Skattenytt nr 7-8 2009 s. 463
Interest Deduction Restrictions: What Can we Learn from the Dutch?
Regeringens proposition 2008/09:65 Sänkt bolagsskatt och vissa andra skatteåtgärder för företag.
The Dutch rules on interest deduction restrictions served as the model for the new Swedish legislation on the same subject, which became effected on the 1st of January 2009.1The Dutch rules have been the subject of considerable debate and have been undergoing changes for more than a decade. Although there are differences between the two sets of rules relating to a number of important issues, mainly affecting their scope of application, there are also important similarities, so that interpretative material relating to the Dutch rules can be of great assistance in understanding how the Swedish rules will work in practice.
To enable better understanding of the Dutch rules, this article first provides a brief overview of the relevant provision in Dutch law, followed by a discussion highlighting the most important similarities and differences between the Dutch and the Swedish rules. Finally, the various components of the Dutch legislation are discussed in light of the relevant case law and pronouncements of the Dutch government. Insofar as this is possible, direct references to the Swedish legislation are provided (immediately below the pertinent heading) to indicate similarities between the Dutch and Swedish wording of the legislation concerned (although it should be emphasized that the wording of the Swedish rules does not necessarily represent a literal translation of the wording of the Dutch rules). Clarifying how the Dutch legislation operates in practice is potentially of great interest to Swedish readers, since considerable uncertainty still surrounds the application of the Swedish rules, which can adversely affect a company's confidence regarding this area of the law. It should be noted, however, that this article is not intended to discuss the Dutch legislation in detail or to provide an in-depth comparison of both sets of rules.
1 Dutch Legislation – ”Interest Is (Not) Deductible Unless ...”
According to the terminology used in the Dutch tax legislation, "interest is deductible for tax purposes unless (...)”. Tax advisors, however, often comment ironically that the wording should really be "interest is not deductible unless (...)”, because of the various limitations that the law places on the deductibility of interest.
Over the years, the limits on the deduction of interest in the Netherlands have been the subject of almost continuous concern and have undergone numerous changes. The Dutch Parliament has introduced a variety of regulations designed to prevent excessive erosion of the tax base and the Supreme Court has issued various decisions on this issue.
The legislative limitations can be classified as falling into several different categories. Of these, a large category is comprised of limitations designed to counter (perceived) abusive structures. Limitations in other categories address general transfer pricing issues and the effective recapture and deferral of interest deductions. Dutch tax law also contains thin capitalization provisions.
The restrictions on the deduction of interest are set out in the Corporate Income Tax Act (CITA), and are also partly based on and supported by case law. The rule, which was introduced in 1997 and which is found in CITA, article 10a, is based in part on pre-1997 anti-tax avoidance case law. The purpose of article 10a is to limit interest deductions on borrowings relating to outstanding dividend distributions, equity contributions, equity redemptions and both internal and external acquisitions of, for example, shares, financed by group companies.
The limits on the deductibility of interest do not apply, however, in the following cases:
If the taxpayer is able to demonstrate that there are business objectives for both the loan and the related transaction; or
The taxpayer can demonstrate that the creditor is subject to a reasonable effective tax rate (as recalculated in accordance with Dutch tax rules). Since 2007, a rate of at least 10 % has been established in legislation as an accepted minimum rate. To qualify for this second exception (known as the "counterbalancing taxation” exception), the recipient must not be entitled to carry forward losses for the year preceding the year in which the relevant loan is granted nor must the loan have been granted to take advantage of losses that will be incurred in the near future, which would have the result that the interest would not actually be taxed at a reasonable rate.
In 2008, Dutch taxpayers became subject to more severe restrictions, when a supplementary condition became law. This condition was introduced to counter structures that were primarily designed to avoid tax by using a country with an effective tax rate higher than 10 % but still much lower than the Dutch effective rate. The Dutch legislator was concerned that the Netherlands would experience a significant loss of revenue if the use of these structures was allowed to continue, with Ireland and Cyprus specifically identified as jurisdictions giving cause for concern.
The supplementary condition prescribes that the second exception (i.e. the counterbalancing taxation exception) will not be applicable, even if the effective tax rate is more than 10 %, if the tax inspector can show that:
The loan was obtained with the intention of offsetting losses or claims that arise in the year in which the loan was taken out or that will arise within a short period of time thereafter; or
There is no business purpose for the loan or the related transaction.
In short, it should be stressed that, with effect from 2008, the only relevance of the existence of counterbalancing taxation is as regards the determination of who has the burden of proof in showing whether there is a business purpose for both the loan and the related transaction. If counterbalancing taxation exists, the tax inspector must show that there is no business purpose to be able successfully to challenge the interest deduction. In the reverse situation, i.e. where there is no counterbalancing taxation, it is up to the company to demonstrate the existence of a business purpose. The way in which CITA article 10a is applied has, thus, actually changed: the first step has to be the establishment of whether counterbalancing taxation exists; only after this step has been completed does the existence of a business purpose have to be established.
2 Similarities and Differences Between the Two Regimes
The Dutch and Swedish rules have the following in common:
Intra-group financing relating to internal reorganizations falls within the scope of the rules;
An exemption from the application of the rules is available if there is a significant business purpose for both the financing and the related acquisition; and
An exemption from the application of the rules is available if the recipient of the interest is taxed at a rate of at least 10 %, although this is no longer a real exemption in the case of the Netherlands, because the interest deduction will still be denied if the tax inspector can demonstrate the absence of a business purpose.
The most important differences between the two sets of rules are as follows:
The above table indicates that the Dutch rules are both more rigorous and broader in their impact than the Swedish rules. For example, if the company receiving the interest has loss carry forwards and is normally taxed at the regular corporate income tax rate, the Dutch legislation will apply to a purely domestic group of companies with no international dimension. Nor is the imposition of an acceptable effective tax rate a genuine safe harbor from the application of the Dutch rules, since the tax inspector may still challenge the deduction on the grounds of the absence of a business purpose. Additionally, there are still schemes that are outside the scope of CITA article 10a that are being challenged before the Dutch courts on the grounds that they offend common anti-avoidance principles (fraus legis). One is compelled to wonder to what extent the Swedish regulations will be the subject of future amendments in the face of avoidance schemes and disappointing tax revenues.
Although beyond the scope of this article, it is worth mentioning that a Dutch company can (anonymously) request a binding advance tax ruling from the tax authorities to secure its tax position. Such a ruling, which takes only a few weeks to obtain, is "final” for the tax authorities, i.e. the tax authorities are not able to appeal a ruling (somewhat redundantly, since the ruling represents the tax authorities' own opinion). Although the taxpayer is also not able to appeal the ruling, the taxpayer has the option of proceeding with the transaction concerned or aborting it if the ruling is not to its satisfaction. In short, in the Netherlands, a taxpayer is able to achieve certainty as to the opinion of the tax authorities in relation to any particular transaction. No such certainty is available in Sweden.
Although, of course it is also possible to request a ruling in Sweden – both the tax authorities and the taxpayer can have a case heard before the Swedish Board for Advance Tax Rulings (Skatterättsnämnden) – in Sweden, the process is considerably more time consuming and the outcome much less certain for the taxpayer. Both the taxpayer and the tax authorities can file an appeal against a ruling with the Supreme Court (Regeringsrätten) and, indeed, the ruling itself can take a long time to obtain. If one takes into account the additional time needed for an appeal to be considered by the Supreme Court, taxpayers will obviously not be able to delay their transactions until they are able to achieve certainty as to their tax treatment, so that the ability to obtain rulings is of little practical use.
3 Dutch Section 10a in Practice
3.1 Connection Between the Loan and the Transaction(24 kap. 10b § IL: (...) till den del skulden avser en förvärv” (...))
To determine whether there is a connection between the loan and the "transaction” that the loan is used to finance, it is important to look at the actual facts. The word "transaction” is used here in a broad sense and includes dividend distributions, equity contributions, equity redemptions and both internal and external acquisitions of shares financed by group companies.
The length of time between the issuing of the loan and the transaction is, in itself, of no great importance in determining a connection between the two, although it could provide an indication of whether there is such a connection. What is decisive, however, is the intention with which the loan was contracted. In other words, did the company at the time of contracting the loan, have the intention to execute the transaction? Most of the relevant case law revolves around this issue.
Since 2007, the Dutch legislation has provided that a connection can also exist if the loan is issued after the transaction has taken place.
3.2 Point in Time at Which the Connection Is Assessed
The connection must be assessed on an annual basis. According to the preparatory work relating to the CITA article 10a legislation, the rules are intended to be applied "dynamically”. As creditor or structure changes can influence the classification of the loan, whether the interest is deductible needs to be tested annually.
3.3 Loans Contracted from Third Parties and Connection to Original Loan(24 kap. 10c § IL: (...) såvida skulden kan anses ha samband med denna fordran (...))
According to the CITA article 10a preparatory work, examples of loans that are formally issued by third parties, but in fact qualify as intra-group financing, and that fall within the scope of article 10a are back-to-back loans and external loans issued under a group company guarantee or bond.
All the relevant facts must be taken into account in determining whether a back-to-back situation exists. Examples of the kinds of facts concerned are: the interest rate, the duration of the loan, the amortization scheme and the loan amount in relation to the intrinsic value of the acquired shares and possible guarantees. Regarding guarantees, the extent to which external loans issued under the guarantee of a group company will fall within the scope of CITA article 10a is often open to question. According to the article 10a preparatory work, this will not be the case if the company that contracted the loan could have obtained a more or less similar loan without the guarantee. The only reason for the guarantee in that case would then be to acquire better loan conditions, such as a lower interest rate.
3.4 Exemption: Sound Business Reasons(24 kap. 10d § & 24 kap. 10e § IL: Såväl förvärvet som den skuld som ligger till grund för ränteutgifterna är huvudsakligen affärsmässigt motiverade)
3.4.1 Double Objective Test
The "double objective test” exemption requires business objectives, other than tax objectives, to be necessary for both the transaction and the way of financing the transaction. In other words, the test recognizes that it is possible for an acquisition to be made to achieve business objectives, while the intra-group financing of the acquisition is based purely on tax objectives2 – in this case the double objective test would not be passed.
The Dutch court has ruled that the intention of reducing taxes does not qualify as a sound business reason.
3.4.2 Business Objectives for Financing
The Dutch Minister of Finance has provided the following example of a financing structure for which there are no business objectives. An international concern acquires a new participation (BV A) via a Dutch second tier holding company (BV X), which company itself has sufficient means to finance the acquisition. However, BV X decides to distribute its free reserves as a dividend to its foreign parent company (Z SA), which in its turn contributes the same amount as equity to its foreign tax haven participation (Ltd Y). Ltd Y consequently issues a loan to BV X, which BV X uses to acquire its new participation.
It is interesting to note that this example was further discussed in Parliament, where the question arose as to whether business objectives would have been present if no capital from the Dutch part of the group had been used for the loan. The Minister of Finance answered this question in the affirmative – if the equity had not been contributed to Ltd Y with the intention of financing the acquisition, business objectives would, indeed, have been present.
Regarding this method of financing, the presence of business objectives will largely depend on the extent to which a company has free available equity and why, if this equity is sufficient, the company did not use it to finance its participation.
The use of available equity in a group (financing) company situated in a tax haven for issuing loans for an acquisition, whether internal or external, by a group company can have a business objective, if the acquiring company does not itself have sufficient funds to finance the acquisition. The only issue that then remains to be addressed is whether the acquisition itself has a business objective.
It is important to realize that there is a difference between the "business-like” character of the terms of the loan, such as the interest rate and the amortization scheme, and the business motives for contracting the loan. The terms of the loan are relevant for determining whether the loan itself should be qualified as a loan or as capital. In the latter instance, the interest on the loan would not be deductible based on legislation other than CITA article 10a. Only after it has been determined that the provision of the funds is indeed to be regarded as a loan, might article 10a be applicable.
3.4.3 Business Objectives for Transaction
Possible business objectives for the transaction itself are not widely discussed in Dutch literature, the preparatory work or case law, at least not in the context of CITA article 10a. However, there are specific policy guidelines in relation to the succession of smaller and medium-sized privately owned businesses, unsurprisingly given the fact that even the simplest Dutch local structure can fall foul of article 10a.
The term "business objectives” appears quite frequently in the CITA, in most cases to describe certain conditions that are prescribed to help prevent tax avoidance involving the use of special tax facilities, for example, in connection with mergers and divisions. The following business objectives have been identified, although the facts of the actual case will always have to be taken into account:
A restructuring following an acquisition of an external group of companies;
A restructuring prior to an upcoming external partial sale of a group of companies; and
A rationalization of a business (meaning changes in the financial and organizational structure of an enterprise with a view to restoring a sound basis for future operations).
There is little available case law on CITA article 10a, mainly because of the relatively great downside risk – i.e. the tax disadvantage deriving from the non-deductibility of interest coupled with penalties and interest on overdue and underpaid tax. For this reason, the application of 10a is the frequent subject of advance tax ruling requests.
3.4.4 Existence of Business Objectives Based on Financing Being Ultimately External
The possibility of arguing for the existence of a business objective based on the financing being external is of great importance in practice. Intra-group financing and the related transaction will meet the business objective criterion if the loan is ultimately financed outside the group and there is consonance between the intra-group loan and the external loan. Whether there is indeed such consonance can be demonstrated by reference to the duration of the loans and the amortization schemes. Differences in interest reimbursement can be justified if they are based on business considerations.
3.4.5 Taxation by a Third Country
Taxation of the interest income can in certain situations take place in a country other than the country of residence of the interest receiving company, for example, where there is taxation under controlled foreign company (CFC) legislation and in situations in which the receiving company is in fact not the ultimate beneficiary of the interest income.
With regard to CFC legislation, it is relatively easy to show that the interest is taxed at the level of the parent company of the receiving company by means of the yearly tax assessment. If the effective tax rate on the interest is at least 10 %, taking into account any carryforward of losses, the exemption from the application of article 10a will apply (see 1., above.)
To determine the ultimate beneficiary of the interest income can be difficult. The State Secretary of Finance has stated, however, that where the recipient of the interest "cannot be forced”, meaning "does not have the obligation”, to transfer the income directly to the ultimate beneficiary, the connection will not be sufficient to allow the ultimate beneficiary to be taken into account.
3.5 Exemption: Reasonable Counter-Balancing Taxation (10 % or More) (24 kap. 10d §: Inkomsten som motsvarar ränteutgiften skulle ha beskattats med minst 10 procent (...))
On 1 January 2007, after 10 years during which the legislator had refrained from specifying a minimum percentage, what constitutes "reasonable counter-balancing taxation” for Dutch tax purposes was incorporated into the legislation, the acceptable rate being 10 % or more.
3.5.1 Influence of Special Facilities/Regimes
The preparatory work for the significant amendments to the CITA that took effect from 2007 addressed the question of how the Belgian notional interest deduction was to be dealt with in the context of determining the existence of reasonable counterbalancing taxation for Dutch tax purposes. The Belgian notional interest deduction provides a fictitious interest deduction for Belgian and foreign companies with a Belgian establishment, calculated on the basis of their risk capital.
The preparatory work refers to the following example.
A Dutch parent company (BV X) contributes 500 in the form of equity to its Belgian subsidiary (BV Y). BV Y, in turn, grants a loan of 500 out of its own equity (which amounts to 1000) to BV X, at an interest rate of 5 %. The profit of BV Y for Belgian tax purposes amounts to 100, calculated as 25 interest receivables + 75 profit from operating activities. The notional interest deduction is calculated as 3.7 % of BV Y's equity (1000) = 37. The taxable profit for Belgian tax purposes is therefore 63 (100–37). At a tax rate of 34 %, the Belgian corporate income tax due is 21.42. However, the taxable profit calculated in accordance with Dutch principles is 100, resulting in a drop in the effective tax rate from 34 % to 21.42 %.
The legislator stated in this case that the effective tax burden on the interest itself is crucial in determining whether the Belgian taxation is reasonable for purposes of the Dutch rules. The notional interest deduction must therefore be allocated between the components of the taxable profit in proper proportion. This allocation should not be made in proportion to the amount of each profit component, but in proportion to the degree to which these components are financed. If the loan is fully financed with equity, which could be the case in the above example, half of the equity of the subsidiary and thus half of the notional interest deduction should be allocated to the loan. The effective tax burden would then be 8.84 %, in which case there would not be reasonable counterbalancing taxation.
3.6 Dutch Restrictions in Relation to EC Law
In 2006, the Dutch State Secretary of Finance stated that he was unable rule out the possibility that CITA article 10a might not be "completely EU-proof” and noted that it would be for the courts to determine whether the article was in violation of EC law.
In a number of cases before the Dutch Supreme Court, the Advocate General decided that prejudicial questions should be referred to the European Court of Justice (ECJ) to determine whether there was a breach of the free movement of capital. The Supreme Court, however, did not follow the Advocate General's reasoning and held that an interest flow designed purely for tax avoidance purposes does not fall within the protection afforded by the free movement of capital principle and thus EC law has no relevance in this context. The second argument, which was also rejected by the Supreme Court, concerned the low taxation levied on the interest income by the Netherlands Antilles. Based on the proportionality principle, the tax levied should have been deducted from the Dutch tax adjustment of the interest deduction. The Supreme Court decided that, as a consequence of the taxation in the Antilles at the parent level, no violation of the proportionality principle had occurred. At the very most, there had only been a distortion, for which the principle provides no remedy.3
P.G.H. Albert and T. Koelman have questioned the Supreme Court's decision in another case that concerns the Netherlands Antilles (Hoge Raad 23 January 2004, BNB 2004/142), arguing that the Court should have referred prejudicial questions to the ECJ with regard to the proportionality principle.
3.7 Anti-Avoidance Regulation Still Applicable?
There has been considerable discussion as to whether the tax authorities can still successfully argue that general anti-avoidance principles are applicable if the interest deduction is not limited under CITA article 10a. The general opinion is that in a case that falls within the scope of neither article 10a nor any other specific provision restricting the deductibility of interest, the tax authorities can still seek, though not necessarily successfully to apply general anti-avoidance principles.
A considerable uncertainty surrounds the application of the Swedish rules concerning interest deduction restrictions on group interest, which can adversely affect a company's confidence regarding this area of the law. When comparing the Swedish rules with the Dutch legislation both similarities and differences can be found, mostly affecting the impact of the legislation.
Elucidating how the Dutch legislation operates in practice and clarifying considerations from the Dutch legislator can be of great interest for future application and development of the Swedish legislation. The Dutch rules have been the subject of considerable debate and have been undergoing changes for more than a decade and it would not surprise me if the Swedish rules await the same fate. If and to what extend the Dutch interpretation will be followed in Sweden will among others depend on similarities in the wording of the legislation and future case law and amendments. It is for certain that when a considerable uncertainty is present around the application of new rules, all possible sources should be evaluated to estimate the consequences of the rules on the facts at hand.4
Anne-Marie Sänger is a Dutch tax lawyer working for Deloitte's International tax team in Stockholm.
An amendment revising the current interest deduction restriction legislation in the Netherlands is expected to be discussed in the Dutch House of Commons before the 1st of July 2009. Unconfirmed rumours indicate that the amendment contains a total defiscalisation of group interest.