Dutch Supreme Court rules in cases on deduction of interest for bank structures
The Dutch Supreme Court ruled in several relevant cases on deduction of interest. This concerned a banking group that had set up a structure to use the so-called Bosal gap.
3 May 2017
In 2003, the European Court of Justice (CJEU) judged in the Bosal Holding case that the then applicable Dutch participation exemption for interest deductions was contrary to European law. At the time, the participation exemption prohibited deduction of interest on loans used to finance the acquisition of a foreign participation, while no limitation of deduction applied for domestic participations. As a result of the Bosal judgment, the Dutch tax authorities were forced to allow deduction of financing interest relating to foreign participations. So since that time there is a mismatch between the deduction of interest (which is, in essence, deductible) and the income from participations (which is not taxed under the Dutch participation exemption). Especially in respect of foreign participations this mismatch may constitute a budgetary risk for the Dutch Treasury, since the profit of a foreign subsidiary is not taxed in the Netherlands taxed while the financing interest is, in principle, deductible. This mismatch is referred to as the “Bosal gap”.
An originally Swiss banking group had set up a tax structure in an attempt to benefit from the Bosal gap. The structure was basically used to acquire third party private limited liability companies that had realized profits in the year prior to the acquisition, e.g., by transferring their businesses. Upon acquisition of these companies, their assets mainly consisted of cash. Next, a flow of loans that existed within the group was transferred to the acquired profit companies through a UK based permanent establishment of the group’s Swiss parent company. The companies used the cash thus obtained to acquire foreign participations. The objective of this structure was to set off the interest on the loans for tax purposes against the profit already realized by the private limited liability companies. The interest payments were financed through dividend distributions (which were exempt under the participation exemption) by the foreign participations acquired. This structure resulted in a number of proceedings at the Dutch Supreme Court.
In one ruling the Supreme Court decided that the structure is to be qualified as fraus legis. For qualification as fraus legis a legal act has to be contrary to the aim and purpose of tax law, with the primary objective to evade taxes. The legal grounds of the ruling show that using the Bosal gap to evade the levying of corporate income tax in itself does not lead to the conclusion that it concerns fraus legis. This is, however, the case if deduction of interest contrary to the CIT regime is created with the decisive objective to evade tax, such as that regime is to be interpreted after the Bosal judgment. The subsequent legal grounds show that the Dutch Supreme Court especially resents that the interest deductions would be charged against profits realized by the interested parties before they were part of the group. For this reason the Supreme Court cancels the interest deductions up to the amount of these “acquired profits.” The ruling stipulates that it concerns acquired profits insofar as the profit has already been realized for tax purposes according to the rules of sound business practice up to the moment that the economic risk relating to the shares in the respective company is transferred. The remaining interest payments are, in essence, deductible, since the ruling does not consider this to be contrary to the CIT regime applicable after the Bosal judgment.
Article 10a CITA 1969
Another case involving the same taxpayer did not concern fraus legis because there was no acquired profit. The inspector still disallowed the interest deductions under art. 10a CITA 1969. This statutory provision briefly stipulates that interest is not deductible if a so-called “contaminated” legal act has been financed with a loan from a group entity. Since 2007, article 10a CITA 1969 also applies to external acquisitions such as those at issue in these proceedings. In the situation under consideration, the permanent establishment that had provided the loan had raised debt capital from third parties. The legislative history shows that art. 10a CITA 1969 does not purport to restrict the deduction of interest on eventually external financing, as long as the internal loan and the external loan show parallelism. The Court of Appeal judged that this condition was met since the interested party had drawn up a statement to that extent, which had not been properly contested by the inspector. The Supreme Court thus ruled that the required parallelism existed.
In the ruling, the Dutch Supreme Court also clarified the scope of the exception for “eventually external borrowing.” In this context it is relevant that art. 10a CITA 1969 provides for a regulation on providing evidence to the contrary that includes two components: the business motive test and compensatory levy. The business motive test implies that both the debt and the related legal act (in this case, the acquisition of the shares) should predominantly be based on business motives. The ruling leads to the conclusion that such a material external loan by definition complies with this double business motive test. Therefore, art. 10a CITA 1969 is de facto not applicable to eventually external borrowings.
Source: Supreme Court April 21, 2017, 15/05278, ECLI:NL:HR:2017:638 and Supreme Court April 21, 2017, 16/03669, ECLI:NL:HR:2017:640