Legal Alert: Helsinki Administrative Court Decides on The Classification of a Hybrid Instrument as Debt or Equity Due to Transfer Pricing Adjustment
On 29th May, Helsinki Administrative Court (Court) rendered its decision (Nr. 13/0844/4) in a case concerning the deductibility of interest on a hybrid loan from a Luxembourg S.á.r.l. parent company (Parent) to its Finnish subsidiary (Company). Previously, the Board of Adjustment of the Large Taxpayers Office had stated that despite being de jure a loan, based on transfer pricing adjustment, the loan was de facto an equity investment whereby the return paid on said investment was not tax-deductible. In its decision, the Court overruled this and stated that disregarding de jure characteristic of the loan based on transfer pricing adjustment was not admissible.
The case concerns taxation year 2009, when the Large Taxpayers Office had adjusted the tax return of the Company by adding to the taxable business income of the Company the interest paid to the Parent, 1.34 MEUR. The loan related to refinancing needs and difficulties faced by the Company during 2009 when the Company needed substantial bridge financing due to the fall in demand for its products, 80 % of whose sales went to the auto industry, following the economic downturn.
The loan was eventually structured to be an unsecured, 15 MEUR loan with no equity related rights and with a fixed interest rate of 30 % p.a., no maturity date and where any interest accrued was added to the loan principal. The loan was secondary to bank loans in terms of ranking of claims; the company was allowed to pay back the loan and interest provided that the position of the senior creditors was honored.
In Finnish taxation practice, the distinction between equity and debt related instruments have been a repeating issue before tax courts. Based on previous practice even if the loan had no fixed maturity date, it would not mean that the debt should be classified as equity as such. Having no maturity date would however enable treating the debt as equity for IFRS purposes, which is not decisive for taxation purposes.
The most interesting juridical question concerned, however, if the loan could be reclassified as equity based solely on the Section 31 of the Finnish Taxation Procedural Act (FTPA) and Article 9 of the Finnish Luxembourg Tax Treaty (FLTT). Section 31 requires that if the terms and conditions of related transactions differ from those agreed between unrelated parties, and the taxable income of the parties is, as a result thereof, lower or the taxable loss of parties is greater than it had been had the conditions been arms length, the taxable income is adjusted by adding to the taxable income the amount representing the terms and conditions between related parties. The tax authorities relied in their decisions on the Section 31 of the FTPA as well as Article 9 the FLTT which, according to them, encompassed a wide arms length principle.
The Company argued that any potential reclassification would require applying the general anti-avoidance clause, i.e., Section 28 of the FTPA the first sentence of which states e.g. that if certain circumstances or actions are performed in a form or manner not representing the actual nature or purpose of the matter, the taxation of the matter shall be carried out based on the de facto form. Relying merely on principles set out in the OECD Transfer Pricing Guidelines would violate against the Finnish Constitution which requires, i.a., that the grounds, scope of subjects as well as legal protection of tax subjects concerning any state tax shall be based on and stipulated by law. The evaluation of the characteristics of a certain hybrid loan and the deductibility of interests related thereto should be thus made based on the interpretation of Finnish domestic internal legislation.
The Court noted that the Board of Adjustment and Large Taxpayers Office had in its decisions applied the Section 31 of the FTPA but not Section 28 of the FTPA and stressed that disregarding the legal form based on transfer pricing adjustment without applying Section 28 of the FTPA should be treated with caution. This was argued to be case especially when considering the explicit reference included in the first sentence of the Section stipulating disregarding the legal form. This applies also specifically to the second sentence of said Section ensuring that the legal protection of the tax payer should also be taken into account.
The Court also stated that the Company had provided information on how hybrid instruments generally have been used in the market, its need to strengthen its capital base and company-specific reasons motivating why it was rational to strengthen the capital structure with hybrid instruments. In this respect, the Court seemed to agree with the rationale provided by the Company why it had resorted to said hybrid loan: to improve its solvency, fulfill the requirements for obtaining bank financing and secure the continuation of the business.
All in all, the case presents an interesting application of the Sections 31 and 28 of the FTPA. Overall, it seems undebatable that Section 31 has priority over Section 28. This can be based on two separate grounds: Firstly, Section 31 concerns a special clause thereby overruling a more general rule, i.e. Section 28 (see e.g. Finnish Supreme Administrative Court, KHO:2009:70). Secondly, Section 31 was added to the FTPA during 2006 whereas Section 28 was included already in the law preceding the current FTPA from 1995. This would grant Section 31 also temporal priority over Section 28. In light of this, the case before the Court seems to demonstrate that even the application of Section 31 may have its limits.
Limiting the applicability of Section 31 may be preferred especially on the basis of legal protection, since as the Court noted, Subsection 2 of the Section 28 grants the tax subject the right to be heard if the tax authorities deem that the case concerns tax avoidance, while Section 31 does not grant such protection. Another important difference between said Sections enforcing the rights of the tax subject is that applying the Section 28 requires a specific tax-avoidance purpose and that said avoidance is obvious or evident. Section 31, on the contrary, is applied without any motivation for tax avoidance although the decision KHO:2009:70 may indicate otherwise.
The ruling is not yet binding and even the decision of the Court was not unanimous. A final decision in the matter will hopefully shed more light and guidance to the distinction between applying Sections 28 and 31 of the FTPA and the factual scope and content of the Section 31 of the FTPA.