Swedish taxation of Management Incentive Programmes and Carried Interest

Introduction

The Swedish tax rules provide a good flexibility for management when making a share investment in a corporate structure. Recently there has been an extensive scrutiny by the Tax Agency on taxation of carried interest. With this article we outline the current tax situation of both Management Incentive Programmes (MIPs) and carried interest in Sweden.

 

Summary

In general, members of management that invest in a corporate structure can choose between a direct investment as an individual or through a personal holding company depending on which factors that are relevant in each situation.

The private equity sector has once again come under tough scrutiny by the Swedish Tax Agency and several years of tax litigation are to be expected. There is a potential opening to codify taxation of private equity structures by means of special legislation.

 

Management Incentive Programmes

To the extent shares or other securities are acquired by management at a price below fair market value, the difference will be treated as a taxable benefit in kind at the time of the acquisition of the shares or securities. The marginal income tax rate is approximately 55 per cent (2024) and taxes due shall be withheld by the employer. Additionally, social security contributions of 31.42 per cent (2024) will be levied on the benefit. The social security contributions are payable by the employer and deductible for income tax purposes by the employer.

The tax burden on employment income, including employment benefits is considerably higher compared to the flat rate (normally 30 per cent) on capital gains. Dividends or capital gains on unlisted shares are taxed at a rate of 25 per cent. Thus, it is fundamental for the total tax burden whether or not a share or security is treated as an employment income or a capital income.

The rate of tax applicable will depend principally on whether the special rules on qualifying shares in closely held companies apply. Under the tax rules for a closely held company (Swe. fåmansföretag) special taxation rules on dividends and capital gains deriving from the company apply. A closely held company is a company with four or fewer owners who directly or indirectly own shares representing more than 50 per cent of the voting rights (although a group of managers is treated as one owner for these purposes). The share is qualified if the owner is active to a significant degree (Swe. betydande omfattning) in the company or another closely held company with the same kind of business. However, if there is an external owner of at least 30 per cent of the shares having a corresponding right to a dividend, the shares in the company would not be deemed qualifying. Note that if the shares had previously been qualifying, a five-year period applies before the shares may be deemed as not qualifying. Under the rules on qualifying shares, a portion of a dividend or a capital gain is taxed as employment income (but social security charges do not apply).

The benefit of holding the Management shares as an individual is that a gain can be taxed at 25 per cent capital taxation as long as the shares are not qualified closely held company shares. With a direct shareholding there is no ongoing administration/running costs as opposed to an investment via a personal holding company. A disadvantage with a direct holding is that taxation will be triggered upon a sale of shares. Further, a share-for-share exchange is more tax complicated in the personal sector compared to a share-for-share exchange by a company.

With a personal holding company dividends and capital gains received by the holding company is in general tax free (participation exemption). Tax is triggered when the manager repatriates income from the personal holding company. The taxation is in general falling under the closely held company rules, whereby the tax needs to be assessed on a case-by-case basis. If the company has been dormant for at least five calendar years, the shares are no long qualified closely company shares and the owner can repatriate dividend/capital gain at 25 per cent capital taxation. Running the company requires a certain degree of administrative work and costs.

It should be noted that the Ministry of Finance (Swe. Finansdepartementet) has released a Governmental Official Report that proposes certain changes to the tax rules regarding the taxation of owners of qualified closely held companies.

 

Taxation of Carried Interest

The Swedish taxation of carried interest has been uncertain for almost 15 years. Since 2014 the Tax Agency has accepted that carried interest received from the General Partner (GP) into a personal holding company owned by a Swedish tax resident individual could be taxed under the Swedish closely held company rules. By using a personal holding company the individual taxation can be postponed until the owner repatriate dividend or capital gains from the holding company.

The closely held company rules may be applicable on options which are regarded as securities from a tax perspective and also shares received from an option or employee stock options (regular employee stock options or qualified employee stock options).

It should be noted that passive owners, non-qualified owners, that hold at least 30 per cent of the shares being entitled to dividend distributions may be regarded as an external owner (Swe. utomstående) under the Swedish closely held company tax rules. If so, the special rules do not apply. The external owner must under the main rule hold the shares for five calendar years for rendering the special rules inapplicable and subject to ordinary capital gains taxation. In situations where a private equity firm or an institutional investor has a majority stake, the closely held company rules are in general not applicable but these tax rules are based on case law and are quite technical. A case-by-case investigation is necessary.

During 2023 the Tax Agency initiated a large number of reassessments resulting carried interest being taxed as income of employment. The Tax Agency's view is that carried interest is regarded as a performance based remuneration for a work performance in connection with the management of the fund. The Tax Agency has now broadly taken the position that the closely held company tax rules are in general not applicable. Under specific circumstances they may still be applicable but narrowed down.

For the closely held company to be applicable at all, it is the Tax Agency's view that only a flow of capital income can be transferred to a personal holding company, i.e. a right to an income taxable as income of employment cannot be transferred to a personal holding company.

To be successful in arguing that the carried interest should be sorted into the closely held company rules there must be a payment classified as income of capital. The Tax Agency's view is that the personal holding company must own shares directly in the General Partner and thus be a direct chain of ownership. Further, there are arguments from the Tax Agency's side that there must be an initial payment for the share/other security. A symbolic payment for a share, for example CLN class of shares in a Lux SCA company has been argued as one circumstance that there is not an acquisition of a capital asset and the carried interest is not a capital stream in itself.

The Tax Agency's view is that the carried interest should be taxable as income of employment when the carried interest has been disposed by the individual and paid out to the individual's holding company.

The 2023 reassessment decisions by the Tax Agency will likely be appealed to the tax courts. Due to the rather time consuming process it is not likely to have a final view on the taxation of carried interest within 4-5 years. In total the tax litigation time for carried interest will be approximately 20 years. The Chief Justice of the Tax Agency has said that he is positive to be part of looking into a legal regulation of carried interest in the Income Tax Act (Swe. Inkomstskattelagen (1999:1229). So far there is no such initiative from the Ministry of Finance.

To avoid a levy of tax surcharge on carried interest it is important that both the individual and the company provide an open disclosure in the tax returns, i.e. to provide the Tax Agency with sufficient information/facts to assess the tax issue. In one of the 2023 reassessment decisions, the Tax Agency levied a full tax surcharge of 40 per cent of the computed tax even though the tax payer had filed an extensive open disclosure. The Tax Agency argued that there were no facts in the open disclosure that the individual's holding company did not directly or indirectly own shares in the General Partner.