tax base from being eroded, in both a purely domestic and cross-border situation. In cross-border situations, the interest deduction restriction hinders to transfer untaxed profits from Sweden to other member states. The Swedish interest deduction restriction also applies in pure internal situations; however, if there are no limitations on entitlement to intra-group transfers between Swedish companies, the examination will lead to the conclusion that internal debt financing is not mainly tax-motivated because those companies would have been able to achieve corresponding deductions by making intra-group transfers (Skatteverket, 2019b).

A first finding: granting the Swedish group taxation (intra-group transfers) means that the interest deduction limitation rules do not apply. Thus, in domestic cases in which the Swedish intra-group transfers is granted, the interest deduction limitation rules will not enter into force. Foreign group companies are not allowed to become part of a Swedish group taxation. In other words: secondary tax advantages of group taxation beyond the primary offsetting of income are denied for foreign companies, while Swedish companies are not affected. According to the CJEU judgment Groupe Steria, C-386/14, Para. 28, it is necessary to examine separately, whether a member state may reserve other advantages of a group tax system than the transfer of losses for foreign companies (CJEU, 2015). Moreover, the settled case law of the CJEU states that non-domestic affiliates cannot be excluded from other tax benefits of domestic group taxation systems than the consolidation of profit and losses: X BV and X NV, C-398/16, C-399/16, Para. 24 (CJEU, 2018a). Within a domestic group of companies, the possibility of the Swedish intra-group transfers leads to the effect that loans between the affiliates are disregarded or considered non-existent for Swedish tax purposes, and therefore, the interest deduction limitation rule does not apply. This secondary tax advantage of the Swedish intra-group transfers is not available in a cross-border situation, irrespective of the fact that Sweden is able to apply the interest deduction limitation rule in pure domestic cases. Moreover, it is also questionable why in cross-border situations, circumvention of the Swedish group taxation rules should exist if this taxation regime is from the very beginning not available in such cases. In reality, the Swedish regulations means that other tax planning options are indirectly restricted that have nothing to do with the circumvention of group taxation. This is inappropriate because debt financing is an independent matter and the freedom to finance or generally equipping a Swedish subsidiary by a foreign group is restricted, which is not the case within domestic groups. Furthermore, compared to multinational groups, domestic Swedish groups are principally not faced by any deduction limitations in regard to Swedish taxation. They are able to periodically offset losses and can avoid negative effects and a decrease in liquidity with regard to Swedish taxation.

Lexel AB and the EU Commission are of the opinion that it is contrary to EU law to refuse tax-effective interest deduction on the basis of the third subparagraph of Paragraph 10 d Swedish law on income tax. Skatteverket, the Swedish Government, and the Swedish Administrative Court of Appeal have a different opinion and have pointed out that the Swedish law is in line with the freedom of establishment. Thus, the Supreme Administrative Court (Högsta förvaltningsdomstolen) has requested for a preliminary ruling to the CJEU (C-484/19), because the existing case law is not clear and asked in that regard the following question (Högsta förvaltningsdomstolen, 2019a):

“Is it compatible with Article 49 TFEU to refuse a Swedish company a deduction for interest paid to a company which is in the same group of associated enterprises and is resident in a different Member State on the ground that the principal reason for the debt having arisen is deemed to be that the group of associated enterprises is to receive a substantial tax benefit, when such a tax benefit would not have been deemed to exist if both companies had been Swedish, since they would then have been covered by the provisions on intra-group transfers?”

This question is of great relevance and goes far beyond the issues of Swedish taxation at hand. First, the question deals with the fundamental aspect whether a member state is legally obligated to grant secondary tax advantages from a domestic group taxation system to companies resident in other member states on the basis of EU law. Examples for that are granting tax-effective deduction of interest expenses and royalties at the level of the domestic paying company in cross-border constellations, roll-over relief, dividend taxation (CJEU, 2015), tax-neutral passing though of profits from foreign permanent establishments, non-sanctioning of internal share deals, etc. Second, Art. 4 of the ATAD, the interest limitation rule, may be affected, and all member states had transposed that rule into their national law (COUNCIL DIRECTIVE, 2016/1164a). According to these rules, exceeding interest expenses and the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) can be calculated at the level of the group and consists of the results of all its members. For this purpose, the member states often revert to national group taxation systems, and interest expenses and interest income equalize, and therefore, the interest deduction limitation does not come into effect in domestic situations. As a foreign parent company and a domestic subsidiary regularly are not allowed forming group taxation according to national law, the interest limitation rule principally applies in cross-border constellations. However, if EU law obliges the member states to grant the secondary tax advantages of a domestic group taxation regime in cross-border situations, a consolidation of interest expenses and interest income would also take place for the purpose of applying the interest limitation rule (4 ATAD).

The embedding of tax-oriented interest limitation rules in the theory of financing and practice of corporate finance should be reviewed. The Swedish interest deduction limitation on affiliates is a prime example of how foreign groups’ leverage is restricted against domestic groups. The freedom of financing gets limited in regard to cross-border situations and multinational groups. Compared to Swedish groups of companies, multinational groups are not free in choosing the financing method of their Swedish subsidiaries. Furthermore, the Swedish rules unilaterally restrict intragroup financing as a tax planning instrument, however, only for foreign groups of companies and create international double taxation. In terms of its practical application, the Swedish interest deduction limitation rule is very critical. The rule is working with a general abuse definition, a vague legal concept, and from a methodical point of view, it is hardly possible to define by law when exactly a tax abuse is at hand.

From the perspective of financing theory, such a concept is also inappropriate, as the leverage, including internal debt, should preferably depend on economic factors, like profitability, liquidity, and the ability to repayment (debt service) of the company. In that respect, there may be an improvement in sight, especially by the implementation of the interest limitation rule of Art. 4 ATAD as of January, 1, 2019, in all member states. In line with Art. 4 ATAD, the deduction limitation now applies in relation to the taxpayers’ exceeding borrowing costs without distinction of whether the costs originate in debt taken out nationally, cross-border, or whether they originate from third parties, associated enterprises or intra-group (Council Directive, 2016/1164b). This is an advantage because there is no longer a distinction between external and internal debt financing and borrowing and companies, in particular multinational groups, receive more freedom to finance. Moreover, the equity-to-assets ratio test (equity escape) allows a kind of motive test, as the debt-financed company is able to demonstrate that its equity over total assets’ ratio is broadly equal to or higher than the equivalent group ratio (Council Directive, 2016/1164c). This is really a more fine-tuned approach than a general abuse rule to identify inappropriate debt financing in a group of companies. Within a group of companies, it is possible to find out exactly whether a particular group company has excessive debt financing compared to the group. At the same time, the group companies have a wider scope to determine their individual leverage ratio. What is more, the safe harbor rule of net interest expenses in the amount of EUR 3,000,000 allows the single enterprise the totally free choice of the financing instrument without any restrictions or without having to adhere to a certain equity ratio. In numbers, this means that each single enterprise can have a volume of up to EUR 60,000,000 debt at an interest rate of 5% without suffering any restriction in the tax deductibility of interest expense. Within the aforementioned safe harbor, debt ratios of more than 99% are possible without having to meet certain equity requirements. This leads to more flexibility in corporate financing, particularly helping small and medium-sized operations.

Finally, fixing the deductibility of net interest expense to the taxpayer’s EBITDA

Earnings before interest, tax, depreciation, and amortization.

Within the 30% EBITDA rule of Art. 4 ATAD, the member states are in principle not able to consider loans as tax abusive and cannot refuse in this relation the deductibility of interest expenses. In that respect, secondary law sets a fixed standard for adequacy and acts as a barrier for the member states. To that extent the current Swedish rules

Prop. 2017/18:245 p. 184.

This article has been engaged in the examination of the freedom of financing in multinational groups against the background of EU law and the theory of finance. In that context, the pending CJEU case Lexel AB, C-484/19, dealing with Swedish tax law, has been analyzed in terms of its compatibility with the freedom of establishment (Art. 49, 54 TFEU). The faced Swedish interest deduction limitation rules on affiliates are a prime example of how intra-group financing within foreign groups gets restricted against domestic groups. Moreover, the Swedish rules consider cross-border intra-group financing principally as tax-motivated and abusive, whereas the same financial transaction within Swedish groups is fully recognized for tax purposes. Another symptomatic element of this tax legislation is that the permission to deduct interest expense in cases of affiliate groups is legally connected with the theoretical access to a domestic group taxation system. However, this requirement can only be fulfilled by domestic groups, and there are defacto disadvantages for foreign groups at hand. The Swedish interest limitation rules in affiliate groups (C-484/19) operate with a vague legal concept of a general abuse definition and are fully inappropriate to identify excessive and tax-motivated debt financing. They are not in any way in line with settled case law and the concept of the CJEU to combat tax evasion and fraud, respective to the avoidance of circumventing national tax law of the member state concerned. From the perspective of the financing theory, the Swedish interest limitation rules in affiliate groups (C-484/19) have to be rejected because they do not consider economic factors of the debt-financed Swedish subsidiary, like profitability, liquidity, and the ability to repay. A detailed analysis under Union law shows that the Swedish interest limitation rules in C-484/19 breaches the freedom of establishment and therefore cannot be applied in the case of Lexel AB. Thus, the CJEU will find an unlawful discrimination in terms of the Articles 49 and 54 TFEU by the host member state Sweden. The implementation of Art. 4 ATAD will lead to improvement, especially in cross-border financing situations, because this approach is more focused on economic factors and the principles of the finance theory, like the ICR. With the implementation of Art. 4 of the ATAD, the member states seem to be on the right way to tackle with the problem of profit shifting by interest payments and also maintaining a balance to adequate corporate finance and preserving the freedom of finance, particularly in multinational groups. Importantly, European secondary law, the 30% EBITDA rule, also sets out a fixed standard for adequacy and acts as a barrier for the member states. Within this threshold, the member states can principally not refuse the deductibility of interest expenses with the argument of tax abuse or the achievement of substantial tax benefits. The achievement of substantial tax benefits by using intra-group financing is not a relevant criterion of Art. 4 ATAD and is therefore irrelevant. This enhances intragroup financing as a tax planning tool in multinational groups. Also, the current Swedish rules on the limitation of the deductibility of interest expenses in affiliated groups, which refer to receive a substantial tax benefit, may infringe European secondary and primary law. Consequently, these regulations are not applicable.