S. 287Chapter 28 Sweden: The Foreign Tax Credit and Disparities

Martin Berglund

28.1. Introduction

The foreign tax credit method aims at mitigating international double taxation. There is broad consensus that the application of tax treaties does not require international double taxation. The predominant view is also that application of the exemption method in tax treaties generally does not require that the other state in fact taxes the income. The question is whether the application of the credit method requires that a certain income is subject to double taxation. Otherwise, there would not seem to be any reason for granting a tax credit. Paragraph 1 of the Commentary on Articles 23 A and 23 B of the OECD Model (2010) states that the articles "deal with the so-called juridical double taxation", which is defined in paragraph 1 of the Introduction to the OECD Model (2010) as "the imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter and for identical periods".

This contribution discusses a recent advance tax ruling on this issue given first by the Swedish Board for Advance Tax Rulings (Skatterättsnämnden, SRN) and later by the Supreme Administrative Court. The case was decided by the SRN on 29 October 2012 (case 127-11/D) and by the Supreme Administrative Court on 7 May 2013 (case 6581-12). The case concerned the interpretation of the method article in the treaty between Sweden and China.

28.2. Facts of the case

The applicant was an employee of a Swedish company. He was supposed to work for a period of time in China and then return to Sweden. His employer contiguously made payments on the employee's behalf to an employee trust.

S. 288Every employee had an equal share of the trust, with adjustment of the employment rate. The payments to the trust were based on the work performed during the year. Once the employee became 60 years old, the trust could start giving payments to the employee. The size of the payments was determined on the basis of the value of the trust at the end of each year.

In China, the employee would be subject to income taxation immediately when the company's payments to the trust were made, while in Sweden the employee will be taxed first when the trust made payments to the employee. Because of this difference, China taxes the employee when he was present in China, but Sweden taxed him when he was present in Sweden. The taxation in China was in accordance with both Chinese domestic tax law and the China-Sweden Tax Treaty, since the employee at the time was a resident of that state.

The applicant posed five questions for an advance tax ruling. The first three concerned whether the income from the employment trust would be exempt from Swedish taxation due to domestic Swedish tax rules. These questions will not be elaborated further below, since both the SRN and the Supreme Administrative Court found that these rules did not apply in the situation. The fourth question was whether a foreign tax credit could be granted for the Chinese tax on the payments to the trust. The fifth question was whether an increase in value of the trust between the time of payment to the trust and the time of payment to the employee should be taken into account when determining the foreign income in the credit limitation formula.

The SRN found no hinder against crediting the foreign tax against the Swedish income tax. The Swedish Tax Agency appealed the decision and demanded that the Board's decision should be affirmed.

28.3. The Court's decision

The Swedish Foreign Tax Credit Act states that the right to a foreign tax credit should first be determined according to an applicable tax treaty. Only if the relevant taxes and income are not covered by a treaty may a foreign tax credit be granted according to domestic tax law. When calculating the credit granted by the treaty, resort must then be taken to the domestic tax law. The Court therefore first determined whether the Chinese tax could be S. 289credited according to the article 23 of the Sweden-China Treaty. The Court found that the applicable treaty was in relevant aspects designed according to the OECD Model. This meant that the Commentary to the OECD Model could be used as guidance when interpreting the particular tax treaty.

The Court held that a fundamental prerequisite for granting a tax credit according to the treaty is that the same income has been taxed in both countries. Furthermore, that income must be covered by one of the allocation rules in the treaty and all requirements in the method article must be fulfilled for granting a tax credit.

The first question addressed by the Court was whether the payments to the employment trust and the later payments from the trust to the employer were in fact the same income. The transactions included in the tax base were clearly different in the two countries. These transactions were also undertaken between different persons. The basis of both transactions, however, was the work that the employee had carried out for the employer. The Court therefore held that there was an intimate connection between the payments to the employment trust and the later payments to the employee. The essential difference was due to a timing mismatch between the two taxing jurisdictions rather than a difference regarding the character of the income. Hence, it could be concluded that the same income had been taxed in both states.

The second question was which state should have the responsibility to mitigate double taxation in the situation. This depends on the applicable allocation rule. The Court discussed whether article 15 on income from employment or article 18 on pensions should be applied to the income from the employment trust. Since the employee was supposed to have the income during an ongoing employment, the Court found that article 15 was applicable. The problem that arose was which of the states was the residence state according to that article. China would be the applicant's residence state when his employer made the payments to the employment trust, while S. 290Sweden will be his residence state when the payments are made to him by the trust. According to the Court, this timing mismatch meant that both countries had a right to tax the income in question.

When applying the method article, the Court discussed which of the two states should grant the applicant a relief from double taxation. As mentioned, both states would be residence states at different times. Since the income that was to be taxed in both countries (see above) would be earned while the applicant worked in China, it was the responsibility of Sweden to eliminate the double taxation by granting a foreign tax credit. The Court referred to paragraphs 4.1-4.2 of the Commentary on Articles 23 A and 23 B of the OECD Model (2010) as support for this conclusion.

The third question was whether it was relevant for the foreign tax credit that the employee would be taxed at different periods of time. In discussing this question, the Court also referred to the Commentary on the OECD Model. According to the Court, paragraph 32.8 of the Commentary on Articles 23 A and 23 B supported the conclusion that the right to a foreign tax credit should not depend on whether there is a timing mismatch between the two countries. The Court therefore concluded that the applicant should be allowed a foreign tax credit in Sweden for taxes paid in China on the payments to the employment trust.

28.4. Comments on the Court's reasoning

The overall approach of the Court when applying the method article is well-balanced and reasonable. Here, two aspects of the judgment will primarily be discussed. Firstly, it may be questioned whether it is necessary to require that the same income has been taxed in both states to be able to apply the foreign tax credit method. Secondly, it can be discussed how to deal with such situations of double residence that have not been resolved by applying article 4(2).

Concerning the question on identical income, it could be argued that it should not matter that the two countries tax different items of income as long as a creditable tax has been levied in the source state. It is not expressly stated in Article 23 B that the same income must have been taxed in both states. However, such a requirement must be regarded as an implicit and necessary component of the credit method. The credit method aims at mitigating international double taxation. It would not make sense to grant a credit for foreign taxes that are levied on completely different income as S. 291compared to the income that is taxed in the residence state. Without requiring the same income, the foreign tax credit would risk leading to double non-taxation and different abusive practices to create excessive tax credits.

On the other hand, it is not advisable to be too formalistic when determining if the same income has been taxed in both states. An illuminating example is the case decided by the Supreme Administrative Court. The tax base in Sweden and in China clearly differed with regards to the employment trust income. Two different transactions were taxed in the two countries. Still, if we keep the purposes of the foreign tax credit in mind, these differences do not seem to be sufficient for denying a credit. The basis for taxation in both countries was payments for the work performed by the employee. Furthermore, both countries taxed payments made in close connection to the employee's funds in the employment trust. Accordingly, granting a foreign tax credit does not create a risk for double non-taxation or abuse. The Court was right in its conclusion.

The second issue is how to resolve situations of double residence that have not been handled by article 4(2). In the case, the Court followed the OECD approach regarding employee stock options. This approach means that a foreign tax credit can be given even if a double residence conflict has not been resolved according to article 4(2). The state where the work has not been performed should credit the source state's taxes. This approach is reasonable when it comes to active income, especially work income. Hence, in the case in question, the Court was right in granting a foreign tax credit in Sweden since the work had been performed in China. But assume, for example, that the taxation concerns passive income. In such a case, it is no longer possible to rely on where the work has been performed. In some cases it might be possible to determine where the passive income is sourced, but this would probably not be a good solution in all cases.

Lastly, the Court was right in concluding that the timing mismatch did not in itself prevent a foreign tax credit. Again, if the purposes of the foreign tax credit are considered, there is no reason to require that an item of income has been taxed exactly at the same time in both states. A timing mismatch will usually not lead to double non-taxation or any abuse. In some cases, it cannot unambiguously be determined if a certain item of income has been taxed in both states. An example is taxes on fictitious income on investment income assets (see chapter 26 in this volume). In such cases, the timing of the taxes may be more important for the right to a foreign tax credit.