Funding by treasury department not ‘artificially diverted’

23/03/23

For Dutch corporate income tax purposes, as a starting point, interest on debts to related entities that are linked to certain tainted transactions, is excluded from deduction. Such transactions include dividend payments, capital contributions and the acquisition or expansion of an interest (Article 10a CITA). However, if the taxpayer provides counterevidence that there were business motives for both the transaction and the financing, the interest is still deductible (“dubbele zakelijkheids toets”, or “double business motive test”). In the case of 3 March 2023, the issue was whether the method of financing the transaction was based on business reasons. The business-like nature of the legal transaction was not in dispute. Based on previous case law, financing is deemed to be business-like if a loan has not been diverted in an artificial manner. The loan is considered artificially diverted if through an artificial construction, often using otherwise useless companies or bodies, an interest flow is created that would not exist without the construction. In this procedure, the Supreme Court ruled that when an internal loan is raised from a company that performs a pivotal financial function within the group (a treasury department) and the treasury department does not merely act as a conduit, there is no artificial diversion.

What does this mean for your company?

Based on this Supreme Court ruling, it becomes easier to meet the burden of proof that the method of financing dividend payments, capital contributions or the acquisition or expansion of an interest is based on business considerations in case the financing was raised through an internal treasury department.

The Judgement

In practice, in an international group, a financial restructuring or making an acquisition involving internal loans through a treasury department can lead to complications as regards the interest deductibility. This is because the taxpayer must then make a plausible case that there are predominantly business motives behind the debt. This is the case, for example, if it can be shown that the loan was ultimately externally financed. What often happens is that external financing is raised by the ultimate holding company or a company at the top of the structure, after which the funds are passed on internally via loans to a company lower down in the structure that carries out the actual transaction. To then be able to prove that the ultimate borrowing took place externally, the organisation needs to have a precise record of which top-level loan is related to which lower-level transaction. Moreover, in principle, the loans in question should be passed on within the group on similar terms where it concerns notional amount, term, interest and repayment schedule (parallelism).

If the loan is not ultimately financed by external loans, it must be otherwise demonstrated that the financing is based on business motives (i.e. non-tax considerations). Previous case law shows that this is the case if the funds have not been diverted artificially. There is an artificial diversion if the funds have been diverted through different companies creating an interest flow, whereas without diversion there would be equity and therefore no interest flow. Also see our earlier Tax News article “Acquisition financing businesslike if from outside group”.

The problem that arises with treasury departments is that it is usually not possible to trace and label which funds are used for what. After all, the function of the treasury department is to pool the cash available in the group and, where necessary, attract external funding in the form of equity or debt, depending on the overall funding needs. As a result, the direct link to a particular transaction cannot always be easily demonstrated. In this judgement, the Supreme Court shows understanding for this.

According to the Supreme Court, if there is a pivotal (financing) function, the funds cannot be said to have been diverted artificially. Therefore, even if the funds have not been borrowed externally but come from group companies, there can be business considerations. The Supreme Court does however make an important nuance and considers that this is different if the entity providing the financing does not have sufficient so-called substance or if it is a conduit.

How should it be assessed whether a company has a pivotal or conduit function?

The Supreme Court also indicates how to assess whether a pivotal function exists. The pivotal function can be performed by an independent body or an independent business unit. When assessing whether there is a pivotal function, the circumstances must be considered in context. The key factor is that the body or independent business unit performs an active financing function within the group and it is mainly engaged in carrying out financial transactions on behalf of group entities, such as borrowing and lending funds and managing excess group resources. Furthermore, it will have to be independent in its day-to-day business operations. Independence exists if the body manages the outstanding funds, and to this end has sufficient and competent staff and its own administration.

The Supreme Court does not explain under what conditions a company has a conduit function. However, we can imagine a situation where a group has a treasury department with a pivotal function and sufficient substance, but where the provision of a loan such as the one in question is not part of the normal treasury function. If, as it were, the treasury function is artificially sought in order to have the loan granted, then there may still be an artificial diversion.

The Dutch general anti abuse doctrine (fraus legis) and Article 10A CITA

At the end of the judgement, the Supreme Court also discusses the relationship between Article 10A CITA and the doctrine of fraus legis (anti-abuse). In short, the doctrine of fraus legis implies that if a taxpayer acts contrary to the purpose and purport of the law, the intended tax benefits must be refused. For this to happen, two requirements must be met: (i) conflict with the purpose and purport of the law, which is thus broader than the mere text of the law (purpose requirement), and (ii) the predominant motive is to evade tax (motive requirement).

The Supreme Court ruled that if the taxpayer makes it plausible that the business reasons test is met, the doctrine of fraus legis can no longer be applied in this case.

This does raise the question of how this relates to the judgement of 15 July 2023 on the application of Article 10A CITA, in which the Supreme Court referred the case back to the Court of Appeal to assess whether the doctrine of fraus legis applies, despite the fact that in that case it was also ruled that there was no question of an artificial diversion. An important difference, however, is that in that case, the doctrine of fraus legis was invoked by the inspector because there was a conflict with the purpose and purport of the Dutch CITA as a whole, and not because there was a conflict with the purpose and purport of Article 10A CITA specifically. This may be related to the fact that the financing in that case did not only relate to the tainted transactions covered by Article 10A CITA, but also to other non-tainted transactions, for which the inspector nevertheless believed he should refuse the interest deduction. See also “Dutch Supreme Court rules on interest deduction in two acquisition structures”.

EU aspects

The Supreme Court ruled in this case that the interest deduction limitation of Article 10A CITA did not prevent the taxpayer from deducting the interest. As a consequence, the Supreme Court did not address the other question in this case which concerned the (in)compatibility of the Dutch fiscal unity regime with the EU freedoms. The taxpayer had argued that if the interest would not have been deductible under Article 10a CITA, it should still have been deductible based on the EU freedom of movement. This is because the relevant transaction (a capital contribution to a group company in another EU Member State) would not have been visible under the fiscal unity rules applicable at the time if this group company had not been established in another EU Member State but in the Netherlands (per-element approach; sister fiscal unity).

The question arose how the present judgement of the Supreme Court relates to the judgement of the Supreme Court of 2 September 2022 (ECLI:NL:HR:2022:1121). In that judgement, the Supreme Court asked the Court of Justice of the EU about the compatibility of Article 10A CITA with EU freedoms. This, in the light of the considerations of the Court of Justice in the Lexel case (C-484/19). In the Lexel case, the Court of Justice seems to rule that for the purposes of applying EU law, there is no abuse of EU law if the prices used are at arm's length (transfer pricing). An restrictive measure, such as the interest deduction limitation in Article 10A CITA, could then possibly conflict with EU law on this basis. Article 10A CITA would then become non-binding insofar as this provision limits deduction of business interest. In interpreting the term 'financial pivotal function', the Supreme Court seems to be moving towards an approach that seems to have some resemblance to the functional analysis in transfer pricing. In the Lexel case, the Court of Justice also seems to be heading for a transfer pricing approach. It therefore remains to be seen whether the Supreme Court will once again have to comment on the question of EU law.