On March 3 2023, the Dutch Supreme Court clarified the scope of a specific interest deduction limitation rule laid down in Article 10a of the Dutch Corporate Income Tax Act of 1969.
Background: Interest deduction rule
Under this rule, interest expense is non-deductible for Dutch corporate income tax purposes if a taxpayer received a loan from a related party that is used for a dividend distribution to a related party. This also applies to a repayment of capital to a related party, a capital contribution to a related party or an acquisition of shares in a company that is, or after acquisition, will be a related party.
Generally, an entity is a related party if:
The Dutch company directly or indirectly owns at least a one third interest in the entity;
The entity directly or indirectly owns at least a one third interest in the Dutch company; or
The Dutch company is directly or indirectly owned by an entity with at least a one third interest in the Dutch company, where this entity also directly or indirectly has a one third interest in another entity.
An exception to this rule applies if the taxpayer can establish that both the loan and the transaction are based on sound business motives. In that case, the interest expense is tax-deductible.
Settled case law
Under settled case law, an external acquisition is a transaction that is based on sound business motives. Further, a related party loan associated with such an external acquisition is also considered to be based on sound business motives if the funds were not diverted in a non-businesslike manner. Such a non-businesslike diversion may be considered, for example, if the Dutch company effectively equity-funds the loan by means of a dividend distribution to its shareholder. This would then contribute the funds to a group company established in a low tax jurisdiction, after which this low tax group company loans the funds back to the Dutch taxpayer.
This case law did not, until the Supreme Court decision, clarify whether this interpretation of the business motives test also applied to transactions other than external acquisitions, such as capital contributions.
Supreme Court ruling
The ruling clarifies that the businesslike nature of the debt is also a given in case of transactions covered by the interest deduction rule other than the external acquisition. This is providing the transaction is based on sound business motives and the funds have not been diverted in the way set out above.
In the specific case, the taxpayer was part of a Swedish multinational group that was exiting from the Italian stock market. The Dutch Supreme Court ruled that the Court of Appeal of ‘s-Hertogenbosch erred by judging that the taxpayer’s debt-financed capital contribution to a newly incorporated Italian subsidiary designed to acquire the listed shares was not based on sound business motives. The taxpayer, however, clearly demonstrated that:
The capital contribution was made to fund the newly incorporated Italian company that would purchase the shares of the listed company; and
The group company from which the loan originated was the group treasury center with sufficient qualified personnel to perform this function.
In relation to the latter, the taxpayer argued that the funds should therefore not be considered diverted in a non-businesslike manner.
The Dutch Supreme Court followed the taxpayer and clarified that funds are not considered to be diverted in a non-businesslike manner if the loan is granted by a group company that performs a pivotal financial function, supported by sufficient qualified personnel. If the taxpayer can establish that the group company performs this function, the burden of proof to establish that the company effectively functions as a conduit lies with the Dutch tax authorities.
Key takeaways
If taxpayers have not yet challenged the application of the specific interest deduction rule in situations similar to those of the Supreme Court ruling, they could consider challenging it going forward. This could be by taking a filing position in the tax return, or by applying the rule in the tax return, but filing an objection against the tax assessment. The latter option poses less risk for penalties and interest if the taxpayer ultimately cannot establish that the interest deduction rule should not apply.
