The Stockholm Administrative Court of Appeal s Ruling in the Nordic Capital Case Taxation of Carried Interest

Transcription

1 143 The Stockholm Administrative Court of Appeal s Ruling in the Nordic Capital Case Taxation of Carried Interest Sven-Åke Bergkvist, Martin Nilsson, Niklas Hagbard and Carl Beyer* Introduction On 19 December 2013, the Administrative Court of Appeal in Stockholm announced a much-awaited ruling regarding NC Advisory AB, the Swedish advisory company to Nordic Capital s funds (Case no ). The question in the case was how the part of the profit split in private equity funds referred to as carried interest should be taxed. The Swedish Tax Agency has scrutinised the Swedish private equity industry, focusing on this issue, since 2007 and in an extensive investigation reassessed almost every Swedish advisory company to larger international private equity funds and individuals employed by these companies. The case against NC Advisory AB is the pilot case and it has thus been closely followed, in Sweden as well as internationally. In this case comment, the authors briefly describe the private equity structure in question and the case against NC Advisory AB, focusing on the ruling from the Administrative Court of Appeal. The comment concludes with a few observations in light of the ruling. * Advokat Sven-Åke Bergkvist, advokat Martin Nilsson, jur kand Niklas Hagbard and advokat Carl Beyer work in the department for corporate taxation at Mannheimer Swartling Advokatbyrå AB, Stockholm. This is an English translation of an article that was originally published in Skat Udland, Karnov Group.

2 144 Business Law International Vol 15 No 2 May 2014 Private equity funds in question The funds in the case (Nordic Capital s funds III, IV and V) are similar to Swedish limited liability partnerships (in Swedish kommanditbolag ) (limited partnership or LP ), which are tax resident on Jersey. Prior to the establishment of the respective funds, the founders (the key executives ) established a corporation (the initial limited partner or ILP) through which the fund establishment is financed and their investments are made. ILP, in turn, established a subsidiary (general partner or GP), which is the manager of the fund. These corporations are also tax resident on Jersey. Both the ILP and GP are parties to the investment agreements entered into with the external investors. In these agreements, the ILP commits to invest capital in the fund and the GP commits to manage the fund. The ILP and GP also agree with the external investors on how the profits in the fund should be allocated between the parties. The participants in the fund are thus the ILP and GP, on the one hand, and the external investors, on the other hand. The external investors mainly consist of Swedish and international institutional investors, for example, insurance companies, pension funds and government funds. The external investors together invest approximately 98 per cent of the capital in the fund and the key executives (through the ILP) invest approximately two per cent of the capital in the fund. The GP employs several experienced people. It is the entity that manages and administers the fund and the only entity that may take binding decisions on behalf of the fund (acquisitions and disposals of shares, etc). The GP also has unlimited liability for the fund s activities and obligations. The activities of the GP require authorisation from and are subject to supervision by the Jersey Financial Services Commission. The GP receives a management fee from the fund for its services. The GP has engaged NC Advisory AB (where the key executives and others are employed), among others, to provide investment advisory services to the GP. For these services, NC Advisory AB receives an advisory fee. The advisory fee should compensate NC Advisory AB on market terms for the work performed. In addition, the GP retains several other advisers such as sister companies to NC Advisory AB in other countries as well as external consultants. The profits in the fund are allocated between the external investors and the ILP in accordance with pre-agreed principles that are stipulated in the investment agreement. Very simply, first all investors receive a return equal to their investments and a preferred return (interest) calculated on that amount. Thereafter, any excess profits are split between the external

3 Case comments 145 investors (80 per cent) and the ILP (20 per cent). The 20 per cent that the ILP receives is the part that is commonly referred to as carried interest. In practice, for carried interest to become distributable, the fund s investments must generate a per annum compounded annual return of at least 13 per cent if costs are taken into consideration (the so-called hurdle rate). In summary, on the one hand, the key executives have a role as founders of and investors in the funds through the ILP and on the other hand, a role as advisers to the funds in their capacity as employees in NC Advisory AB. Certain employees in NC Advisory AB who are not key executives have had the opportunity to invest in the ILP through profit participation loans (profit loan agreements or PLAs). Through the PLAs, these employees ( PLA-holders ) have had a right to receive a portion of the carried interest received by the ILP. For this right, the PLA-holders have paid a premium. Swedish Tax Agency s view in brief 1 The Tax Agency has, in the case, argued that the carried interest received by the ILP in reality is a compensation for work performed. The origin of carried interest is a capital gain on shares, but this capital gain belongs to the external investors. The Tax Agency therefore argues that the external investors have waived a portion of their profits to incentivise the key executives and PLAholders to work actively with the value creation in the funds. According to the Tax Agency, this work has been performed in NC Advisory AB where the key executives and the PLA-holders are employed. The GP only has administrative and legal control functions according to the Tax Agency. The ILP has no personnel. Consequently, neither the GP nor the ILP can perform the value creating work in the funds and therefore, carried interest cannot belong to any of these companies. NC Advisory AB is not a party to the investment agreements and does not have any contractual right to carried interest. However, the actual purport of the agreements is that carried interest rightly should belong to NC Advisory AB since the key executives and PLA-holders have performed the value creating work in this company. Carried interest is in reality a compensation for this work according to the Tax Agency 1 It may be noted that NC Advisory AB partly won in the tax committee, the Tax Agency s internal tribunal, which previously was the decision-making body within the Tax Agency. The part won by NC Advisory AB was subsequently appealed by the Public Attorney (in Swedish Allmänna ombudet) and the same person has thereafter argued the case for both the Tax Agency and the Public Attorney. Since the Tax Agency and the Public Attorney assert the same support for their claims, they are both referred to as the Tax Agency in this article for reasons of simplification.

4 146 Business Law International Vol 15 No 2 May 2014 NC Advisory AB should therefore treat carried interest as business income. Since NC Advisory AB does not have this money, the corresponding amount should be considered to have been paid out by NC Advisory AB as salaries to the key executives and PLA-holders. As a result, the Tax Agency levied NC Advisory AB with social security contributions based on this fictional salary payment. The Tax Agency also levied tax surcharges. Ruling from the Administrative Court in Stockholm On 6 December 2012, the Administrative Court in Stockholm (the court of first instance) announced its ruling. The exchange of writings had then been ongoing for over two years before it was finalised with an oral hearing. The reasons for the Administrative Court s decision were very generally drawn up. In summary, the Administrative Court concluded that even though carried interest constitutes part of the agreed profit allocation between the investors, it cannot be considered to be connected to the investment made by the key executives and PLA-holders. Instead, carried interest is a compensation for the value-creating work that the key executives and PLA-holders perform for the fund as employees in NC Advisory AB. Carried interest should therefore be treated as a compensation for work performed. Since the work has been performed by the key executives and PLA-holders in their capacity as employees in NC Advisory AB, the company should be taxed for carried interest as a business income but the same amount should be considered paid out as salaries, which resulted in social security contributions being levied. The Administrative Court also found that there were grounds to levy tax surcharges in accordance with the Tax Agency s claim. The Administrative Court thus granted the Tax Agency s claim in its entirety. Ruling from the Administrative Court of Appeal in Stockholm The Administrative Court of Appeal opens up the reasons for its decision by stating that it is common ground in the case that the fund structures are set up as they are described by NC Advisory AB and that all agreements entered into between those involved in the fund structures are legally valid. The Administrative Court of Appeal thereafter states that, in general, taxes are charged on the basis of the actual purport of legal acts irrespective of the designation ascribed to them in agreements and, in such context, it may be necessary to carry out an overall assessment of the circumstances in order to classify the legal relationship. Accordingly, the Administrative Court of Appeal must examine whether the actual purport of the agreements and fund structures deviates from the legal purport thereof.

5 Case comments 147 To do this, the Administrative Court of Appeal divides the issues in the case into two questions: 1. Has the company (NC Advisory AB) played a role other than as expressed in the agreements and the fund structures? 2. Has carried interest been paid for the value-creating work carried out by the key executives and PLA-holders on behalf of the company? With respect to the first question, the Administrative Court of Appeal concludes that it may be deemed established that the division of the funds into advisory and management functions has been a requirement from the external investors. In the opinion of the Administrative Court of Appeal, the fact that there is a Jersey financial supervisory authority with an established supervisory role in respect of a GP that includes the granting of authorisation and approval of members of the board of directors already in itself suggests that the GP, also in practice, holds a position in the fund structures other than one that is purely administrative. From the evidence presented by NC Advisory AB it has also come to light that the GP acts independently and takes decisions that are based both on administrative considerations and on commercial assessments made by GP itself and that the board of directors of the GP consists of very experienced and qualified persons. Thus, the Swedish Tax Agency has not demonstrated that NC Advisory AB has any possibility to push through decisions against the will of the GP or anything that suggests that the employees of NC Advisory AB exercise any concealed influence over the GP and by these means have controlled the actions of the GP. Also the fact that the GP retains a number of consultants in addition to NC Advisory AB strongly contravenes the Swedish Tax Agency s assertion that NC Advisory AB, in reality, has had the decision-making function in the funds. In summary, the Administrative Court of Appeal thus finds that it has been established in the case that NC Advisory AB, in accordance with the agreements entered into, has only had an advisory function in the fund structures and that the GP has had the decision-making function. As regards the second question, the Administrative Court of Appeal concludes that it is established in the case that the agreement between the external investors and the ILP regarding carried interest is based upon commercial considerations based on the risk that the key executives, unlike other investors, have taken in establishing the funds. The fact that a couple of external parties (so-called sponsors ) were entitled to carried interest by undertaking to bear a share of the costs in the event of a failure to establish the fund, also strongly suggests that carried interest is not to be regarded as performance-based compensation in the manner asserted by the Swedish Tax Agency. The Administrative Court of Appeal further finds, in light of the extensive evidence presented in the case, that it has been established that the value

6 148 Business Law International Vol 15 No 2 May 2014 growth that occurs in the funds and that constitutes the basis for carried interest is related to a number of different circumstances, and not only to the work efforts of the key executives and PLA-holders. Accordingly, the Administrative Court of Appeal notes in summary that the discovery in the case does not provide support for the assertions made by the Swedish Tax Agency according to which the actual purport of the agreements and the fund structures are other than as expressed and that carried interest paid constitutes compensation for the work performance of the key executives and PLA-holders as employees of NC Advisory AB. Therefore, according to the Administrative Court of Appeal, the conditions are not present for taxing carried interest at NC Advisory AB and levying social security contributions in the manner as occurred in the decisions of the Swedish Tax Agency and the ruling of the Administrative Court. NC Advisory AB s appeal was therefore granted in its entirety and the decision of the Swedish Tax Agency and the ruling of the Administrative Court reversed. Finally, it may also be noted that the Administrative Court of Appeal remarked on how the Tax Agency had argued its case and on the ruling from the Administrative Court. In relation to the question of compensation to NC Advisory AB for legal fees incurred, the Administrative Court stated: the discovery of the Swedish Tax Agency has been characterised by deficiencies in so far as, as late as during the proceedings before the Administrative Court of Appeal, there were uncertainties regarding the grounds for the claims brought by the Tax Agency, which circumstances the Swedish Tax Agency treated as common ground, and the Swedish Tax Agency s action in certain respects was inadequately supported. Furthermore, according to the Administrative Court of Appeal, the decision by the Administrative Court was very general and may be deemed to have entitled the company to pursue additional discovery. A few observations As legal counsel in a case where the court rules in favour of your client, it is perhaps not a surprising conclusion that the authors share the court s view. Nevertheless, the authors allow themselves to express the opinion that the Administrative Court of Appeal s ruling is comprehensive and well motivated. This is a complex case in which the exchange of writings has been ongoing for several years. In addition, a two-day oral hearing took place, which is quite rare in tax cases. Under such circumstances, it is of particular importance that the court clearly demonstrates in its ruling that it has understood the issues at hand in the case and the arguments presented by the parties.

7 Case comments 149 It is also of principal interest to note that the Administrative Court of Appeal clearly establishes that agreements should be respected when evaluated from a tax perspective and that no general substance over form principle exists, which the Tax Agency has claimed throughout the proceedings. As is often the case when legally valid agreements and corporate constructions are challenged by the Tax Agency with a general reference to substance over form, this case has been marked by a difficulty in understanding exactly what the Tax Agency s legal support has been for its assertions and, in the authors experience, an unwillingness from the Tax Agency to express its legal support more precisely. The Administrative Court of Appeal s ruling clearly demonstrates that it does not suffice for the Tax Agency to litigate its cases in such an unclear manner but instead a higher degree of precision is required and a respect for who bears the burden of proof. However, irrespective of what additional evidence the Tax Agency could have presented, in the authors opinion there is no legal support for the Tax Agency s assertion that carried interest should be taxed at NC Advisory AB. In Swedish law, no general principle exists according to which a taxpayer can be taxed for income that the taxpayer could have had or should have had. Instead, the actual purport of legal acts, determined by the contractual laws governing them, governs taxation unless there are specific tax rules stating otherwise. At the time of writing, it is still unclear if the Tax Agency will appeal the ruling from the Administrative Court of Appeal to the Supreme Administrative Court. The ruling from the Administrative Court of Appeal is based on what has been discovered in the case, that is, questions of evidence. The primary function of the Supreme Administrative Court is to create precedents and a leave to appeal must be granted for a ruling from the Administrative Court of Appeal to be tried. The Supreme Administrative Court only grants leave to appeal for a small percentage of the rulings in tax cases that are appealed. For leave to appeal to be granted, the Supreme Administrative Court must either find that a lower court has made a major procedural or material mistake or that the case is of importance as a precedent, that is to say provides guidance for how other similar cases should be considered. Questions of evidence are normally not considered to be of importance as a precedent. According to a judge of the Supreme Administrative Court Kristina Ståhl, a case must involve an unclear issue of law where there is a need for guidance from the highest court for leave to appeal to be granted Justice Kristina Ståhl, The Supreme Administrative Court 100 Years, 501.