Dutch Supreme Court on deductibility of interest rate swaps
02/03/22
On 25 February 2022, the Supreme Court passed an important judgement (in Dutch) in which it addressed the tax treatment of redemption fees owed by a company or organisation upon termination of financing instruments (loans and the like). In particular, it concerns the question of whether it is permissible to charge such penalty interest/redemption sum as a lump sum against taxable profit for tax purposes or whether it must first be capitalised and then written off (depreciated) over a certain period, for example the remaining term of the original loan.
What does this mean for your organisation?
Depending on the situation, it is possible to deduct lump-sum payments in connection with the termination of loans (penalty interest) and flanking instruments, such as interest rate swaps, from the profit. In principle, a company can also choose to capitalise and depreciate such payments at its own discretion.
Present case
In this case, the taxpayer - a housing association - had taken out a loan with a variable interest rate in combination with an interest rate swap agreement (IRS). The housing association paid the variable (market) interest due on the loan. On the IRS it received or had to pay the difference between the variable interest rate and the agreed rate. Since the market interest rate had fallen since the instruments were concluded, the taxpayer had to make additional payments on the IRS. Furthermore, the IRS contained margin calls on the basis of which the taxpayer had to deposit amounts with the bank as security when the market interest rate fell below certain percentages. This seriously impaired the association’s liquidity. For this reason, the taxpayer terminated the IRS and the variable interest loan and replaced them with a fixed interest loan for a specific term. When the IRS was terminated, the taxpayer owed a lump-sum payment. According to the Supreme Court, in this specific case the lump-sum redemption fee can be charged to the taxable profit.
Mini-lecture of the Supreme Court
What is interesting about this judgement is that the Supreme Court gives, as it were, a mini-lecture on the tax treatment of loans, risk-hedging instruments (such as, in this case, the IRS) and redemption fees on termination in certain situations.
According to the Supreme Court, the rules for the calculation of the taxable profit are as follows:
1. Fixed interest loans, falling market interest rates
A declining market interest rate generally affects the fair value of the liability of a fixed interest loan. The value of the liability increases. However, it is not permitted to set the value of the loan on the liability side of the balance sheet for tax purposes at this higher fair value and deduct the related expense in the year in which the interest rate decrease occurs. The annually agreed and payable interest costs are deducted in the years to which they relate (and of course with due observance of any statutory interest deduction restrictions).
2. Interest adjustment premium for fixed rate loan
Where a lower fixed interest rate is agreed for the remaining term of a loan in return for the payment of a premium (interest adjustment), the amount paid may not be charged at once to the profit. This amount must be capitalised and depreciated over the remaining term of the loan.
3. Early repayment of fixed-interest loan, resulting in new replacement loan
If a premium (penalty interest) is payable on early repayment and a new loan is subsequently taken out, the penalty interest may not be charged to taxable profit in one lump sum. In this case, the payment must be capitalised and depreciated over the remaining term of the original loan or the term of the replacement loan, if this is shorter. Whether the loan must be identified as a replacement loan must be assessed in the light of the circumstances.
The same rules apply in situations where a variable interest loan has been agreed in combination with an interest rate swap (IRS). For example, in the event of an interest rate decrease with an IRS, an (additional) payment obligation arises. In its judgement of 8 November 2019, the Supreme Court ruled that if the IRS is connected with a variable interest loan, the additional payment obligation on the IRS may not be passivated.
If an IRS is surrendered and the related variable rate loan is also terminated, the surrender price of the interest rate swap may be charged to the profit in the year of surrender. This is only different if a new loan is taken out to replace the combination variable rate loan and IRS. In that case, the redemption fee must be capitalised and depreciated.
However, if there is a substantial difference between the two situations, there is no substitution for the purposes of these rules. In that case, the redemption sums may again be charged to the taxable profit in a lump sum. The Supreme Court has ruled that there is a substantial difference, for example, if in the original situation an IRS could entail obligations to make security payments ('margin calls'), and this is no longer the case in the new situation.
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