NL Supreme Court on interest deduction and finance costs

27/03/24

On Friday 22 March 2024, the Dutch Supreme Court ruled in a case about interest deduction on shareholder loans and the tax treatment of financing costs (arrangement fees). The case concerns a private equity structure with which a company was purchased. According to the Supreme Court, the interest is not deductible to the extent that the structure for the purchase was set up to avoid a rule to restrict interest deduction (Article 10a of the Dutch Corporate Tax Act 1969). In addition, the Supreme Court decided in this judgement that the one-off costs for taking out a loan may be charged directly to the result, unless this includes prepaid interest.

What does this mean for your organisation?

With this judgement, the Supreme Court has given substance to the possibility of testing interest deduction against the Taxpayer's intention to evade the law (fraus legis). More specifically, it has been clarified when there is a set of legal acts which has been concluded with the overriding intention of defeating 'relatedness' within the meaning of Article 10a of the Corporate Tax Act 1969 (hereinafter “CIT Act”). Article 10a CIT Act aims to prevent the Dutch tax base from being eroded by artificially creation of interest charges within a group of taxpayers. Who belongs to that group is determined based on the ‘relatedness’ criterion. In short, this involved all persons and companies with a legal or economic interest of 1/3 or more. However, even if the structure tries to (artificially) avoid this connection, there may be an interest deduction limitation. After years of uncertainty about this, the Supreme Court has now made this clear.

In addition to the question about interest deduction, the Supreme Court has also decided on the tax treatment of the one-off costs for taking out a loan. These may be charged directly to the result unless the closing costs involve prepaid interest (in which case the costs must be capitalised and amortised over the term of the loan). According to the Supreme Court, you may therefore charge the costs to the result all at once in the year in which they are incurred, but you may also choose to activate the costs and amortise them over the term of the loan. For completeness’ sake, we note that the one-off costs cannot always be (fully) deducted in the year in which they areincurred based on a different rule, namely the so-called earnings stripping measure.

Case

Taxpayer (TopCo) is part of a corporate (private equity) structure that was established by a fund to purchase a group. The fund has established four Limited Partners (LPs), which are based in Guernsey. Each LP has established a Guernsey-based sub-fund. The LPs provided the capital raised from investors as equity to the sub-funds. The sub-funds have partly lent these assets to the Taxpayer. The question is, among other things, whether the interest on these loans is deductible.

One of the five sub-funds (Guernsey Ltd V) was newly established in the run-up to the acquisition and on the advice of a tax advisor. The investors in Guernsey Ltd V were the same investors as in Guernsey Ltd I (via LP I). Guernsey Ltd I was the only sub-fund to have an interest that exceeded the then relatedness criterion of Article 10a CIT Act. However, this interest was reduced below the relatedness criterion by the addition of the fifth sub-fund.

Judgement on interest deduction

The Supreme Court follows the Court of Appeal in the factual judgement that the shareholder loans qualify as “non-arm’s length loans”. These are loans that an independent third party would not have entered into due to the high risk for the debtor. Because of this, the judgement corrected the interest rate for tax purposes from 11%-14% to a risk-free interest rate of 2.5%. This significantly reduced the size of the Taxpayer’s possible interest deduction. The Supreme Court then discusses fraus legis, namely for (i) conflict with the purpose and intent of Article 10a CIT Act and (ii) conflict with the purpose and intent of the law as a whole.

Regarding the question of whether there is a violation of the purpose and purport of Article 10a CIT Act (first form of fraus legis), the Supreme Court rules as follows:

entering into the debt to Guernsey Ltd V is part of a set of legal acts between related entities, and
this set has been established with the overriding intention of defeating the relatedness criterion within the meaning of Article 10a, paragraph 4 CIT Act. For the other sub-funds, that had been established at an earlier stage, the Supreme Court decided that based on the facts, there is no such set of legal acts.

Subsequently, the Supreme Court states that for these other subfunds there is also no conflict of purpose and intent with the law as a whole (second form of fraus legis). The Supreme Court refers to the legislative history in which it is stated that (i) although it is not excluded that fraus legis may apply if Article 10a CIT Act does not apply, (ii) this must, however, concern exceptional cases, (iii) which do not occur quickly in practice, given the extensive codification of such cases.