By Jens Wittendorff

On 15 April 2008, the Danish Minister of Taxation introduced a bill (Bill No. L 181) in Parliament which aims at closing international tax loopholes caused by discrepancies between domestic tax law in Denmark and the law in other countries (including the U.S.). The bill addresses the following:

• The tax treatment of convertible bonds;
• The qualification of branch offices, partnerships and other transparent entities; and
• The broadening of the scope of the dual consolidated loss rules.

The bill also includes a measure on the transfer of leased cars from business use to private use but this measure does not have any significant international ramifications.

Convertible Bonds

Capital gains and losses on convertible bonds normally receive the same tax treatment as capital gains and losses on shares. Accordingly, capital gains on convertible bonds are tax-free if they held for at least three years.

In some countries, convertible bonds are treated as debt and capital losses are tax deductible. To take advantage of this discrepancy, Danish companies have set up structures where zero-coupon convertible bonds are issued by a foreign subsidiary and purchased by a Danish parent company, with the effect that a build-in discount on the convertible bond is tax deductible for the foreign subsidiary. On the other hand, the corresponding capital gain on the convertible bonds is tax-free for the Danish parent company provided the three-year holding period is met. The Danish Tax Assessment Council, in principle, approved this approach in a binding ruling where the subsidiary was resident in Sweden (SKM2007.464.SR). In essence, the effect of the approach is that taxable interest income is converted into a tax-free capital gain for the Danish parent company.

The new bill includes a proposed section 9 A of the Act on Capital Gains on Shares, whereby capital gains and losses on convertible bonds held for at least three years would be taxable income. Capital losses on convertible bonds held for at least three years would be tax deductible, but ring-fenced so that losses only could be set off against capital gains on convertible bonds held for at least three years. As previously, the conversion of a convertible bond into shares would not trigger any Danish taxation. The new provision would apply regardless of whether the debtor company is Danish or foreign or whether the debtor company may deduct a capital loss on the convertible bond in accordance with foreign tax law.

If approved by Parliament, the provision on convertible bonds would take effect for capital gains realized on or after 15 April 2008. No transition rules would be available for existing structures.

Qualification of Transparent Entities

Under Danish law, general and limited partnerships are considered transparent rather than separate entities, so that participants in such transparent entities must include the income and expenses in their taxable income. In some countries, such as the U.S., entities classified as transparent under Danish tax law are treated as separate entities for tax purposes, or taxpayers have an option to treat such entities as transparent or separate. According to the Minister of Taxation, this disparity in treatment gives rise to a potential for abuse, with transparent entities being set up that escape both Danish and foreign taxation.

It follows from the commentaries to the bill that the proposed changes are specifically targeted at U.S. investors setting up Danish partnerships. The Minister of Taxation provides an example of U.S. investors establishing a Danish partnership and transferring intangibles to the partnership. The partnership arranges for a Danish or foreign subsidiary to manufacture products on a contract basis using the intangibles; the finished products are then distributed by other Danish or foreign subsidiaries. According to the example, the profits associated with the intangibles may escape both Danish and U.S. taxation provided the partnership does not maintain a permanent establishment in Denmark.

The bill proposes a new section 2 C of the Corporate Tax Act, whereby an entity would be treated as separate entity for Danish tax purposes provided the following conditions are satisfied:

• The entity is registered as a Danish branch office of a foreign company, or the entity is transparent under Danish tax law and is registered in Denmark, has its registered office in Denmark pursuant to the articles of association or has its place of effective management in Denmark; and
• Persons tax resident in one or several foreign countries, the Faeroe Islands or Greenland hold directly more than 50% of the capital or voting power of the entity, the entity is treated as a separate entity for tax purposes in such jurisdictions, or the jurisdiction does not exchange information with the Danish tax authorities under a tax treaty or other international conventions or agreements.

It is not necessary under the proposed measure that the entity be affiliated with the participants in the sense that they belong to the same group. For instance, a Danish partnership owned by 20 U.S. investors could be covered by section 2 C if the entity is treated as separate entity for U.S. tax purposes. Moreover, if a U.S. company owns 60% of a Swedish partnership that owns 100% of a Danish partnership, and both partnerships are treated as separate entities for U.S. tax purposes, the U.S. company would be deemed to own directly 60% of the Danish partnership, thus triggering application of section 2 C. However, if the Danish partnership is owned by another Danish partnership that is requalified as a separate entity under section 2 C, the first-mentioned partnership (i.e. the “bottom” partnership) would not be covered by the provision, since it would be deemed to be directly owned by the other Danish partnership.

According to the proposal, new section 2 C would not be applicable to foreign partnerships, i.e. partnerships that are not registered in Denmark, do not have a registered office in Denmark pursuant to the articles of association and do not have a place of effective management in Denmark.

An entity covered by section 2 C would be subject to the same tax treatment as companies that are tax resident in Denmark. The participants would be deemed to have disposed of all assets and liabilities at fair market value at the time the entity is classified as a separate entity. The entity normally would be deemed to have acquired all assets and liabilities at fair market value at the time it is classified as a separate entity. A disposal of an interest in the entity would be governed by the Danish Act on Capital Gains on Shares. A distribution to the participants would be deemed to constitute a dividend distribution, possibly triggering a 28% withholding tax. If the entity ceases to be covered by section 2 C, all assets and liabilities would be deemed to be disposed of to the participants at fair market value.

If approved by Parliament, section 2 C would take effect from income years beginning on or after 15 April 2008. However, if the participants make an election pursuant to foreign tax law on or after 15 April 2008 , which brings an entity within the scope of section 2 C, the provision would take effect from the time the election has effect, although not prior to 15 April 2008.

Proposed section 2 C will complement section 2 A which deals with companies that are treated as separate entities for Danish tax purposes and as transparent entities according to foreign tax law. Section 2 A was enacted in 2004 to prevent tax planning caused by the U.S. check-the-box rules.

Dual Consolidated Loss Rules

Dual consolidated loss rules enacted in 1996 (section 5 G of the Tax Assessment Act) disallow a deduction for expenses in Denmark if the expenses also are deductible in a foreign country (i.e. “double dip”). The rules apply, inter alia, when an expense may be deducted by a foreign affiliated company. The new bill expands the scope of the dual consolidated loss rules to include situations where the affiliation is caused by unrelated taxpayers acting in concert or through a transparent entity.

The change to section 5 G would take effect for expenses incurred on or after 15 April 2008.

Conclusion

The new rules on convertible bonds should be of immediate relevance to a number of Danish multinationals. On the contrary, the new rules on re-qualifications of transparent entities do not seem to be of significant relevance to many companies. Likewise, the adjustment of the rules on dual consolidated losses is not likely to be of much practical relevance.