Friday, 21 July 2017

Netherlands: Supreme Court rules on deductibility of interest

The Dutch Supreme Court issued two decisions on 21 April 2017 that clarify the circumstances in which interest expense will be deductible for tax purposes. The cases involve banking group structures intended to benefit from the mismatch between the Dutch participation exemption and the rules that generally permit the deduction of interest expense on loans used to acquire participations (i.e. the “Bosal gap”).

In 2003, the Court of Justice of the European Union (CJEU) ruled in the Bosal Holding case that the Dutch rules applicable at the time for the deduction of interest expense incurred on loans in relation to participations were contrary to EU law. At the time, the Dutch participation exemption prohibited the deduction of interest on loans used to finance the acquisition of a foreign participation, whereas no such limitation applied for domestic participations.
Dutch tax law was amended as from 2007 to allow the deduction of “financing interest” relating to foreign participations. Since that time, there has been a mismatch between the treatment of such interest expense (which is, in essence, deductible) and the income from qualifying participations (which is not taxable as a consequence of the Dutch participation exemption). Particularly in respect of foreign participations, this mismatch may create a risk of lost revenue for the Dutch treasury, since the profits of a foreign subsidiary generally are not taxable in the Netherlands, while the financing interest is, in principle, deductible in the Netherlands. This mismatch is referred to as the Bosal
Facts of the cases
The two cases before the Supreme Court involve the same taxpayer and essentially the same structure.
A Swiss banking group set up a tax structure in an attempt to benefit from the Bosal gap. The first case involved a structure that basically was used to acquire third-party Dutch private limited liability companies that already had earned profits in the same year as that in which they were acquired, but before the actual date of acquisition (for example, by disposing of the assets that comprised their businesses). Once the companies were acquired, their assets mainly consisted of cash. The second case involved private limited liability companies that did not earn any profits before the acquisition.
Subsequently, funding from loans that existed within the group was transferred to the acquired companies through a UK-based permanent establishment (PE) of the group’s Swiss parent company, i.e. the acquired companies became the borrowers on intercompany loans. The companies used the cash thus obtained to acquire foreign participations.
The objective of the structures was to set off the interest deductible on the loans against the profits already earned by the private limited liability companies. The interest payments were financed through dividend distributions (which were exempt under the participation exemption) by the foreign participations acquired. The Dutch tax authorities challenged the structures, resulting in several proceedings, which eventually reached the Supreme Court.
Supreme Court decisions
In the first case, the Supreme Court decided that there was an abuse of law based on the fraus legis concept, but such abuse was not found in the second case (although there was another issue, as discussed below).
If the fraus legis doctrine is applied, tax will be imposed by either disregarding a transaction or substituting the relevant transaction with another transaction. To be considered fraus legis, a legal act (e.g. a transaction) must be contrary to the aim and purpose of the tax law, and the prevailing purpose of the act must be to evade tax. The legal grounds provided in the court’s decision indicate that using the Bosal gap to evade the levying of corporate income tax, in and of itself, does not automatically lead to the conclusion that the transaction is abusive. However, abuse may exist if a deduction of interest contrary to the aim and purpose of the corporate income tax rules (as they are to be
interpreted following the Bosal decision) is taken with the definitive objective to evade tax.
The Supreme Court took exception to the fact that the interest deductions were to be offset against profits earned by the acquired companies before they became part of the group. For this reason, the court disallowed the interest deductions up to the amount of the “acquired profits.” Acquired profits for this purpose relate to profits that were earned according to the sound business practice principle, up to the time the economic risk relating to the shares in the acquired company was transferred to the acquiring company. The remaining interest payments were, in essence, deductible, since the court did not consider the deduction of these payments to be contrary to the corporate income tax rules applicable after the Bosal decision.
A separate issue existed regarding the deductibility of interest because the tax inspector had disallowed the interest deductions under article 10a of the Corporate Income Tax Act 1969. Under this statutory provision, briefly, interest is not deductible if a “tainted” legal act has been financed with a loan from a group entity. Since 2007, article 10a has applied to external acquisitions of participations, such as those at issue in these cases.
In the cases, the PE that had granted the loan to the taxpayer had raised debt capital from third parties. The relevant legislative history indicates that article 10a does not purport to restrict the deduction of interest on an internal loan from a group entity if an external loan indirectly was used to finance the internal loan, as long as the internal loan and the external loan show “parallelism” (i.e. identical characteristics). The Court of Appeal had concluded that this condition was fulfilled since the taxpayer had drawn up a statement to that effect, and the tax inspector had not properly contested the statement. The Supreme Court accepted the lower tax court’s finding and, thus, effectively
ruled that the required parallelism existed.
The Supreme Court also clarified the scope of the exception to the application of article 10a for interest on an internal borrowing that ultimately was financed by an external borrowing. In this context, it is relevant that article 10a provides for a “safe harbor” to allow a taxpayer to avoid the application of article 10a by providing evidence that either the “business motive test” is satisfied or that there is a compensatory levy. The business motive test implies that both the debt and the related legal act (in this case, the acquisition of the shares) are predominantly based on business motives. The Supreme Court’s decision clarifies that such an external loan, by definition (and, by extension, the related internal loan), complies with this test (i.e. that both the debt and the related legal act have a justifiable business motive). Therefore, article 10a is not applicable to internal borrowings that ultimately were financed by external borrowings.
The effect of the Supreme Court decision could be favorable to taxpayers because it may limit the application of article 10a.

Source: Deloitte