Financing of Dutch real estate companies: sit tight or action needed?

Based on the Budget Day plans unveiled by the Dutch government on September 17 2024, new measures may prevent the 'fragmentation' of real estate companies to maximise Dutch tax-deductible interest deductions. This article explores the potential impact and how real estate companies could prepare for the change.

Currently, in practice, by structuring a real estate company with multiple rental properties (leased to third parties) into separate entities, a €1 million limit for allowed Dutch corporate income tax deductible interest expenses may be applied multiple times (i.e., once per company). This enables greater interest deductions compared with a scenario where only (net) interest expenses up to 20% (2024 rate) of the fiscal EBITDA would be deductible (the main rule).

If the proposal outlined on Budget Day is adopted, the €1 million threshold may no longer apply to real estate companies that typically (at least 50% of the time) and primarily (at least 70%) own and lease real estate to third parties. A company is considered a real estate company if at least 50% of its assets consist of real estate. If the proposal is adopted, these real estate companies may only claim interest deductions up to an amount of 25% of fiscal EBITDA (2025 rate).

The adjustment of the earnings stripping rule could have a significant impact on real estate companies, especially those that previously utilised the fragmentation strategy to benefit from the €1 million threshold multiple times. Real estate companies that have relied on this strategy will need to prepare for a limitation in interest deductions that could be considerably lower than before. For real estate companies largely dependent on external financing, this may result in a higher tax burden and thus reduced net returns.

Real estate companies should carefully review their financing structures and property portfolios in light of the upcoming change.

However, real estate companies should prepare for the forthcoming change with flexibility. The proposal was recently discussed in parliament; during which, several uncertainties regarding the proposal were highlighted. Consequently, it is possible that the legislative proposal that is ultimately adopted by parliament may differ from the original proposal. Given this uncertainty, it is advisable for real estate companies to maintain flexibility, enabling them to implement necessary changes promptly.

Furthermore, the legislative change imposing a limitation on interest deduction possibilities for real estate companies appears unfavourable for these companies. However, the deductible interest threshold as a percentage of EBITDA will increase from 20% to 25%. Moreover, any interest expenses that are disallowed due to the interest deduction limitation may be carried forward indefinitely, allowing these amounts to be deducted in future years when sufficient taxable income is available. This carry-forward provision ensures that non-deductible interest expenses are not permanently lost but can instead be utilised over time, depending on the company's future earnings. As a result, while the immediate deduction is restricted, this is in some cases only a timing difference, since the interest expenses remain available for offset against taxable income in subsequent periods.

An out-of-the-box approach could involve adding other activities (assets) to a real estate entity. This 'mixing' of activities may result in the entity no longer meeting the criteria of a "real estate entity" as defined under the new regime, which is the case if 70% or more of the assets consist of real estate that is rented out to third parties for at least 50% of the time. This works best if a group has both operational activities and passive real estate activities, which is often seen in family businesses.

The adjustment of the earnings stripping measure as of January 1 2025 places greater pressure on real estate companies to carefully consider their structure and financing. The focus of this measure is clear: to prevent tax avoidance through dividing real estate over multiple entities.

Given the potential financial impact, real estate companies should review the impact and determine whether any action is necessary. While the changes may initially seem unfavourable, it may be possible to mitigate the adverse tax impact.