Bill limits participation exemption for currency hedges

The measure will have implications for cases where currency risks on foreign participations are hedged with loans or other hedging instruments. 

The current law offers taxpayers the possibility to apply the participation exemption to results from instruments that serve to hedge currency risks on a participation. This regime can be applied to various types of hedges, including:

• loans denominated in the currency of the participation;

• forward exchange contracts;

• currency options; and 

• combinations of such instruments.

This regime aims to prevent a situation where currency results on the participation itself fall outside the scope of taxation, while corresponding results on the hedging instrument would be taxed.

The direct cause for the legislative proposal is the judgement on the liquidation loss regime. The resulting budgetary shortfall needed to be covered. According to the legislator, the current regime for the tax treatment of hedging instruments goes beyond the neutral hedging of currency risks. As such, a solution was found in this regime.

This particularly concerns situations in which a participation is held in a currency that is expected to depreciate against the euro. In such cases, the interest rate on a loan in that currency is typically higher than on a comparable euro-denominated loan. That interest premium reflects not only credit and liquidity risks, but also the market expectation that the currency will decline in value. From an economic perspective, part of the higher interest therefore constitutes compensation for an expected future currency depreciation.

Under the current regime, this leads to a advantageous outcome tax-wise. The higher interest on the loan is deductible, while the full currency result on that same loan can, upon request, be brought under the participation exemption. On balance, this creates an asymmetry: the compensation for the expected currency loss reduces taxable profit, while the corresponding currency result remains outside the scope of taxation.

The legislative proposal restricts the scope of the participation exemption to so-called non-priced-in benefits.

This introduces a distinction between:

• currency results that are already embedded in the price of the hedging instrument (priced-in currency results); and

• currency results that arise from actual exchange rate movements not previously reflected in the market price (non-priced-in currency results).

The priced-in portion of the currency result will, according to the proposal, no longer qualify for application (upon request) of the participation exemption.

This is not achieved through a limitation on the deductibility of interest. Nor is there any intervention in the level of the interest itself. The correction takes place through a restriction of the participation exemption. As a result, a corresponding portion of the currency result on the hedging instrument becomes taxable after all.

The priced-in currency result is determined as the difference between the spot rate and the forward rate. The taxpayer is in principle free to determine which sources are used as the basis for calculating the forward rate.

It will also become possible to request that the participation exemption will no longer be applied to the hedging instrument from any given point in time. Following such a request, the full currency result falls within the taxable sphere from the moment the complete request is received or, if later, the date specified in the request.

The legislative proposal further provides that the hedging instrument is valued at fair market value upon transition from the taxable to the exempt sphere and vice versa. In addition, for clarification purposes, it is proposed that objection and appeal against the ruling may only relate to the requirement that the legal transaction serves to hedge the currency risk associated with the participation.

For enterprises affected by this, the proposal still raises a number of questions:

• what documentation is required to substantiate the non-priced-in portion; and

• to what extent (complex) derivatives in which currency components are incorporated into the price are also affected.

The legislative proposal provides for transitional rules for existing hedging instruments, addressing two situations:

1. The old law continues to apply insofar as a benefit is attributable to the period prior to the first financial year commencing on or after 1 January 2027. The condition is that a ruling has been issued or a complete request has been received before that financial year. The priced-in benefit for that period remains exempt, without revaluation to fair market value.
2. Deferred application applies to instruments entered into before 15 September 2026 that at that time already fell under the participation exemption or for which a complete request had been received before that date. For the benefit attributable to the period up to and including 31 December 2027, these instruments are fully settled under the old law.

Despite the uncertainty surrounding the calculation and distinction between priced-in and non-priced-in currency results, no policy decree or general administrative order will be issued to explain or approve calculation methods. The State Secretary considers that the Explanatory Memorandum and the examples included in it provide sufficient flexibility and guidance.

In the memorandum in response to the report on the 2027 Tax Plan, the government states that, in certain circumstances, the proposed measure combined with the application of an interest deduction limitation may result in double taxation. The government regards this primarily as a consequence of applying the interest deduction limitation rather than of the proposed amendment and will not introduce an additional measure to address it.

The legislative proposal achieves a more economic approach to currency hedges within the participation exemption. The current possibility of combining a deductible interest payment with a fully exempt currency result is restricted. Although the system of the participation exemption remains intact, in the future it will only apply (upon request) to currency results that are not already priced into the hedging instrument.