Decision from the European Court of Justice in important tax case

Tax Alert

Published: 2021-01-26

The European Court of Justice has in an advanced ruling on January 20, 2021 (C-484/19) tested the interest deduction limitation rules applicable to the income years 2013-2018 and their combability with EU-law. Based on the description of the rules which was presented in the case, the Court decided that the rules under certain circumstances are considered to be in conflict with the freedom of establishment protected under EU-law. The purpose of the said rules was to prevent aggressive tax planning with interest deductions and to protect the Swedish tax base.

The Court case concerned the Swedish company Lexel, which was denied a deduction for interest expenses paid to a French group company. In France, it was possible to deduct tax losses in such a way that no cash tax would be paid. Deductions were denied on the basis of the so-called exception rule. The exception rule states that even if deductions are to be allowed according to the main rule, deductions can still be denied if the main reason for the debt relationship is that the group of connected parties shall receive a significant tax benefit. 

The case was appealed to the Supreme Administrative Court which sought a preliminary ruling on the question whether the exception rule constitutes a restriction on the freedom of establishment as stated in article 49 of the TFEU, and, if such a restriction can be considered justified.

The ruling of the European Court of Justice

The Court begins by stating that there is a restriction on the freedom of establishment as the current rule would not be applicable if the company that received the interest payment was domiciled in Sweden, and the conditions for group contributions where fulfilled as under these conditions no tax advantage would have arisen.

The Court then ruled that the restriction could not be justified either by the purpose of combating tax evasion or the need for a balanced distribution of the right to taxation between Member States. From the reasoning that emerges from EU case law, it can be deduced that in order for a restriction on the freedom of establishment to be justified in the view of the purpose in counteracting tax evasion, the specific purpose of such a restriction must be to prevent behaviours which consist of staging fictitious schemes which have no sound economic basis and which are arranged for the purpose of avoiding taxes that are normally payable on the profit generated on activities conducted in the country. The Court finds that the exception rule can cover transactions that are carried out on market terms and which consequently do not constitute purely artificial or fictitious schemes in order to avoid the tax that is normally payable on profits generated on activities conducted in the country. The Court finds that the mere fact that a company wishes to deduct interest in a cross-border situation without any fictitious transfer cannot justify a measure which entails a restriction on the freedom of establishment.

The motivation for ensuring a balanced distribution of taxation between Member States is rejected in the light of the fact that a reduction in tax revenue cannot be regarded as such an overriding reason in the public interest that can be invoked to justify a measure which is in principle contrary to a fundamental freedom and that the interest for which Lexel requested a deduction would have been deductible if the recipient company had not been a connected party to Lexel. When the terms of an intra-group cross-border transaction and the terms of an external cross-border transaction correspond to market conditions, there is no difference between these transactions in terms of the balanced distribution of taxation between Member States.

Deloitte’s comment

The advanced ruling from the European Court of Justice is welcome in several ways as the application of the rules has been characterized by great legal uncertainty. We now know that the Swedish Tax Agency's interpretation of the regulations is contrary to EU law and that a large number of tax decisions are therefore incorrect. Moreover, the ruling provides good guidance for legislators to consider when drafting new regulations.

However, the full width of effect the ruling will have on the application of the Swedish interest deduction rules is still unclear and the Supreme Administrative Court now has an extensive task ahead of it in ruling in the case. There is no clear guidance on how such an advanced ruling ruling should be incorporated into the application of Swedish tax law. In addition, there are some important issues the Supreme Administrative Court needs to consider in their ruling, namely whether the information provided by the Swedish Tax Agency on the applicability of the rules is correct and how these affect the justification assessment.

Once the Supreme Administrative Court announces its verdict, we will hopefully get more clarity regarding the application of the rules and it is only then that questions about compatibility with the free movement of capital, the impact on the application of the other exemption rule and the consequences for the new interest deduction limitation rules become relevant. However, it is already clear at this stage that many taxation decisions are incorrect regardless of the additional questions above. There is therefore every reason to reconsider whether the advanced ruling gives reason to appeal denied interest deductions. We are of course happy to take part in such a discussion.

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