This article was originally written on 5 March 2007.
The Danish Government proposes to make some very significant changes to the corporate tax regime, some with effect from 1 January 2007. The proposed changes would impact all parties with interests in a Danish company.
All Danish companies will be affected. There will be winners and losers if the proposals are brought into law. However, the overall impact is in our view negative. Had we considered the overall impact to have been positive, perhaps the title of this article could have been ‘The "Spring Tax Package"’. But we are in little doubt that "Winter" is more appropriate.
1. Key features – brief summary
- Patent income: net royalty income and gains on sale of certain patents would be taxed at only 12.1%.
- Dividends received: can only be exempt if paid by a company in a country with a tax treaty with Denmark or in the EU or EEA .
- Corporate tax rate: down from 28% to 22%.
- Deductibility of interest, etc: in addition to the existing thin capitalisation rules, further stringent limitations would apply for the deductibility of "net financial expenses" exceeding DKK 10m (about EUR 1.3m).
- Liquidation distributions: in the case of shareholders owning more than 10% and not resident in a treaty country or the EU or EEA - these will be subject to dividend withholding tax.
- CFC regime: would be extended to apply to Danish subsidiaries; would only apply if the Danish shareholder has more than 50% ownership (previously 25%); would only apply if the subsidiary has more than 50% financial income; would apply irrespective of the effective tax rate abroad.
- Tax depreciation: would be significantly restricted.
- Acquisitions of Danish companies (a non-tax item): new restrictions concerning post-acquisition dividends and agreements with the target company’s board and senior management.
- Public companies (a non-tax item): would need prior shareholder approval for certain stock option arrangements.
Items A-E are dealt with further in Section 4, below.
2. Commencement dates
There are different proposed commencement dates for different items and circumstances, being 1 January 2007, 1 April 2007, 1 June 2007 and income year 2008.
For details see after each Item in Section 4, below.
3. Sheltons’ comments on the political position
The proposals were published by the Danish Government in the form of a draft tax bill. The bill has not been presented to Parliament but was sent to "hearing" until Friday, 23 February. The hearing is a process which enables interested parties to make written submissions.
The submissions are now being studied by the Ministry of Taxation and the Government.
The proposals have received considerable flack from many operators, from AP Moeller-Maersk (who have threatened to move their headquarters from Denmark if the proposals go ahead in their current form), to the banking sector, Danish corporate groups with foreign subsidiaries, acquisitive companies, the American Chamber of Commerce, accounting and legal professional bodies - and the Conservative Party, which forms part of the current coalition government.
Politically, the key elements of the bill causing debate are the limitations on interest deductibility ("net financial expenses") and the related justification – the reduction in the tax rate from 28% to 22%. The interest limitation has caused something of an uproar, with industry bodies and a range of influential players stating that they would prefer to keep the status quo, including the 28% tax rate. It is quite possible that the Government will back down to some extent on the interest limitation aspect but this might also mean that the quid pro quo - the proposed reduction in corporate tax from 28% to 22% - will be affected.
Despite this massive opposition, it is our view that the element which has borne the brunt of the criticism, the stringent restrictions on the deductibility of interest and the related reduction in corporate tax from 28% to 22%, will remain, in essence, but that the final Bill will be somewhat watered down. Our view on the future of each of the various elements of the proposal is as follows (but note that this is just an educated guess at this stage):
- Patent income: net royalty income and gains on sale of patents would be taxed at only 12.1%.
- Dividends received: can only be exempt if from a country with a tax treaty with Denmark or from the EU or EEA (this group covers about 80-85 countries).
- Company tax rate: down from 28% to 22%.
- Deductibility of interest: in addition to the existing thin capitalisation rules, further stringent limitations would apply for "net financial expenses" exceeding DKK 10m (about EUR 1.3m).
- Liquidation distributions: in the case of certain shareholders - will become subject to dividend withholding tax.
- CFC regime: would apply to Danish subsidiaries; would only apply if the Danish shareholder has more than 50% ownership (previously 25%); would only apply if the subsidiary has more than 50% financial income; would apply irrespective of the effective tax rate abroad.
- Tax depreciation: would be significantly tightened up.
Our view: the current proposal will be maintained; possibly with an extension to cover other intangible property of the kind which results from scientific research, other than just patents; the tax rate might end up slightly higher than 12.1%.
Our view: will be dropped.
Our view: will end at about 25%.
Our view: will be relaxed and will probably be more focused on foreign private equity funds instead of the current proposal which affect all companies other than the smallest.
Our view: the current proposal will be maintained.
Our view: the current proposal will be maintained.
Our view: the current proposal will be significantly relaxed
4. Further comments on Items A-E
A. Patent income
It is proposed to tax certain patent income at only 12.1%. Only 55% of such income would be taxable, and with the proposed reduction of corporate tax from 28% to 22%, the effective tax rate would be 12.1%.
Only 55% of expenses would be deductible, so the tax benefit of expenses would only be 12.1%.
Only patents would be eligible for the special tax treatment; income and expenses related to other intangible property such as know how, copyrights, etc., would be taxed at the normal corporate tax rate.
It would seem that a Danish licensee paying royalties to a Danish company which elects to use this "patent box" regime would still be able to deduct the royalty at 22% even though the recipient would only be taxed at 12.1%.
The proposed commencement date is the 2007 income year, being 1 January 2007 for companies with a 31 December year-end.
B. Dividends received.
It is proposed to change two aspects. It is relevant to note here that amongst the necessary conditions for dividend to be exempt from tax is that the Danish company owns at least 15% of the nominal capital of the dividend paying company. (The 15% will be reduced to 10% from 1 January 2009, following the minimum requirements set out in the EU Parent-Subsidiary Directive). A further condition is that the shares must be held for at least 12 months, although a dividend received during the 12 months can be exempt so long as the 12 months is eventually reached.
The first proposed change is that if a dividend is not exempt due to ownership of less than 15%, the dividend will be fully taxed. Under the current law only 66% of the dividend is taxed.
The second an most important proposal is that a further condition will be added, requiring that for the dividend received by the Danish company to be exempt it must be derived from a company in a jurisdiction which has a tax treaty with Denmark or is in the EU or EEA. This would cover about 80 countries. There are approximately 200 countries in the world so this presents an issue for Danish companies receiving dividend for the other 120 countries. Amongst those 120 countries include several important Latin American and African countries. The Danish based group AP Moeller – Maersk has stated that this proposal would affect dividends from some 80 countries.
The proposal would apply to dividends distributed from 1 June 2007.
C. Company tax rate
The proposal to reduce the corporate tax rate from 28% to 22% is closely connected with the limitation of the deductibility of interest.
It may be of interest to note that Danish companies pay 28% on the first and last kroner of income – there is no progression. Further, there are no state or local taxes at the corporate level. Other than the tax rate, none of these features are proposed to be changed.
Under the proposal the reduced rate would apply to income in the 2007 year, being the year commencing on 1 January 2007 for companies with a 31 December year-end.
D. Deductibility of interest: in addition to the existing thin capitalisation rules, further stringent limitations would apply for net financial expenses exceeding DKK 10m (about EUR 1.3m).
This is by far the most controversial aspect of the proposals and as noted above will almost certainly be changed, but it will not be dropped, just watered down.
Under the thin capitalisation regime a debt / equity ratio of 4:1 applies. Only interest on related party debt is disallowed under the thin capitalisation regime. Further, the regime does not apply if the total related party debt is less than DKK 10,000,000 (about EUR 1.3m). The proposed new rules would not change this – they would be in addition to the thin capitalisation regime.
The proposal is essentially that "net financial expenses" would not be deductible at all if the amount exceeds an amount calculated as 6.5% of "operating assets", referred to here as the "calculated rate of return". Even if the net financial expenses are less than the calculated rate of return, then only 55% is deductible, giving a tax effect of only 12.1% (55% * 22%).
The proposed limitation would not apply where the net financial expenses are less that DKK 10,000,000.
Operating assets are defined as all assets excluding, inter alia, shares (unless they are shares forming part of a share trading business), claims, financial contracts and the value of tax losses carried forward. Accordingly, a pure holding company, for example whose only asset is shares, will have nil operating assets and thus will not be entitled to deduct the net financial expenses. In short, a pure holding company will not be entitled to an interest deduction.
"Net financial expense" is calculated as
- Interest income less interest expenses
- Loan commissions
- Capital gains and losses on claims, debt and financial contracts (excluding losses from a financial trading activity), and
- Interest income and expense embedded in financial leasing contracts
The non-deductible interest will not be available for carry forward.
There are a number of reasons for this part of the proposal to have caused considerable disturbance, one of which is the complexity. The complexity has a wide range of aspects, just one of which is the connected to the fact that all Danish entities belonging to the same group must be group taxed. The application of the group tax (tax consolidation) rules together what the proposed net financial expense limitations would lead to considerable compliance burdens, bearing in mind that the determination of the net financial expenses amount and the operating assets amount need to be done on a group basis. Further, the determination of the amount of operating assets under the proposal involves a difference in the case of Danish subsidiaries (which must be group taxed) and foreign subsidiaries, a matter that not only adds to the complexity, but raises issues under EU law as well.
Under the proposal the restrictions would have effect for net financial expenses allocable to the period commencing on 1 April 2007.
E. Liquidation distributions
Currently, liquidation distributions are not treated as dividend for Danish dividend withholding tax purposes but as a capital gain derived by the foreign shareholder. Such distributions are specifically dealt with in the section of the law imposing dividend withholding tax, where the law categorically states that such payments are not dividends for the purposes of dividend withholding tax.
Under the proposals the exemption from Danish dividend withholding tax would only apply if the recipient has at least 15% of the Danish company (10% from 2009) and is in the EU, EEA or a country with which Denmark has a tax treaty.
Under the proposal any liquidation proceeds distributed from 1 April 2007 would be affected.
5. Further information.
Please feel free to contact the undersigned for further details. In addition, we will be posting details on our website once the Bill is presented to the Danish Parliament.
Ned Shelton, Managing Partner, Sheltons, Danish & International Tax Counsel
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.