No Match Found
On 9 and 16 July 2021, the Dutch Supreme Court gave two important judgments with respect to the deduction of interest in acquisition structures. In both decisions, the Supreme Court tests the structures against the abuse of law legis. In short, the abuse of law legis doctrine holds that if there is an act contrary to the aim and purpose of the law, the intended tax benefits must be denied. In both cases, this would mean that the interest due on the financing of the acquisition is not tax deductible. It is remarkable that in the first case the Supreme Court ruled that there was no conflict with the aim and purpose of the law (i.e. no abuse of law), but in the second situation there was.
Does your enterprise use joint investment funds? In that case it is important that the Supreme Court ruled that the deduction of interest on acquisition loans may in certain situations be contrary to the aim and purpose of the 1969 Corporate Income Tax Act (CITA) as a whole. This means that, even if specific articles of the CITA limiting the interest deduction are not applicable, the interest deduction can still be refused on the basis of the abuse of law doctrine. In the second case, the taxpayer’s arguments in favor of arguing the business reasons of the chosen route (such as allowing third parties to invest on a joint account basis under the joint management of an investment fund) were not sufficient. Importantly, interest owed to unrelated parties may also be excluded from deduction. For portfolio companies, for example, this could mean that their interest rate position has to be reassessed.
The taxpayer in this proceeding concerns a fiscal unity for corporate income tax purposes that consists of several Dutch entities (BVs). The Dutch BVs are part of an international group with an American parent company. The Dutch companies are engaged in holding activities, consisting of acquiring and holding participating interests in various countries. In doing so, they make use (among other entities) of a French hybrid entity, a so-called SNC. After a few intermediate steps, the fiscal unity (the Dutch BVs) has obtained loans from a Luxembourg group company to finance these activities. The Luxembourg group company in turn financed these loans by placing a public bond loan, so that there is ultimately external financing via the Luxembourg company. The Dutch fiscal unity wants to deduct the interest it owes on the loans.
The tax authorities refused the deduction of these interest payments and put forward several arguments to that effect, the most important being that in this complex structure, the interest is not only deducted at the level of the Dutch fiscal unity, but also in France at the level of the SNC and even in the United States at the level of the American parent company. A 'triple dip': three times deduction for the same amount of interest. This is possible due to tax qualification differences based on the laws in the United States, the Netherlands and France.
This proceeding concerns a group of institutional investors who, through four French entities which are managed by a private equity firm, took over the Dutch X group in 2011. The institutional investors have provided capital to the French entities. The French entities have provided this capital partly as equity to the Dutch holding company (a cooperative) which has actually taken over the Dutch X group from a third party. The French entities have provided the remaining capital as a convertible bond to the Dutch holding company. The Dutch holding company wants to deduct the interest on the convertible bond from its taxable profit.
The four French entities participate in a ratio of 30, 30, 30 and 10 percent, so that this situation does not satisfy the legal conditions for the application of the interest deduction limitation. However, it is disputed whether the interest deduction can nevertheless be refused on the basis of the doctrine of abuse of law.
The cases underlying the judgments of 9 July and 16 July 2021 are similar in that they both relate to interest due on the financing of the acquisition of participations. In both cases, the taxable company is a Dutch holding company that has taken out loans in order to finance the purchase price for an acquisition of participating interests. In both cases, the loans were initially provided by parties who are also the shareholders of the taxpayers. However, there are also a number of important differences.
First, in the case of the judgment of 9 July 2021, the financing to which the interest payments relate, is eventually (albeit through a number of intermediaries) raised from external parties (namely by means of the public bonds placed by the Luxembourg group company) and not from the shareholder(s) of the Dutch holding company. In the case of the judgment of 16 July 2021, however, the situation is different. In this case, risk-bearing capital is first raised by the institutional investors in the four (French) funds, after which these funds lend that capital to the Dutch holding company (instead of transferring this risk-bearing capital as equity in the Dutch holding company).
A second important difference is that the interest in the case of the judgment of 9 July 2021 is not set off against the operating result of the company acquired, while in the case of the judgment of 16 July 2021 it effectively is.
Freedom of choice with respect to financing
The basic principle in both judgments is that taxpayers have the freedom of choice with regard to the manner of financing the acquisition of a participation and with regard to the structure of their group. The law does not determine which activities must be placed within a group. This freedom also applies if the financing method and structure of a group are dictated by the group's interest in paying as little tax as possible worldwide. The Supreme Court also states that the intention of the parties involved is irrelevant. However, this freedom is not unlimited, as appears from the second judgment (of 16 July 2021), but is limited if the method of structuring conflicts with the aim and purpose of the law (application of the abuse of law doctrine, see below).
Parallelism of final external financing
In the judgment of 9 July 2021, it was disputed whether the public bonds issued by the Luxembourg group company counted as external financing for the Dutch fiscal entity. External financing requires that these bonds are sufficiently parallel in terms of interest, term and conditions to the loan or on-lending between the Luxembourg group company and the Dutch fiscal unity. With regard to this parallelism, the Supreme Court considered the following:
In the mere replacement of one internal loan by another internal loan, the link with the external loan is not lost.
For the assessment of parallelism for Article 10a CITA, Dutch standards are taken into account. How other jurisdictions interpret these loans is irrelevant.
The fact that in this situation the bonds were denominated in US dollars and the (on-)lending took place in Euros did not mean that the terms of the loans were not sufficiently parallel.
In the judgment of 9 July 2021, the business test of Article 10a CITA was addressed as well. According to the text of the law as it currently applies, this is a double business motives test. This means that both the business nature of the transaction (for example, the acquisition of a participation or a capital contribution or a payment of dividend) and the business nature of its financing as well must be tested. In the taxable year concerned, the legal provisions were less clearly arranged. The Supreme Court ruled that in this specific case a simple business motives test was sufficient: the financing met business reasons because the debt was actually incurred with a third party. Please note: as of 2018, the legislator has amended Article 10a VpB CITA in such a way that a double business motives test must always be applied.
Furthermore, the Supreme Court ruled that it is immaterial for the business motives test whether the Dutch company was engaged for tax reasons. This judgment is also relevant to the next aspect of the two judgments, namely whether the doctrine of abuse of law can be applied.
The abuse of law doctrine – also known as the doctrine of evasion of the law or fraus legis – has been developed in case law. According to settled case law of the Supreme Court, the following two requirements must be met simultaneously in order to be able to apply fraus legis:
The decisive motive for entering into a (legal) act is the thwarting of taxation (the subjective or motive test);
The chosen method of tax avoidance is contrary to the aim and purpose of the law (the objective requirement or normative test).
In both the judgments of 9 July 2021 and 16 July 2021, the Supreme Court tested the deductibility of the interest against the criteria of the abuse of law doctrine.
In its judgment of 9 July 2021, the Supreme Court ruled that the doctrine of abuse of law does not preclude the interest deduction in this case. The Supreme Court reasoned that (1) the interest costs are not set off against artificially created benefits (such as purchased profits), and (2) the so-called Bosal gap (i.e. asymmetry in the treatment of income and the related charges in the event of an EU participation) fell within the system of the law at the time of this case, so that there is no question of acting contrary to the law.
In its judgment of 16 July 2021, however, the Supreme Court confirmed the decision of the Amsterdam Court of Appeal that the interest deduction can be refused on the basis of the abuse of law doctrine. In so many words, the Court of Appeal ruled that the assets of the funds had been diverted without business reasons. Furthermore, in the words of the Court of Appeal, there was also an internal transfer because the acquisition of the Dutch X group was initially agreed upon by another group entity, after which that group entity transferred the rights from the sale agreement to the taxpayer, who eventually realised the acquisition.
According to the wording of the decision of the Court of Appeal, the impression could arise that in fact the interest deduction limitation of Article 10a CITA was applied, with a correction on the basis of the abuse of law doctrine. However, in its judgment of 16 July 2021, the Supreme Court clarified this point. The Supreme Court ruled that not the application of the abuse of law doctrine with regard to Article 10a CITA in particular was concerned, but acting contrary to the aim and purpose of the CITA as a whole. This ruling is important, because it means that the interest relating to the part of the convertible bond loans that was not used for contaminated activities such as those referred to in Article 10a CITA as well as the interest owed to unrelated parties is non-deductible as well.
In both proceedings it was discussed whether refusing the interest deduction would be contrary to the freedom of establishment or the free movement of capital on the basis of the Treaty on the Functioning of the European Union (TFEU).
In its first judgment (9 July 2021), the Supreme Court does not address this question. After all, the outcome of the proceedings is that the interest is deductible, so that there is no obstacle to the freedom of establishment or the free movement of capital. It is striking that the Supreme Court pays no attention to other aspects of EU law. The Court of Justice of the European Union in Luxembourg (CJEU) has ruled that under EU law, Member States have an obligation to combat abuse. The question then arises whether, although Dutch national law allows the interest to be deducted in this situation, there is not an obligation on the basis of EU law for the Netherlands to refuse the deduction.
In its second judgment (16 July 2021), the Supreme Court discussed the application of EU law in more detail. The outcome of this judgment is that the interest deduction can be refused as a result of the application of the abuse of law doctrine. The Supreme Court considers in this regard that this application does not constitute an unjustified infringement of the EU free movement of capital or the EU freedom of establishment.
According to the Supreme Court, taxpayers cannot rely on EU law in abusive situations. This judgment also raises a question as well. The CJEU has determined in recent case law that when related parties act under arm's length conditions, it can in principle be assumed that there is no abuse of law. One might have expected that the Supreme Court had still assessed whether the conditions under which the loans provided by the four (French) funds (in terms of interest, term, repayment terms, securities and the like) were at arm's length.
In its judgment of 16 July 2021, the Supreme Court also made an important statement about the moment at which costs related to a promised acquisition bonus are deductible. A separate Tax News item will be published shortly about this. Keep an eye on our website!