Global Tax Alert | 21 February 2014

Swedish Supreme Administrative Court rules on the distinction between debt and equity for a convertible bond

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The Swedish Supreme Administrative Court (the Court) issued a ruling on 14 February 2014, pertaining to the distinction between debt and equity – where it concluded that interest paid on a mandatory convertible should be non-deductible.

Background

The case involved the issuer of a convertible bond, who upon maturity was entitled to repay the principal (and any capitalized interest) either in cash, or through newly issued shares.

In accordance with IFRS GAAP, the convertible bond had been recognized as equity for accounting purposes. Consequently, any interest accrued on the bond had not been expensed in the statutory P/L.

The Court ruling

The Court initially noted that while a convertible bond at least in form falls under the definition of a debt instrument from a legal standpoint, other areas of company law (e.g., the rules around distributions of dividends) disregard the formal legal labelling of a financial instrument, and instead adhere to the treatment in the statutory accounts under relevant GAAP.

The Court went on to mention that the accounting treatment could serve as a relevant starting point also when determining the classification for tax purposes but that the tax treatment nevertheless in certain cases should not necessarily be bound by the classification in the accounts.

In this instance, the Court also highlighted the fact that in addition to the accounting treatment, the instrument did not represent an obligation for the issuer to repay the principal out of its own funds, as it could choose to repay either through cash or newly issued shares. The Court considered this feature to deviate from what typically would be the case for debt.

The Court finally concluded that given the accounting treatment of the bond as equity, treating the instrument as debt for tax purposes effectively would have rendered deductibility to what from a legal standpoint would represent dispositions of distributable reserves.

Based on the above, the Court ruled that the convertible bond should be considered as equity for tax purposes, and thus that interest expenses on the bond should be non-deductible.

Implications

This case indicates that while the accounting treatment of a financial instrument should represent a significant factor, Swedish courts should still be free to determine the tax treatment based on the features of the instrument on a case-by-case basis. Further, it is also clear that the Court considered the issuer’s possibility to choose repayment through the issuing of new shares to deviate from what typically should be considered as debt for tax purposes.

For additional information with respect to this Alert, please contact the following:

Ernst & Young AB, Stockholm
  • Erik Hultman
    +46 8 520 294 68
    erik.hultman@se.ey.com
  • Rikard Strom
    +46 8 520 592 08
    rikard.strom@se.ey.com
Ernst & Young LLP, Scandinavian Tax Desk, New York
  • Martin Norin
    +1 212 773 2982
    martin.norin@ey.com

EYG no. CM4193