The Dutch anti-base erosion rule denies deduction of interest paid by a Dutch corporate taxpayer to a related party in so far as the relevant debt is connected with a ‘tainted transaction’, unless:
The interest income is subject to sufficient taxation; or
The funding and tainted transaction are predominantly based on sound business reasons (i.e., the anti-abuse rule).
Based on EU case law (Lexel) on a similar Swedish interest deduction limitation rule, the denial of arm’s-length interest expenses was found to be in violation of EU law. Therefore, the Dutch Supreme Court requested a preliminary ruling from the Court of Justice of the European Union (CJEU) on whether the Dutch anti-base erosion rule is in violation of EU law where it denies the interest deduction on arm’s-length interest expenses.
Dutch interest deduction
As in many other jurisdictions, under Dutch tax law, remunerations for debt (interest) are generally deductible, while remunerations for equity (profit distributions) are not deductible. Therefore, it is important to qualify the nature of a financial instrument (i.e., debt versus equity).
Qualification of debt versus equity
In principle, whether a financial instrument is considered debt or equity is determined on the basis of its civil law qualification. The distinction essentially comes down to whether there is a repayment obligation. If a financial instrument has a repayment obligation, it is in principle considered debt.
However, there are three exceptions as a result of which debt is requalified to equity for Dutch tax purposes:
Sham loans (schijnleningen);
Loss financing loans (bodemloze putleningen); and
Participating loans (deelnemerschapsleningen).
If none of these exceptions applies, debt for civil law purposes is considered debt for Dutch tax purposes as well.
Arm’s-length conditions
Under Dutch tax law, only the arm’s-length interest expenses on related-party debt are deductible for corporate income tax purposes. The arm’s-length interest rate is the concluded interest rate if the related parties were independent parties.
If a loan arrangement bears a non-businesslike interest rate (onzakelijke rente), an arm's-length interest rate should be determined and applied for tax purposes. In the event that no such arm’s-length interest rate can be established, the loan is qualified as an un-businesslike loan (onzakelijke lening). Any write-downs on an un-businesslike loan are not deductible for the creditor.
In practice, the arm’s-length interest rate is often substantiated by a transfer pricing analysis taking into account various factors, such as the credit rating and debt capacity of the debtor.
Support for the arm’s-length nature of a loan is also enhanced by dividing intercompany loans into tranches (with different maturities, collateral, and interest rates), thereby ensuring that:
Only specific tranches of the loan may qualify as an un-businesslike loan; and
The arm’s-length interest expenses relating to the other tranches of the loan remain deductible for corporate income tax purposes.
Anti-base erosion rules
Currently, at-arm’s-length interest expenses can be denied if the Dutch anti-base erosion rule applies. The anti-base erosion rule denies the deduction of interest paid by a Dutch corporate taxpayer to a related party in so far as the relevant debt is connected with a ‘tainted transaction’ (such as acquisition of shares in a related company), unless one of the rebuttal rules can be invoked.
Under the rebuttal rules, the Dutch corporate taxpayer must demonstrate that:
The interest income is subject to an effective tax rate of 10%; or
The relevant transactions (i.e., the funding and the connected tainted transaction) are based on sound business reasons.
If one of the rebuttal rules can be invoked, the interest expenses remain deductible.
The Lexel case
Under EU law, a domestic measure aimed at preventing tax evasion or tax avoidance by restricting interest deduction is in principle allowed if it targets ‘purely artificial arrangements’; i.e., arrangements without any underlying commercial justification.
The CJEU ruled that transactions that are carried out at arm’s length should not qualify as purely artificial arrangements. Moreover, the principle of proportionality requires that the denial of a deduction of interest should be limited to the proportion exceeding the arm’s-length interest rate.
Therefore, the Swedish domestic measure (which restricts interest deduction on related-party debt if the main reason for incurring such debt is receiving a substantial tax benefit) was considered in violation of EU law.
Impact on the Dutch anti-base erosion rule
The Dutch anti-base erosion rule is under dispute in a present case before the Dutch Supreme Court. In this case, the Dutch corporate taxpayer argues that – with reference to Lexel – the denial of the arm’s-length interest expenses on an intercompany loan related to an external acquisition (tainted transaction) is in violation of EU law.
Given the similarities between the Dutch anti-base erosion rule and the Swedish domestic measure in the Lexel case, the Dutch Supreme Court requested a preliminary ruling from the CJEU on whether the Dutch anti-base erosion rule is in violation of EU law.
If the CJEU follows its previous judgment in Lexel, the Dutch anti-base erosion rule will likely be considered in violation of EU law where it denies the interest deduction of arm’s-length interest expenses; i.e., the Dutch anti-base erosion rule should not apply to loans that are carried out at arm’s length.
Key takeaways
The judgment of the CJEU in Lexel leaves little to the imagination; i.e., a domestic measure is in violation of EU law where it denies the deduction of arm’s-length interest expenses. If the CJEU follows this judgment in its present Dutch preliminary ruling case, the Dutch anti-base erosion rule is likely in violation of EU law.
Therefore, it will be even more important in practice to maintain transfer pricing documentation supporting the arm's-length nature of a loan to demonstrate the deductibility of interest expenses on loans that are in scope of the Dutch anti-base erosion rule. Support for the arm’s-length nature of an intercompany loan can be enhanced by dividing the loan into tranches (with different maturities, collateral, and interest rates).
