Court: acquisition interest not deductible due to fraus legis

23/06/23

Within the Dutch Corporate Income Tax Act the basic principle is that taxpayers have freedom of choice in the method of financing a company in which they participate. Statutory deduction restrictions that violate this must, according to the Supreme Court, be interpreted in a limited way. In a case in which the Supreme Court had previously considered that the interest deduction limitation of Article 10a Wet Vpb 1969 (anti-base erosion rule) does not apply due to a successful appeal to the counter-evidence rule, the Amsterdam Court of Appeal had to investigate whether there were other grounds on which the interest could be limited in deduction. In this referred judgement, the court ruled that the interest deduction on a shareholder loan should still be refused, namely on the basis of the doctrine of fraus legis (evasion of the law).

The case

This case concerns a Dutch retail chain that is taken over by a fund structure in which Dutch and foreign pension funds participate. The takeover was designed with the help of a Luxembourg parent company in which these funds participate. The Luxembourg parent company subsequently provided loans (debt capital) to a Dutch company, which eventually bought the shares in the Dutch retail chain. Subsequently, the retail chain was in turn included in the corporate tax fiscal unity with the Dutch company. The question at issue is whether the Dutch company can deduct from the profit the interest that it pays on the loan with which it financed the acquisition. Due to the nature of the fiscal unity, this interest deduction was offset against the profit of the acquired company (the retail chain).

Legal framework

The starting point is that interest costs are deductible from the taxable profit. However, the Dutch Corporate Income Tax Act (Wet Vpb 1969) makes various exceptions to this. For example, interest deduction may not apply if Article 10a of the Wet Vpb 1969 applies, or if the doctrine of fraus legis applies.

Article 10a Vpb Act 1969

The Corporate Income Tax Act 1969 defines a number of transactions for which, if these transactions are financed with loans, the interest on these loans is non-deductible if that interest is owed to an entity associated with the taxpayer (Article 10a Wet Vpb 1969). The main purpose of this legal provision is to prevent the creation of artificial interest deductions (anti-base erosion). However, the interest is still deductible if there is either a sufficient levy at the recipient of the interest, or if the transaction and the financing are at arm's length. The burden of proof for this rests with the taxpayer.

Fraus Legis

In short, the fraus legis doctrine means that if there is any question of acting contrary to the purpose and purport of the law, the intended tax benefits must be refused. For this, two requirements must be met (i) conflict with the purpose and purport of the law, which is therefore broader than the text of the law (purpose requirement), and (ii) the decisive motive is to avoid tax (motive requirement). In practice, it is unclear in which cases fraus legis can still limit the deduction of interest, while the interest would not be deductible on the basis of Article 10a Wet Vpb. In other words: how does the doctrine of fraus legis interact with Article 10a Wet Vpb, which in itself is also an anti-abuse provision?

The dispute

In the present proceedings, funds were raised ultimately from the funds that had equity capital contributed by their investors. None of the entities that made up these funds had an interest of one third or more in the Dutch company that acquired the shares in the retail chain. Based on the statutory regulations, these funds are therefore not so-called related entities of the Dutch company. However, the funds were first provided to the Luxembourg parent company, which subsequently lent them to the Dutch company. The Luxembourg parent company is a related entity, which meant that the situation fell within the scope of the legal provision. The Dutch tax authorities took the position that because the funds themselves had equity capital, they could also have provided the means for the acquisition in the form of equity capital to the Dutch company. In that case there would be no interest. Providing the funds in the form of a loan (borrowed capital) via the Luxembourg parent company would constitute a diversion. The Dutch tax authorities (and at the Supreme Court, the State Secretary) then found that there was no business reason for the (method of) financing.

The Supreme Court: freedom of choice in financing and counter-evidence

The Supreme Court considered in their earlier referred judgement that the starting point is that the taxpayer in principle has freedom of choice in the manner of financing a company in which he participates. Insofar as Article 10a of the Wet Vpb 1969 constitutes an infringement of this freedom of choice, this provision must be interpreted restrictively. The Supreme Court then states that a loan is mainly based on business considerations 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 that provided the loan has obtained the funds used for this loan from another entity from the same group as the taxpayer. The Supreme Court then considered that 'group' (in Dutch: ‘groep’ or ‘concern’) is not defined in the law and therefore for the counter-evidence rule and in particular the question of whether the resources within the group have been diverted unbusinesslike, an entity does not belong to 'the group' of the taxpayer if that entity is not related to the taxpayer within the meaning of Article 10a Wet Vpb 1969. In view of this, the loan at hand is mainly based on commercial considerations and meets the counter-evidence rule.

Referral back to the Court of Appeal

The Supreme Court subsequently referred the case back to the Court of Appeal for further assessment of whether the interest is still deductible on other grounds. This referral judgement of the Amsterdam Court of Appeal was published on 12 June 2023. The court concludes that the doctrine of fraus legis applies. This is a striking result, because in other judgements the Supreme Court ruled that the doctrine of fraus legis cannot be applied if the loan and the interest fall within the scope of Article 10a Wet Vpb and a successful appeal has been made to the counter-evidence rule of that provision (see our earlier Tax News article). However, according to this reference decision of the court, fraus legis could nevertheless come into play while the deductibility of the interest is also governed by Article 10a of the Wet Vpb 1969. This seems to deviate from the line of the Supreme Court. According to the Court of Appeal, the application of the doctrine of fraus legis requires, among other things, that tax reasons for the deduction of interest have been decisive.

The court finds that this condition is met in this case. In the opinion of the court, allowing the interest due to be deducted would lead to a conflict with the purpose and purport of the Dutch Corporate Income Tax Act as a whole. After all, the purpose and purport of this act is to preclude the levying of corporate income tax being arbitrarily and continuously frustrated, achieved by bringing together a company's profits on the one hand and artificially created interest costs on the other hand, in an arbitrary and continuous manner (base erosion). Even if the ultimate goals are considered business goals in themselves the structure can still be considered unlawful tax avoidance if the tax benefits are obtained by engaging in legal acts that are not necessary for the achievement of those business goals and the legal acts can only be traced back to the overriding motive of achieving the intended tax consequences. In addition, the court sees no conflict between the application of fraus legis in the present case and European Union law.

What’s next?

The taxpayer still has the option to appeal this decision in cassation. The Supreme Court must then ultimately pass judgement on the question of whether fraus legis can indeed be applied.