Controlling Shareholders and Constructive Dividends

For tax purposes a company and its shareholder are two separate persons. They may therefore enter into agreements with each other.

A controlling shareholder may, for example, be employed by the company, lease a property to the company, lend money to the company or buy and sell assets to or from the company.

As a starting point such transactions are treated in the same way as agreements between independent parties.

Problems typically arise if the Danish Tax Agency considers that the terms do not correspond to what independent parties would have agreed.

If a controlling shareholder receives a payment that the agency regards as excessive, the difference may be taxed as a constructive dividend.

Under section 16 A of the Danish Tax Assessment Act a shareholder is, as a starting point, taxed on dividends from the company.

This applies not only to ordinary dividends formally resolved and paid out. Other economic benefits may also be treated as dividends.

What a payment or transaction has been called is therefore not decisive on its own.

If a payment genuinely relates to salary, rent, interest or consideration for an asset, it should as a starting point be treated under the rules governing those items.

If, on the other hand, the agency considers that the payment is wholly or partly attributable to the shareholder's influence over the company, the amount may be regarded as a constructive dividend.

That can lead to taxation of the shareholder while the company is at the same time denied a deduction for the expense.

In many constructive dividend cases the facts and the documentation become decisive.

This includes what was actually agreed between the company and the shareholder, what a payment relates to, whether the company received genuine consideration, and how the value of an asset or service was determined.

The Danish Tax Agency often applies strict documentation requirements to agreements between related parties.

We therefore review agreements, invoices, payments, bookkeeping, correspondence and other information capable of shedding light on the transaction.

How an entry appears in the accounts is not necessarily decisive. What matters is what actually happened.

A classic issue arises where the company has incurred an expense that the Danish Tax Agency considers to relate wholly or partly to the shareholder privately.

This may involve housing, cars, travel, renovation or other private matters.

These cases require a specific assessment of why the company incurred the expense, who benefited from it, and whether the expense had a genuine business connection to the company's activities.

The fact that an expense also benefited the shareholder does not in itself mean that the full amount must be taxed as a constructive dividend.

Constructive dividend cases also frequently arise on purchases and sales of assets between the company and the shareholder.

This may concern real property, cars, securities or other assets.

If the agency considers that the shareholder bought an asset too cheaply from the company, or sold an asset to the company at an inflated price, the difference may in the circumstances be taxed as a constructive dividend.

Valuation then often becomes the central question.

It may therefore be necessary to examine how the price was determined, what comparable transactions exist, and whether the agency's valuation is in fact correct.

Where the dispute concerns the sale or purchase of real property, a car or another asset between the company and its controlling shareholder, the valuation of the asset may be decisive.

Where a major transaction has not yet been carried out and there is real uncertainty about the valuation or the tax treatment, a binding tax ruling from the Danish Tax Agency may be worth considering.

It can clarify the tax consequences before the transaction between the company and its controlling shareholder is completed.

An economic benefit does not have to be paid directly to the shareholder before a constructive dividend case can arise.

If the company pays an expense for the shareholder's spouse, children or other related parties, the agency may in the circumstances regard the benefit as having passed through the shareholder.

That can result in taxation of the shareholder even though the funds did not go directly to that person.

Such cases call for a specific assessment of both the relationship between the parties and the background to the transaction.

The same issue can arise between companies within the same group.

If a parent and a subsidiary transact on terms that the agency considers to deviate from market terms, a tax adjustment may follow.

This can be relevant to management fees, transfers of assets or the payment of expenses between the companies.

Here too it is often decisive whether documentation exists for the services delivered and for how the price was determined.

In many cases the rules on constructive dividends are closely connected to the rules on shareholder loans.

Under section 16 E of the Danish Tax Assessment Act a loan from the company to a controlling shareholder may in the circumstances be taxed as salary or as a dividend.

This is often seen in connection with current accounts, where the agency reviews each withdrawal and entry.

It is important to establish how each amount arose and whether the agency has treated the entries correctly.

In some cases it is relevant to examine whether a compensating payment is available under section 2(5) of the Danish Tax Assessment Act.

There may also be situations where a transaction can be reversed under section 29 of the Danish Tax Administration Act.

Whether that is possible depends on the specific circumstances and on the type of transaction involved.

It should therefore be assessed specifically and as early as possible.

A constructive dividend case can in some situations lead to more than a tax adjustment.

If the Danish Tax Agency considers that the shareholder intentionally or with gross negligence failed to report a taxable benefit, the case may also take a criminal track.

That can result in a fine and, in more serious cases, imprisonment.

At HAY LAW we handle both tax cases and tax criminal cases. We can therefore manage the matter as a whole if a constructive dividend case also develops into a criminal case.