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Swedish private equity: legal and tax developments

This report from Baker & McKenzie outlines some of the key legal issues affecting Swedish private equity funds, including the structure of funds, taxation, the stock market and competition laws. It raises some vital areas to pay attention to when conducting due diligence into Swedish private equity firms.

During recent years, the private equity industry in Sweden has grown at a rapid pace. At the end of 2000, the number of private equity companies had increased to about 130, which in total had more than SEK80bn in funds. During 1999, Swedish private companies invested over SEK11bn. With these figures, Sweden ranked third in the world in terms of private equity investments after the US and the UK. However, as for most other countries, the boom within the private equity sector came to an abrupt end last year. Besides this downturn, there have also been some legal and tax developments in Sweden during recent years which affect the private equity industry. This article addresses these developments.

Private equity fund structures
Traditionally, private equity companies in Sweden have been independent companies, generally limited liability companies (Sw. aktiebolag), funded by the owners. The last few years have seen an increasing interest in listing such companies on stock exchanges. However, the declining stock markets put a stop to this trend last year.

Another trend is the change in the way private equity companies are structured. There is an increasing tendency to organise private equity companies in the manner that is customary in the US and United Kingdom - by setting up independent closed-ended funds as the investment vehicle, with a general partner responsible for identifying investments. In Sweden, the vehicle available for such funds is a limited liability company or a limited partnership (Sw. kommanditbolag). With few exceptions, the vehicle used in Sweden is the limited partnership. However, the tax disadvantages of Swedish limited partnerships for domestic investors (as will be further described below), has led many private equity companies to establish funds abroad.

Taxation issues
A Swedish limited liability company is liable to pay a corporate income tax of 28 per cent on its business income. All company income is considered as business income. To avoid tax on income that is subject to capital gains, a Swedish limited liability company must obtain status as a 'qualified investment company'. If such status is obtained, capital gains will not be taxed as business income but calculated at a standard rate of two per cent of the opening balance each year. Furthermore, dividends will only be taxed if distributed as a dividend to the owners of the 'qualified investment company' in the same year as the dividend was received. However, the rules for obtaining this status are quite strict. For instance, they are only applicable to listed companies.

A Swedish limited partnership is treated as a transparent entity for income tax purposes. The tax rate is determined by partner level. For Swedish general partners, the entire income from the limited partnership is taxed and is included in the profit of the general partner. Deficits may be offset against the general partner's other income.

Limited partners that are Swedish companies may not deduct more than the amount invested or stated to be invested into the company, (ie the partnership share). The remainder of the deficit must be forwarded and may only be deducted from the future income of the limited partnership. Income from the limited partnership will be taxed as business income. This is a disadvantage for companies receiving favourable tax treatment of capital gains and has led to, as mentioned above, many private equity companies considering other alternatives, for instance, funds abroad. However, it should be noted that the Swedish tax authorities may regard a foreign limited partnership as tax transparent for Swedish tax purposes and tax matters must therefore be investigated thoroughly when setting up the structure. In order to obtain the favourable tax treatment for capital gains, many Swedish investors invest directly and in parallel with the fund.

Dividends paid to non-residents are subject to a 30 per cent non-resident withholding tax. Depending upon the residency, however, it may be possible to reduce the rate of tax payable in accordance with the provisions of a double taxation treaty. There is no withholding tax on dividends if the non-resident company holds at least 25 per cent of the capital in the Swedish investee company and is subject to an income tax similar to the Swedish income tax. Under the Swedish law implementing the provisions of the EC Parent-Subsidiary Directive, there is no withholding tax on dividends paid to a 'parent' company in another Member State if the 'parent' owns at least 25 per cent of the capital in the Swedish subsidiary.

A capital gain derived from the sale of shares in a Swedish company is taxable for a non-resident company only if it is attributed to a permanent establishment in Sweden. A permanent establishment is considered to be any fixed place through which a business is run, either wholly or in part. The tax rate for the non-resident company is the same as for resident companies.

The Swedish Ministry of Finance has proposed (by the report SOU 2001:11) that capital gains on business-related (organisational) shares become tax exempt. Furthermore, capital losses on business-related shares will not be deductible. Business-related shares are proposed to be such shares that: (1) represent at least ten per cent of the voting rights; or (2) are otherwise necessary for the business conducted by the shareholding company or a related company. The shares must be held for a continuous period of one year. The new rules are expected to become effective 1 January 2002.

Fundraising issues
Concerning fundraising, the placement may be subject to particular rules if the fund is a limited liability company. In this case, it must be determined whether the offering requires approval and registration under the Trade in Financial Instruments Act (the 'FTI Act') or not. As long as the offering will only be made to a limited pre-selected group of investors, it will not qualify as an offering that requires filing with the Financial Supervisory Authority (the 'FSA') and subsequent approval and registration under the FTI Act. To fall outside the filing, approval and registration requirements, the offering may not be to an 'open-ended group' - as stated in the FTI Act. This type of restricted group is not primarily defined through the number of persons/individuals it contains, but is according to whether it is possible to identify the group members and if they are replaceable ie, if group members may change, or vary in number. Furthermore, provided that the minimum amount to be paid by an individual investor is SEK300,000, the offering is exempted from filing requirements even if the group of investors is deemed to be open-ended.

Stock market issues and insider trading
Many private equity companies have been increasingly interested in companies listed on stock exchanges. Considering the amounts available in funds and the low stock prices for many companies, especially small and medium-sized companies, it is likely that this trend will continue. If so, private equity companies will face a number of rules that are applicable to such transactions.

First of all, the acquisition of a listed company is strictly regulated by the FTI Act and by the FSA. Furthermore, such acquisitions are regulated by a number of recommendations, among other things, recommendations issued by the Swedish Industry and Commerce Stock Exchange Committee. These recommendations form a part of the stock exchange listing contract and are thus binding for listed companies. However, even though the recommendations are not binding for many purchasers, the recommendations are generally followed as with the London City Code on Takeovers and Mergers.

When acquiring the whole or a part of the shares in a listed company, both the FTI Act and recommendations issued by the Swedish Industry and Commerce Stock Exchange Committee set forth certain rules for public announcement by the purchaser. Effective from 1 July 1999, the recommendations issued set out an obligation to make a public offer to purchase all remaining shares if the purchaser's shareholdings reach or exceed 40 per cent of the target company's votes.

From 1 January 2001, Sweden adopted new legislation concerning insider trading. The new legislation does not entail any changes that affect private equity firms, but they should be aware that investment in companies listed on a stock exchange means that the rules on insider trading may be applicable to transactions; for instance, the rules entail regulations concerning notification and prohibition to trade under certain circumstances.

Competition issues
Competition law and merger notification rules are not the main worry or topic in private equity placement transactions. The common understanding of the merger rules is that these are only aimed at thwarting the creation of dominant market operators or to bar major competitors from acquiring each other. The duty to notify and the material impact of the transaction on the market are two different matters, but are sometimes confused. This conceptual misunderstanding may have serious, or at least unnecessary, consequences.

As from 1 April 2000, the Swedish Competition Act was amended in respect to its merger notification rules. Sweden has now adopted a merger control regime, which mirrors EU merger rules. Sweden has thus adopted the notion of 'concentration'. A concentration is any transaction that results in one or more undertakings or persons, not previously in control, gaining sole or joint control over another entity or business. A concentration is subject to mandatory notification to the Swedish Competition Authority (SCA), provided that the turnover thresholds are met. Failure to notify may result in fines. A concentration must be notified if:

(i) The undertakings concerned have combined aggregate worldwide turnover exceeding SEK4bn, and

(ii) Each of at least two of the undertakings concerned has a Swedish turnover exceeding SEK100m.

Joint control is the normal situation in a private equity investment, where the investor is the new party and where the old shareholder(s) retains a (majority) degree of control. Joint control is defined as having a decisive influence over the strategic business decisions of a company. Strategic decisions may, for example, involve the appointment of senior management, adoption of the business plan or budget approval. It is sufficient to have a veto right on such issues to establish a decisive influence. Consequently, a 'mere' 15 or 30 per cent of the shares in the target company may give a decisive influence depending on the contents of the shareholders' agreement.

The merger notification rules treat a private equity investment as any other share/asset acquisition or merger transaction. For example, a financial investment by a private equity company in a small but promising IT company may be treated the same way as a merger between or acquisition among competing car manufacturers. Even though the investee company's turnover may be 'insignificant', an investment may be subject to mandatory notification if, for example, one of the previous shareholders and the investor meet the thresholds. This is because the investee company's turnover may not be relevant at all in situations of joint control.

The terms decisive influence and turnover are important in any assessment of the notification duty, but may raise particular problems in private equity investments. First, it has to be determined if the investor acquires a decisive influence over the target company at all. This is often a key element in the negotiations; how much influence does the investment warrant? The negotiations may flow back and forth and the level of influence may be agreed on at a rather late stage.

Secondly, the turnover of the private equity firm may have to be calculated. A private equity firm is deemed to be a financial holding company under the competition rules. Such a company does not achieve 'regular' turnover in terms of sales of products or services. The turnover of a financial holding company is established by adding interest income, income from shares and other variable yield securities, net profit on financial operations etc. to a proportionate part of the turnover generated by those portfolio companies in which the private equity firm has a decisive influence. Consequently, the degree of influence in each portfolio company has to be assessed and the turnover of the relevant companies has to be calculated (including the turnover of companies in which the portfolio company has a decisive influence).

It is important to identify the potential notification duty at an early stage to be able to properly deal with the issues involved. A 'late arrival' causes delays, additional costs and, not least, uncertainty. A notification of a 'concentration' is a rather cumbersome, time-consuming and expensive affair. A great deal of information must be gathered from the parties and occasionally from third parties (for example from portfolio companies of the investor). If the notification duty is identified as late as at signing, serious disruption and delays may occur. If identified after signing, the notification duty may result in uncertainty and inability to complete the investment. Once notified, the deal may not be closed prior to approval from the SCA. This means that the investor, during the SCA's review period (25 working days), is not allowed to take part in the decision-making concerning the target company.

Michael Nyman, Erik Björkeson and Carl Bökwall are with the Stockholm office of Baker & McKenzie.

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