Swedish Supreme Administrative Court Clarifies Taxation of Carried Interest

The Swedish Supreme Administrative Court recently issued a judgment, an appealed advance tax ruling ("Förhandsbesked") from the Swedish Council for Advance Tax Rulings ("Skatterättsnämnden"), in which the Swedish tax classification of carried interest was assessed. The ruling constitutes a welcome clarification of the legal position, in that civil law circumstances appear to have been given decisive weight in the taxation.

What did the advance tax ruling concern?

The advance ruling concerned the taxation of a person who was active as a manager of a private equity fund, who was entitled to carried interest. More specifically, the individual fund manager posed two questions, both concerning whether he personally would be taxed with Swedish progressive employment income tax when carried interest was distributed from the fund, passing by different entities on its way to the fund manager's personal Swedish holding company.

The applicant thus wanted to know whether he, as an individual, would be taxed as employment income upon distribution of the carried interest to his wholly owned Swedish limited liability company ("Aktiebolag").

How have similar arrangements been assessed by the Swedish Tax Agency?

In Swedish court cases from administrative courts of appeal, a number of different approaches have been applied in the taxation of carried interest. In some cases, the Swedish Tax Agency has successfully argued that carried interest is, by its nature, remuneration for work, and therefore cannot be taxed as capital income.

In these cases, the Swedish Tax Agency has primarily pointed to the fact that fund managers received compensation in the form of carried interest that was disproportionately large in relation to the contribution they had indirectly invested in the fund, which according to the Swedish Tax Agency meant that it was to be classified as employment income for Swedish tax purposes, despite it having been paid out as a dividend.

In other cases, the Swedish Tax Agency has — sometimes successfully — argued that taxation should occur under the so-called closely held company tax regime (the "3:12" rules), which result in taxation partly as capital income, partly as employment income.

How did the Swedish Supreme Administrative Court reason in its judgment?

In the case at hand, the Swedish Supreme Administrative Court began by assessing whether the agreed profit distribution among the partners in the fund — that is, the General Partner, the external investors, and the managers' (LP) company which was the potential recipient of carried interest — should be accepted for tax purposes.

The Supreme Administrative Court stated, with regard to this issue, what is to be understood as meaning that the allocation was clearly at arm’s length, and that the civil law distribution should therefore be accepted also for tax purposes. Given this, the individual who was a manager in the fund should not be taxed when the managers’ LP company, which had contributed approximately 2% of the capital in the fund, was taxed upon the payment of carried interest to this company in which the managers were indirect shareholders.

What is interesting in the judgment is that the majority of the Supreme Administrative Court did not explicitly address whether the fund manager personally would be taxed upon the dividend to his own closely held company. However, from the Court’s decision to affirm the advance ruling issued by the Council for Advance Tax Rulings, it follows that it was considered that no taxation as employment income should occur at this stage.

In summary, the ruling expresses an acceptance of what was agreed under civil law, in the sense that carried interest, given the capital contribution made by the fund managers' LP company, should not be regarded as a profit distribution that should be disregarded for tax purposes. The Supreme Administrative Court also appears to emphasize that taxation as employment income should not occur, regardless of the nature of the compensation, to the extent that the taxable event has not yet occurred — which should happen no earlier than when an individual can dispose of the income.

The ruling represents a welcome clarification, and hopefully, one consequence of it will be that the Swedish Tax Agency ceases the hunt it has pursued over the past decade, where it appears to have attempted to impose taxation as employment income by various indirect means — despite the fact that, in other cases, it has accepted taxation as capital income when the funds clearly derived from work performed by the recipient of the distribution.