2022 Tax plan: Preventing mismatches when applying arm's length principle

22/09/21

This article is up to date up to and including the implementation on 1 January 2022.

On 1 January 2022, the previously announced Bill preventing mismatches when applying the arm’s length principle was implemented. The at arm’s length principle must ensure that taxable profits are, in fact, at arm's length. The purpose of the bill is to eliminate mismatches in taxation that arise due to the application of the at arm's length principle, in the case of informal capital structures and in the case of deemed profit distributions. Because not every country applies the arm's length principle (in the same way), this can lead to part of the profits of a multinational company remaining untaxed. In 2021, a public online consultation was held in which companies, advisors and other interested parties could react to the government's plans.

On 11 November 2021, the Lower House of Parliament passed this bill, as well as an amendment that brings non-facilitated cross-border mergers and demergers under the bill. 'Non-facilitated' means that these transactions are not (or cannot be) covered by a facility and corporate tax is levied on transferred capital gains.

What does this mean for your organisation?

The new legislation may lead to a higher taxable profit in the Netherlands in situations where before, on the basis of the arm's length principle, certain costs were taken into account in the Netherlands, for which there was no corresponding income recognised within the group. As a result of the measure, the expense will not (or not fully) be taken into account if a corresponding amount is not taxed (or is taxed at a lower amount) as income at the level of the affiliated company. This will particularly occur if the affiliated party is established in another country. In this way, the measure aims to counteract tax planning that takes place through so-called informal capital structures.

Situation before the new legislation

Tax law is based on the principle that affiliated entities must trade with each other on a commercial basis. This means that affiliated entities are expected to operate among themselves for tax purposes as independent entities would do under comparable circumstances. This principle is known as the arm's length principle.

In practice, however, it often occurs that entities do not trade with each other on a market-conform basis. Based on the profit determination rules, the profit in such cases is corrected by adjusting the fees that the entities charge to each other for tax purposes in a manner that is market-conform. This goes both ways: if a fee is too low, it is adjusted upwards. But also vice versa: if a fee is too high, it is reduced to a market-conform lower amount. This may concern, for example, interest, rental or lease installments, but also the price that is charged when assets are transferred (business assets, intellectual property, etc.).

If a Dutch entity pays no or too little remuneration to an (often foreign) affiliated entity, then the Dutch entity could apply a remuneration at an amount that would be at arm's length (i.e. if the entities were not affiliated with each other). This could then lead to an (additional) deduction when determining the taxable profit in the Netherlands: a downward adjustment of the profit. Because the amount is not actually paid, a corresponding counterentry needs to be reflected in the bookkeeping of the paying entity. For tax purposes such a counterentry takes the form of an informal capital or deemed dividend. This downward adjustment is now, under circumstances, limited.

Content of the new legislation

Elimination of double non-taxation through transfer pricing differences

The new legislation aims to eliminate double non-taxation due to differences between countries (mismatches or transfer pricing differences) in the application of the arm's-length principle. To this end, five provisions were added to the Dutch Corporate Income Tax Act 1969: articles 8ba, 8bb, 8bc, 8bd and article 35. The measures are intended to ensure that transfer pricing differences are neutralised, thereby contributing to profit being taxed at least once. As such, the legislator aims at being more in line with international practice. The legislator considers the infringement on the so-called ‘total profit concept’ necessary to realise the objective of the proposed legislation. Already since 1 July 2019, the Dutch tax authorities have no longer provided certainty in advance in the form of a ruling in situations of double non-taxation due to transfer pricing differences.

Limitation of downward adjustment of taxable profits

The measure limits a downward adjustment of the taxable profit in the Netherlands for taxpayers who do not make a plausible case that the other entity involved in the related transaction does not have a corresponding upward adjustment, or that the corresponding upward adjustment of the profit tax base is too low. In short, this means that in informal capital structures, the Netherlands does not allow deductions when the foreign country does not tax the corresponding income. For example, think of the deduction of accrued interest in case of an interest free loan which, according to the jurisprudence of the Supreme Court, must be regarded as informal capital. The limitation in the downward adjustment takes place by using (/continuing to use) the conditions that were actually agreed upon between the taxpayer and the entity affiliated with this taxpayer, including the price, for the determination of the tax base, instead of the at arm’s length conditions. Capital contributions and profit distributions in kind have also been brought within the scope of the bill.

In order to avoid double taxation, the Netherlands will still allow a downward adjustment if the other entity involved in the related transaction has an corresponding upward adjustment in the profit tax base in an earlier or later year. In the situation where the taxpayer has entered into the transaction with a related hybrid entity, the downward adjustment may also be taken into account under certain conditions. This under the condition that the taxpayer makes it plausible that a corresponding upward adjustment is included in the tax base of the participants in that hybrid entity.

Transfer of assets

The new legislation also addresses transfer price differences in the transfer of assets, including debts, between associated entities. This can occur when an asset is transferred from a transferring foreign entity to an acquiring Dutch entity, whereby the transferring entity takes into account a low(er) transfer price, while the acquiring Dutch entity activates the asset for tax purposes in the Netherlands at a high(er) arm's length price and depreciates on it. Under the new legislation, in such cases it is no longer allowed to write off the arm's length price for tax purposes in the same way as explained above. The taxpayer then is only able to depreciate over the lower price actually agreed upon. Capitalisation at the higher than agreed arm's length price is no longer allowed for tax purposes. This again unless the taxpayer makes it plausible that a corresponding upward adjustment has been included in the profit tax base of the transferring entity abroad.

Effect on other corporate tax provisions

In the explanatory memorandum, the legislator clarifies that in situations where the measure is applied, a previously untaxed or exempt capital transfer is converted into a taxed capital transfer. An informal capital contribution becomes profit and a hidden profit distribution becomes non-exempt profit. The legislator explains how this affects the application of various other corporate tax provisions, such as the participation exemption, the liquidation loss scheme and the limitations on interest deduction. There is no provision for a scheme that addresses the concurrence with the CFC measure or the conditional withholding tax on interest and royalties pursuant to the Withholding Tax Act 2021. The legislator recognises that this may give rise to double taxation and considers this appropriate in light of the prohibitive and discouraging nature of these measures.

Consequences for existing informal capital structures

The legislation entered into force on 1 January 2022. The amendments that this legislation brings are immediately applicable to the so-called informal capital structures in the cost sphere. An example of this is the imputation of interest costs in the case of an interest-free loan.

The legislation also affects existing informal capital structures in the sphere of transferred assets. A depreciation limitation is introduced for informal capital situations in which a taxpayer has acquired a business asset from an affiliated entity in financial years starting on or after 1 July 2019 and before 1 January 2022 and which can still be depreciated in a financial year starting on or after 1 January 2022. In such cases, with effect from the financial years commencing on or after 1 January 2022, depreciation may no longer, in principle, be applied for tax purposes on the basis of the transfer price as determined in accordance with the arm's-length principle. From then on, depreciation must be based on an adjusted lower value. The measure addresses depreciation and not book value. Acquisitions of assets in financial years commencing before 1 July 2019 are outside the scope of the bill. The date referred to has been adjusted in relation to the consultation proposal and has been chosen to be in line with the effective date of the new ruling practice, which no longer provides certainty in advance for structures aimed at achieving double non-taxation through transfer pricing differences, which is also the focus of the present bill.

EU aspects

The legislator considers the new legislation compatible with the EU treaty freedoms. For the application of these freedoms, the legislator considers the following not comparable: (i) the situation in which the downward adjustment of the taxpayer is limited because of the lack of a corresponding upward adjustment abroad and (ii) the situation in which the downward adjustment of the taxpayer is not limited because there is a corresponding upward adjustment at home or abroad. According to the legislator, these are not equal cases in the light of the objective of the legislation (the avoidance of double non-taxation). Therefore, according to the legislator, this is not in conflict with the freedom of movement. The different treatment would thus be permissible under EU law. The legislator refers to the judgment of the Court of Justice in the Schempp case (C-403/03) for substantiation.

In the responses to the internet consultation, various interested parties indicated that the measure may conflict with the EU treaty freedoms. The limitation of the downward adjustment in the bill would de facto only have an effect in cross-border situations and on this basis impede the right to free movement. This obstacle would only be permissible under Union law if it could be justified by overriding reasons of general interest, such as the balanced allocation of taxing powers or the fight against abuse and tax evasion. An appeal to the division of taxing rights would not be possible, because the Netherlands would not be competent in respect of the tax base which it wishes to include in the levy on the basis of the legislative proposal. An appeal to combat abuse would not be possible, because this is only open to purely artificial constructions whereby taxpayers would also have to be given the opportunity to provide counter evidence. However, in view of the arguments mentioned above, the legislator is of the opinion that these arguments do not apply here.

Background of the rule

In a nutshell, a situation can arise that the Netherlands applies the arm's length principle and the other country does not, or not in the same way. In international situations, such a mismatch can lead to part of the profits of a group not being taxed. Although these situations are known and are in line with laws and regulations, their effect is no longer desirable.

On 15 April 2020, the Advisory Committee on the Taxation of Multinationals ("Committee ter Haar") published the report ‘Op weg naar balans in de vennootschapsbelasting’ (in English: "Towards a balance in corporate tax"). The report recommends a number of basic variants and a number of additional measures. In one of the basic variants, the Committee recommended not to apply the arm’s length principle if this principle leads to a reduction in the taxable profit in the Netherlands, insofar as the other country involved in the transaction does not include it in its base (informal capital).

On Budget Day 2020, the Dutch Government announced it would adopt Committee ter Haar’s idea and publish a legislative proposal. This has now happened with the publication of the proposed legislation on 21 September 2021, and its subsequent implementation on 1 January 2022.