Legal Alert – Top Management’s Incentive Scheme Considered as Tax Avoidance
The Finnish Supreme Administrative Court (the SAC) issued a ruling (KHO:2014:66, 2 May 2014) in which benefits received by a top management through a holding company structure were considered as earned income under the general anti-avoidance rule. This ruling overturned the preliminary ruling issued by the Finnish Central Tax Board.
In the case at hand, the top management of A Oyj had set up a holding company B Oy that acquired shares of A Oyj. The acquisition of the shares was financed with equity capital contributed by the top management and a loan issued by A Oyj to B Oy. A Oyj and the top management had concluded a shareholders’ agreement that included i.a. leaver provisions and restrictions on the right of pledge and disposal of B Oy’s and A Oyj’s shares. Moreover, it was agreed that after a certain date the shareholders of B Oy and A Oyj’s board of directors will decide to dissolve the holding company structure and potential income arising as a result will be paid to B Oy’s shareholders in A Oyjs shares. Under the agreement, the primary way to dissolve the structure was to merge B Oy to A Oyj, but also alternative measures, such as selling of A Oyj’s shares followed by liquidation of B Oy, were accepted.
Based on information provided by B Oy, the holding company structure was set up to enhance the top management’s collective and long-term commitment to A Oyj and to create a joint financial interest to meet A Oyj’s strategic objectives. In addition, the structure was considered to be transparent and clear in the light of insider rules and corporate governance regulation. Members of the top management have a real risk to lose their significant equity capital contribution to B Oy. Moreover, the loan agreement between B Oy and A Oyj was concluded at arm’s length terms.
In its ruling, the SAC stated that the essential question in the case is whether the planned arrangements should be evaluated based on their civil-law form or whether the arrangements as a whole should be taken as a starting point for the evaluation. In its evaluation, the SAC highlighted A Oyj’s integral involvement in the arrangements and the fact that the arrangements concern only the top management of A Oyj. Consequently, the SAC concluded that the arrangements constituted above all a managements incentive scheme the material intention of which was that the top management will benefit from the potential increase in the share value.
The SAC regarded that in the case at hand the business reasons for the form of the management incentive scheme were relatively weak. Furthermore, the SAC found it evident that one of the intentions of the structure was that benefit received based on the employment would not be taxed as earned income.
The SAC concluded that the arrangements should be evaluated as a whole taking also the Finnish anti-avoidance rules into account. Based on this evaluation, the primary intention of the arrangements was considered to be that the top management potentially obtains A Oyj’s shares at a price lower than the fair market value. Therefore, the SAC ruled that as a result of the arrangements the top management receives an employment-related benefit that will be treated as earned income in taxation.
Due to the non-specific nature of the Finnish general anti-avoidance rule, principles of tax avoidance are based materially on legal practice. Conventionally, the general anti-avoidance rule has not been applied if the taxpayer has been able to prove that there is no inconsistency between the legal form and true nature of the transaction or if the taxpayer has demonstrated that the motive of the transaction has not been to avoid taxes.
Tax avoidance allegation has been usually dismissed if a taxpayer has been able to demonstrate business reasons for the transaction. In the case at hand the demonstration of the business reasons by the taxpayer was not sufficient, but instead the SAC evaluated the applicability of the anti-avoidance rule by comparing validity and materiality of the business reasons presented with the tax avoidance motive. The approach taken in the decision can be seen to impair foreseeability and legal security in taxation.