Acquisition financing businesslike if from outside group
20/07/22
This article is based on the information as known on 15 July 2022
Interest on the financing of an acquisition is in principle deductible for corporate income tax purposes only if this financing is business-like. Financing can be considered not to be business-like if it has been artificially diverted so that an interest flow is created, while without such a diversion there would have been equity financing and therefore no interest flow. The Dutch Supreme Court rules that such artificial diversion is only assumed if it takes place within the group of so-called 'affiliated entities'. The Court does not apply a separate group concept, but adheres to the legal affiliation criterion as defined in Dutch corporate income tax law.
What does this mean for your organisation?
Provided that the financing is based on business motives, you are free to decide whether to take out a loan or use equity to finance your activities. The Dutch Supreme Court confirms in its judgments that the starting point is that companies are free to choose whether to finance their participations with loan capital or equity capital. The legal provision at issue here, which can limit the interest deduction (and as such restricts this freedom of choice) must therefore be interpreted restrictively.
Background
On 15 July 2022, the Supreme Court rendered two judgments on the deductibility of interest on financing in acquisition structures. One of the issues at stake was whether there is an artificial diversion, as a result of which the interest is not deductible under article 10a of the Corporation Income Tax Act). In this context, the Court made interesting statements on how the statutory concept of 'affiliation' relates to the concepts of 'concern' or 'group', and to a collaborating group'.
The case
Both judgments concern acquisition structures in which investment funds make an acquisition. The first judgement concerns a Dutch retail chain acquired by funds in which Dutch and foreign pension funds participate. The acquisition was structured with the assistance of a Luxembourg parent company in which these funds participate. The Luxembourg parent company then provided loans (loan capital) to a Dutch company which bought (via a (retail) subsidiary which was included in the fiscal unity with it) the shares in the Dutch retail chain. Subsequently, the retail chain, in its turn, was included in the fiscal unity with the Dutch company. The second judgement concerns a similar structure, whereby the Court referred to the first judgement for its considerations.
The question in both proceedings is whether the interest paid by the Dutch company on the loan with which it financed the acquisition can be deducted from its taxable profits. Due to of the operation of the fiscal unity, this interest deduction could be set off against the profit of the acquired company, in the first judgement: the retail chain.
Legal Framework
The Dutch Corporate Income Tax Act 1969 defines a number of transactions for which the basic principle is that if these transactions are financed by loans, the interest on these loans is non-deductible if that interest is owed to an entity affiliated with the taxpayer (article 10a Corporate Income Tax Act 1969). The main purpose of this statutory provision is to prevent the creation of artificial interest deduction (base erosion). However, the interest is deductible if either: there is sufficient taxation at the recipient of the interest (after all, there is no major tax benefit, which implicitly assumes that there is no base erosion); or if the transaction and the financing are at arm's length / (ruled by business motives). The burden of proof for this lies with the taxpayer.
Dispute
In both proceedings, the taxpayer argued that the transaction (the acquisition) and the financing were at arm's length. Because it concerns an external acquisition, the businesslike nature of the transaction is not in dispute. The crux of these proceedings is whether the financing has been arranged in a businesslike manner.
In the present proceedings, the funding was ultimately raised from the funds that had equity deposited by their investors (in particular pension funds). None of the entities behind those funds had an interest of one third or more in the Dutch company which acquired the shares in the retail chain. Therefore, on the basis of the statutory scheme, those funds are not considered to be ‘affiliated entities’ of the Dutch taxpayer. However, the funds were first granted to the Luxembourg parent company which then on-lent them to the Netherlands company. The Luxembourg parent company is indeed to be considered an affiliated entity, so, according to the Court, the situation fell within the scope of the statutory provision.
The Dutch tax authorities took the position that because the funds themselves had equity, they could also have provided the funds for the acquisition in the form of equity to the Dutch company. In that case there would be no interest. Providing the funds in the form of a loan (debt capital) through the Luxembourg parent company would be a diversion. The tax authorities (and in the Supreme Court, the State Secretary) then considered that the financing was not based businesslike.
The Dutch Supreme Court: freedom of choice in financing
The Court took as a starting point that the taxpayer is, in principle, free to choose the method of financing a company in which it participates. To the extent that article 10a of the Dutch Corporate Income Tax Act infringes such a freedom of choice, this provision must be interpreted restrictively.
The Supreme Court then stated that a debt is predominantly based on business motives if the funds used for the external acquisition have not been diverted. According to the examples given in the legislative history, there is only a diversion if the related entity which granted the loan (i.e. the Luxembourg parent company) obtained the funds used for this loan from another entity in the same group as the taxpayer. The next question was whether there was a group in this case.
Group or concern?
Since none of the entities that make up the funds owned more than one third in the Luxembourg parent company (the shareholder of the Dutch company), they are not affiliated entities within the meaning of the statutory provision (article 10a(4) of the Dutch Corporate Income Tax Act). The Supreme Court then noted that 'group' and 'concern' are not defined in law or in legislative history. The Court subsequently ruled that for the application of the rebuttal rules and in particular the question of whether the funds have been diverted within the group or concern, an entity does not belong to the 'a concern' or the ' a group' of the taxpayer if that entity is not affiliated with the taxpayer under the law. This also applies if that entity has any interest in the taxpayer or is otherwise affiliated with it. In short, the Supreme Court did not want to apply a separate extra-legal criterion for the assumption of a 'group' or 'concern', but adhered to the legal affiliation criterion.
This leaves the question whether the possible existence of a collaborating group could still create affiliation. The Supreme Court replied in the negative. Unrelated entities that have an interest in the taxpayer or in the entity that finances the taxpayer can indeed form a collaborating group, but this does not create an affiliation.
Observation PwC
This case concerns the book year 2011/2012. In 2017, a new provision was introduced in defining the term collaboration group'. In our view, the Supreme Court's consideration on this point would possibly be different if the proceedings concerned a tax year of 2017 or later.
Referral back to the Court of Appeal
In both proceedings, the Supreme Court referred the cases back to the Court of Appeals for further assessment as to whether the interest was non-deductible on other grounds.
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