Recent case law: interest deduction limitation to prevent base erosion

On 5 June 2016 and on 8 July 2016, the Dutch Supreme Court decided in two important cases on the rebuttal rules in the interest deduction limitation to prevent base erosion included in article 10a of the Dutch Corporate Income Tax Act (“CITA”). The considerations of the Dutch Supreme Court provides more clarity on the scope and interpretation of the rebuttal rules.

Background: article 10a CITA

The Dutch base erosion rules stipulate that interest charges (and costs) on related party debt are not deductible if the debt is connected with certain tainted transactions such as acquisitions, capital contributions or dividend distributions. There are two rebuttal rules included in article 10a CIT. This limitation does not apply, if the taxpayer can demonstrate that:

a) Business reasons predominantly underlie the transaction and the debt obligation connected therewith (“business reason exception”); or

b) The interest is, on balance, subject to a reasonable taxation according to Dutch standards (“reasonable taxation exception”).¹

5 June 2016: Mauritius case

In this case, a South African listed company issued shares and the proceeds were wired to a Dutch subsidiary company. From a legal viewpoint, the proceeds were contributed in the capital of a Mauritian subsidiary company, which uses the funds to grant an interest free loan to a Mauritian financing company. The financing company, which was not subject to taxation, granted an interest bearing loan to the Dutch company. The proceeds were finally used for acquisitions by the Dutch taxpayer, although this was not clear upon borrowing the funds. The Dutch taxpayer claimed application of the business reason exception and deducted the interest charge on the funds borrowed from the Mauritian financing company.

Relevant considerations of the Dutch Supreme Court were the following:

• The burden of proof to demonstrate that the rebuttal rule(s) is met lies with the taxpayer.
• For application of the business reason exception, all parties that are involved in the transaction should be taken into account.
• A parent company is free to fund its subsidiaries with either debt or equity. Hence, if funds are not diverted through low-taxed group companies but lent directly to the Dutch taxpayer, the
• consequences (i.e. interest deduction) are in principle accepted.
• Older case law (based on the abuse of law doctrine prior to the codification of this doctrine in article 10a CITA), based on which the debt is by definition inspired by business reasons if the funds are used for a third party acquisition, is not relevant.
• For meeting the business reasons exception for the loan, it is not relevant that the funds borrowed were attracted for acquisitions in general and not for a specific acquisition.

The Dutch supreme court decided in this case that the Dutch taxpayer did not demonstrate sufficient business reasons for the loan borrowed from the Mauritian financing company. The interest on this loan was therefore not tax deductible.²

16 July 2016: Swedish case

In this case, a Swedish top holding company held approx. 72% of the shares in an Italian subsidiary company while the remaining shares were publicly traded. It was decided to delist the Italian company. A Dutch holding company borrowed funds from the Swedish top holding company and used the proceeds to contribute capital to a special purpose Italian bidding entity, incorporated to acquire the shares by means of a public offer. The Swedish top holding company had borrowed the funds on lent to the Netherlands from a UK group company. At the level of the Swedish company the interest income

was not subject to taxation , due to the mechanism of the group contribution rules..

In this case, the Dutch Supreme Court addressed both the business reasons exception and the reasonable taxation exception.

Some important considerations in respect of the business reasons exception:

• A parent company is free to fund its subsidiaries with either debt or equity (see also the Mauritius case);
• Key is the consideration that a group is free to decide to bundle the economic interest and the funds required in a Dutch holding company, even if the choice for the Netherlands is tax motivated. This means that the fact that the interposition of the Dutch company is not essential to achieve the result is not relevant for determining the application of the business reasons exception.
• For the business reasons exception, it should be tested whether there are any business reasons for having the Italian bidding company delist the shares, instead of the Dutch entity doing directly.

With regard to the reasonable taxation exception, the taxpayer argued that the reasonable taxation should be tested at the level of the UK company, which was sufficiently subject to tax. The lower court decided that this is only the case in the event the Swedish company has the legal obligation to repay the interest to the UK company. The Supreme Court did not apply a formal criterion (legal obligation) but ruled that the reasonable taxation exception should be applied at the level of the factual financing party. In this respect term, repayments schedule, interest payment, volume and timing of the loan should be taking into consideration to determine whether the UK company can be considered as factual financing party.

The Supreme Court decided that the interest was tax deductible based on the rebuttal rule(s).

However, proceedings have been deferred since a preliminary ruling is requested from the ECJ regarding the possible infringement of article 10a CITA with the freedom of establishment. If the Italian bidding company could have been included in the fiscal unity, article 10a CITA was not applicable since the capital contribution within the fiscal unity is not recognized for tax purposes. We refer to our other newsletter.

Practical implications

The Dutch Supreme Court provides in these two cases more clarification on the scope of the two exceptions. Most important is the consideration that using a Dutch intermediary company for tax reasons does not by definition imply that the business reasons exception is not met. The debt and the transaction (acquisition, capital contribution, dividend) should be tested on its own merits. The Mauritius case shows confirms the heavy burden of proof for business reasons on the funds borrowed.

The look-through approach with respect to the reasonable taxation exception implies that this test should not be applied to the direct recipient of the interest income (main rule) if there is, based on the relevant facts and circumstances, in fact l another financing party. The Supreme Court confirms that a formal obligation to repay the interest is not required to apply this look-through approach.

All in all, two decisions which may provide the tax authorities and taxpayers practical guidance on the application of the rebuttal rules.

¹ The reasonable taxation exception is however not a safe harbour in the event the tax authorities demonstrate that the reasonable taxation exception cannot be applied.

² Any possible infringement with EU law was not addressed by the Supreme Court.