Fraus legis prevents interest deduction in external acquisition financing arrangement | Deloitte Netherlands


Fraus legis prevents interest deduction in external acquisition financing arrangement

The Supreme Court has ruled that interest deduction can be denied on the basis of fraus legis if an external acquisition is financed by artificially converting equity capital into loan capital and making use of fiscally transparent creditors.

21 July 2021

External acquisition with shareholder loan

The interested party, X BV, initially established as a cooperative, is the parent company of a fiscal unity containing two affiliated (sub)subsidiaries. Both the interested party and the two consolidated entities were established in 2010 by a French private equity fund in order to acquire the Dutch Y group. The French investment fund consists, inter alia, of four French Fonds Communs de Placement à Risques (“FCPRs”). The FCPRs are considered to be fiscally transparent in France, but for Dutch tax purposes they qualify as non-transparent, open-ended mutual funds. None of the FCPRs held an interest of one third or more in the fiscal unity, so there was no affiliation in the years in question (2010/2011 and 2011/2012).

The institutional investors in the fund each participate as shareholders in one or more of the four FCPRs and the deposits of these investors are distributed among the four FCPRs. To finance the acquisition of the Y group, from the equity of the FCPRs the interested party received member capital and payments on the convertible loans issued by the interested party. These funds were subsequently provided in the form of capital contributions and money loans to the consolidated subsubsidiary of the interested Party. On top of that, external financing was raised.

One of the disputes before the Court of Appeal in Amsterdam was whether the interest owed by the interested party to the French FCPRs on the convertible loans could be deducted from the profits of the fiscal unity in FY 2010/2011 and FY 2011/2012.

Fraus legis prevents interest deduction

The Court of Appeal has ruled that the convertible loans do not actually function as equity and must therefore be regarded as loans. Moreover, no non-arm’s length loan or interest charges are involved. Nor can the interest deduction limitation of Article 10a of the Dutch Corporate Income Tax Act 1969 apply, as there is no question of affiliation between the FCPRs and the interested party. However, according to the Court of Appeal, the application of fraus legis (abuse of law) still prevents the deduction of the interest on the convertible loans. Following this judgment, both the interested party and the State Secretary lodged - cross - appeals in cassation.

In cassation, the Supreme Court upheld the judgment of the Court of Appeal that fraus legis prevents deduction of the interest owed by the interested party in respect of the convertible loans. In order to finance the acquisition, the investors provided equity capital converted into loan capital to the FCPRs for tax purposes only, i.e. to create a deductible interest expense. Because the Y group was included in the fiscal unity of the interested party immediately after the acquisition, this artificially created interest expense was effectively offset against the profit of the Y group. The Supreme Court argued that interest deduction under these circumstances is contrary to the aim and purpose of the law. Another factor is that there is no compensatory taxation, as the FCPRs are transparent for tax purposes in the state of residence. Both the motive requirement and the norm requirement are met for the application of fraus legis. According to the Supreme Court, the refusal of interest deduction in such a case is not contrary to EU law either.

Commentary Deloitte

Particularly decisive in this judgment seems to be the fact that without economic justification, equity at the level of the FCPRs has been converted into loan capital towards the Dutch taxpayer, with these “artificially created interest charges” subsequently being set off against the profits of a company. It remains unclear whether it is relevant in this respect whether the FCPRs concerned are part of the group of which the taxpayer is part as well. In our opinion this is important, because the provision of equity-financed loan capital by a third party should not in itself have an impact on the deductibility of interest owed by a Dutch non-affiliated debtor. This would mean that the mere conversion of equity into loan capital within the group would already render the deduction of interest on such a loan in a Dutch group company questionable for tax purposes, unless there is compensatory taxation at the level of the group creditor.

Unlike in the ruling rendered by the Supreme Court on 9 July, no. 19/05112 (in Dutch) the freedom of choice that the taxpayer has in the financing method of a company in which it participates and the financing requirement that arises from the choice to have shares in a company acquired by the Dutch taxpayer, cannot help the taxpayer in this case. Apparently because in the former case there was no question of a conversion of group equity into group debt. After all, it was established that external borrowing had taken place. Hence, the assessment of fraus legis was not so much at the level of the group creditor - although there was no compensatory taxation there either. Instead, the abovementioned financing freedom and requirement did play a role.

Source: HR 16 July 2021, 19/02596, ECLI:NL:HR:2021:1152

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