Finnish Interest Deduction Rules to Tackle Leveraged Buy-outs
By Einari Karhu
Posted: 16th October 2013 09:25Because of their economic nature as investment vehicles and collective asset unity, investment funds and institutional investors are usually treated as tax-exempt or fiscally transparent vehicles. Therefore any additional tax burden at the level of investment object is an additional cost to the investors.
Finland has recently introduced its version of thin cap legislation which aims at reducing the use of debt financing between related entities and thus the tax optimisation of international investors. The new tax legislation has great significance in international tax planning and is of special interest in leveraged buy-outs because it may increase the Finnish tax burden of Finnish-bound investments. Although the new rules are directed to the leveraged Finnish entity (and permanent establishments in Finland) at the level of annual corporate taxation, it has direct effect to the return on investment of the investors.
Until now, interest expenses have been widely deductible in Finnish business taxation. Taking into consideration the fact that interest payments to non-resident creditors are generally not subject to withholding tax, use of considerable debt financing has been a customary method to structure Finnish acquisitions and minimise Finnish tax burden. Only the general anti-avoidance provision, where the application threshold has generally been high, has limited the use of debt in corporate financing.
According to the new rules, the deductibility of interest payable to affiliate companies is limited if the company’s annual interest expenses exceed the annual interest income during the tax year in question. In such case interest paid to affiliate companies (domestic or foreign) would become non-deductible for the part of the net interest expenses exceeding 30% of the company’s adjusted operating profit. The operating profits are adjusted e.g. by received and given group contributions in accordance with the Finnish group taxation rules.
In order to prevent the companies from circumventing the provisions via a non-affiliated intermediary, interest paid to third parties may also be considered as related party interest in certain cases and therefore being subject to the limitations. For example, interest paid in back-to-back arrangements or on third-party loans that have been secured by related-party receivables is regarded as related party interest.
Small amounts of net interest expenses have been released from the limitations. In practice, if the annual net interest expenses of a Finnish company remain below EUR 500,000, the limitations would not apply irrespective of the level of operating profits. Also, real estate companies and financial, insurance, and pension institutions are in principle exempted from the limitations. However, the limitations are expected to be extended to real estate companies in the future.
The new legislation provides an additional safe harbour rule also for larger companies in the form of consolidated balance sheet test, which exempts Finnish companies having equal or better equity-to-assets ratio than in the consolidated balance sheet of the group parent company.
Instead of being an anti-avoidance rule, the Finnish interest deduction rules affect all larger debt-financed companies, irrespective of business motives or deviation from arm’s length principle. Therefore Finnish groups have to readjust their group financing policies. For example, it is common that parent companies prefer to finance new subsidiaries in risky projects such as entering new markets or introducing new products with debt. However, the new provisions may affect such debt financing. Also, due to being bound to operating profits, the provisions may have unwanted effect in business sectors where economic fluctuations between tax years are significant. Therefore private sector has flagged that the new legislation may have negative consequences to the Finnish economic growth.
It seems obvious that the new legislation aims especially to the structures where foreign private equity or institutional investors make highly leveraged investments to Finnish companies. While currently it is common to take advantage of the withholding tax exemption and the broad deductibility of interests, where the acquisition company’s interest expenses are financed by the operative Finnish company, in future it is likely to see structures where the lending is divided between the joint investors in order to have the financing sourcing from non-affiliate parties instead of using a joint financing holding company. Should there be a sole investor without any possibility to divide the financing, it may become necessary to reorganise the group by merging the operative company with the parent holding company in order to strengthen the interest deduction position of the interest paying entity. Finally, it may become necessary to consider the possibility to structure the financing by using the consolidated balance sheet test in order to exempt the Finnish entity from the limitations.
The new legislation will enter into effect as of tax year 2014. However, as the provisions apply to current structures as well as future structures, investors and companies should review the current financing structures of the Finnish companies in order to avoid any unexpected Finnish tax burden.
Einari Karhu is senior associate in the tax group of Attorneys-at-law Borenius. He advises in Finnish and international corporate taxation and EU tax issues and has extensive experience in corporate cross-border taxation and M&A structuring as well as EU tax litigation and tax treaties. He has Master's degrees both in Law and in Economics. Einari is a member of the Finnish Tax Advisors' Association and a member of the International Fiscal Association. He was admitted to Finnish Bar in 2010.
Mr Karhu can be contacted via e-mail at firstname.lastname@example.org or alternatively via telephone at +358 9 6153 3488.