DANISH SUPREME COURT CONFIRMS NO TAXATION ON INVALID TRANSACTIONS TO BE REPAID

As a general rule, income is taxable at the time the taxpayer has acquired a final legal right to it (Da: "retserhvervelsesprincippet"), in the following "the principle of accrual of income". Where a company controlled by the taxpayer transfers funds that are subsequently found to be invalid under company law, e.g., because the payments were not authorised by the company's management or lacked a legitimate business purpose, the question arises as to whether the recipient can be said to have finally acquired right to the amounts for tax purposes, and if not, whether an earlier taxation of those amounts can be reversed once invalidity is established and the funds are repaid.

The Danish Tax Agency had taken the position that such reversal could only be achieved via the rules on rectification (Da: "omgørelse") under section 29 of the Danish Tax Administration Act (Da: "skatteforvaltningsloven"), and that repayment following a finding of invalidity did not itself remove the tax liability in the income year in which the funds were received.

The taxpayer ("A") controlled a Danish company ("X ApS"). In 2016 and 2017, a number of transfers were made from X ApS to A and to persons and companies closely connected to A. The Danish Tax Agency treated these transfers as salary and disguised salary to A and raised his taxable income for 2016 and 2017 accordingly. The Danish Tax Tribunal upheld the Tax Agency's decision on 14 October 2021.

X ApS was declared bankrupt on 14 February 2018. The trustee of the bankruptcy estate subsequently brought proceedings against A and his connected parties, arguing that the transfers lacked a business rationale, were invalid, and had to be repaid to the estate. By judgment of 14 February 2022, the relevant city court held that the transfers were invalid and had to be repaid. That judgment was appealed but the parties subsequently settled on the basis that A and his connected parties accepted the court's judgment, and the amounts were repaid to the estate.

The case as originally brought before the Western High Court and the Supreme Court concerned two separate categories of transfers: (i) the transfers covered by the city court's invalidity judgment and subsequently repaid, and (ii) a further 13 disputed transfers that had not been part of the repayment proceedings, in respect of which the Western High Court held that A had not discharged his burden of proving a business rationale and accordingly upheld his taxation. Before the Supreme Court, A withdrew the part of the appeal relating to those further transfers, so that the Supreme Court's judgment addresses only the transfers that had been declared invalid and were repaid.

A argued in the tax proceedings that because the underlying transfers had been declared invalid and the funds had in fact been repaid, he had never obtained a taxable economic advantage that could be taxed as salary or disguised salary under section 4 of the Danish State Tax Act (Da: "statsskatteloven").

The Danish Tax Agency and the Ministry of Taxation, by contrast, argued that A had realised taxable income in 2016 and 2017 under the principle of accrual of income, since he actually received the amounts and there was no dispute as to the validity of the transfers before the end of those income years. In their view, reversing the taxation with retroactive effect required rectification under section 29 of the Danish Tax Administration Act, and the subsequent finding of invalidity and repayment could not itself set aside taxation already accrued. As a subsidiary argument before the Supreme Court, the Ministry of Taxation also contended that the transfers made to A's connected parties had been reclassified for tax purposes as salary to A himself, and that the civil-law invalidity established by the trustee's claim only related to the transfers made to A's connected parties, and not the reclassification of salary to A. Therefore, the invalidity and repayment should not affect the taxation of A of the reclassified salary transfers.

The Ministry of Taxation further argued that the legislative history of section 16 E of the Danish Tax Assessment Act (Da: "ligningsloven") on shareholder loans presupposed that repayment of a shareholder loan could not reverse the taxation of the loan, and that the same approach should apply to salary transfers that were invalid under corporate law, so that repayment following a finding of invalidity should not set aside the taxation of the transfers in this case. 

The Western High Court found in favour of A that he could not be regarded as having finally acquired a right to the amounts for tax purposes given the subsequent, final determination of invalidity and the repayment of the funds, and that he was accordingly not taxable on the amounts under section 4 of the Danish State Tax Act. The Western High Court further held that section 16 E of the Danish Tax Assessment Act, which by its wording and preparatory works covers loans only, did not apply on the facts of this case. The same applied to section 16 A of the same act that by its wording covers dividends only.

The Ministry of Taxation appealed the Western High Court's judgment to the Supreme Court.

The Supreme Court upheld the Western High Court's judgment in full.

The Supreme Court held that decisive weight had to be given to the fact that the transfers underlying the increase of A's taxable income for 2016 and 2017 had, by final judgment and following a claim brought by the trustee, been found to be invalid, and that the amounts had been repaid. This applied both to the transfers made directly to A and to the transfers made to persons and companies closely connected to A. The Supreme Court's reasoning does not expressly engage with the Ministry's arguments on rectification under section 29 of the Danish Tax Administration Act or on the reclassification of the connected-party transfers as salary to A; it proceeds directly to the question of final acquisition of a right to the amounts under the principle of accrual of income.

On this basis, the Supreme Court found that A could not be regarded as having acquired a final right to the amounts later being repaid within the meaning of section 4 of the Danish State Tax Act, and that he was accordingly not taxable on them.

The Supreme Court further agreed with the Western High Court that section 16 E of the Danish Tax Assessment Act (only covering loans), and also section 16 A of the same act (only covering dividends) did not provide a basis for taxing the amounts in this case. 

The judgment is a welcome development, and it is fair to say that common sense prevailed in the Supreme Court. The ruling confirms that taxation cannot be based solely on the fact that funds were transferred from one account to another at some point in time when it is subsequently established, with finality, that the recipient did not have a legal right to retain them.