In its final judgment of July 16 2021, the Dutch Supreme Court followed the Advocate General’s (A-G) conclusion and decided – in line with the preceding judgement by the Court of Appeal – that the financing structure of a French private equity (PE) consortium for the acquisition of a Dutch group in 2011 constituted abuse of law (fraus legis). The Supreme Court hereby ruled in favour of the Dutch tax authorities by denying the interest expenses on the relevant convertible loan instruments.
In our previous article on this case, we have discussed the A-G’s conclusion and outlined the various steps that are followed upon assessing the interest deductibility on shareholder loans.
The case concerned a French investment fund that acquired a group of Dutch companies in 2011. To finance the acquisition, the investment fund obtained funding from its investors. The collected funds were contributed as capital investments and were divided among four French fiscally transparent investment vehicles, so-called fonds commun de placement à risque (FCPRs). These four FCPRs were the limited partners of an UK partnership which was transparent for Dutch tax purposes.
In short, a Dutch acquisition vehicle (NL Bidco - Coop) was set up to acquire the shares of the Dutch group. Three of the funds held directly an interest of 30% in the acquisition vehicle and the remaining interest of 10% was held by the fourth fund. The NL Bidco - Coop received the funding from the FCPRs, partly in the form of convertible loan instruments with a compounded annual interest rate of 13% and partly in the form of equity contribution.
Following the acquisition, the acquired Dutch group joined the CIT fiscal unity with NL Bidco - Coop as the parent company. The chosen fund arrangement created a situation in which the fiscal unity's interest expenses could be offset against the Dutch group's profits, whereas the interest income was left untaxed in France due to the hybrid nature of the FCPRs. See below a simplified structure chart.
Of particular importance in this case is the application of the anti-base erosion interest deduction limitation rule within the meaning of Article 10a of the Dutch Corporate Income Tax Act 1969. The anti-base erosion rule denies the deduction of interest paid by a Dutch corporate taxpayer to a related party insofar the relevant debt is connected with, inter alia, an acquisition of shares in a company, unless predominantly sound business reasons underlie the acquisition and the funding of the acquisition.
The entity that provides the debt instrument is defined as a related party when it holds an interest of a third or more in the debtor, or another party holds an interest of a third or more in the creditor and debtor. Since none of the FCPRs held a sufficiently large interest (a third or more) in the Dutch entity, the Court of Appeal and the A-G found that the denial of interest could not be based on the anti-base erosion rule.
The fact that the anti-base erosion rule has been amended as of 2017 with an extension of the definition of related parties by the so-called collaborating group (samenwerkende groep), could not be applied with retrospective affect and therefore not change the meaning of related parties at the time of the underlying transaction (2011).
Abuse of law
Pursuant to Dutch case law, abuse of law consists of three constituent elements: the arrangement is created with a tax (avoidance) motive, the arrangement is artificial and its outcome is not in line with the object and purpose of the law.
The Court of Appeal indicated that the convertible bond instruments were provided by formally separate FCPR’s that were not subject to tax on the interest income and the structure was arranged in a way to avoid applicability of Dutch interest deduction rules (i.e. criteria of related parties). Consequently, a tax advantage was realised which caused the structure to be considered both artificial and set up with a tax avoidance motive. The Supreme Court followed the Court of Appeal’s decision.
In addition, it must be established whether the outcome of the arrangement is not in line with the object and purpose of the anti-base erosion rule. The Court of Appeal concluded that the essence of Dutch case law on this matter is that interest deduction should not be allowed on loans that – except for the avoidance of taxation – have no real (business) function. In this context, the Court of Appeal (followed by the A-G) considered the apparently meaningless intermediate steps of the acquisition financing arrangement not in line with the object and purpose of the law.
The Supreme Court stipulates that the objective and purpose of the law prevent that the levying of CIT is arbitrarily and continually frustrated by legal transactions (e.g. the convertible bond instruments) which are not necessary to the attainment of the pursued (commercial) objectives (e.g. the acquisition of the target) and are attributable only to the overriding tax motive. Therefore, the Supreme Court upholds the decision of the Court of Appeal and denies the interest expenses on the convertible bond instruments due to the established abuse of law.
Freedom of choice
The Supreme Court reiterates that, in principle, a Dutch entity has the freedom of choice to attract either equity or loan for the acquisition of a target. This is also in line with settled case law and was reaffirmed in a recent Supreme Court case of July 9 2021. Since the Supreme Court found the financing structure to be artificial, motived by tax reasons and contrary to the object and purpose of the law, the freedom of choice in financing the acquisition had to be restricted in the present case.
Although this case dates back to 2011 and the law has changed since then, this is considered a landmark case for many PE funds that have acquired Dutch entities through similar acquisition financing structures in the past. It stresses once again the importance of careful tax planning when setting up the acquisition financing structure of a fund.
The Supreme Court has been reluctant in the past to restrict companies in their choice of financing business investments (either in the form of debt or equity). However, as can be concluded from this judgment, this freedom should not be considered unlimited.
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