On 15 July 2022, the Dutch Supreme Court issued rulings in two similar cases involving the application of the interest deduction limitation rules in private equity structures. Both cases/structures involved investments in Dutch target companies through Dutch acquisition holding companies held by Luxembourg holding companies. To finance the investments, the Luxembourg holding companies issued preferred equity certificates to the investment fund vehicles and co-investors. The proceeds from the equity certificates were used to fund the Dutch acquisition holding companies through equity and shareholder loans. In the structure, the Dutch acquisition holding companies acquired all shares in the target companies, forming a Dutch fiscal unity (tax group). Having formed a fiscal unity, the interest payments on the shareholder loans by the acquisition holding companies could be deducted from the profit of the target companies, although this was challenged by the Dutch tax authority.
In the rulings, the Supreme Court addressed the interest deduction limitation rule under article 10a of the Corporate Income Tax Act (CITA), which concerns related party financing. In general, the rule provides that interest payments on related party financing are not deductible where the debt is connected with, among other things, a third-party acquisition. For this purpose, two entities are related if one entity holds a direct or indirect interest of at least one-third in the other entity. However, interest payments may still be deducted if a taxpayer demonstrates that business reasons underly the loan and the related transaction, which is generally considered the case if the funds have not been re-routed within a group in a non-commercial manner. With respect to this rule, the Supreme Court found that the conditions for the exemption were met. According to the Court, the funds used for the acquisition were not re-routed within a group in a non-commercial manner since the funds were obtained by the Luxembourg holding companies from the investment fund vehicles and fund investors, none of which held an interest of at least one-third.
In regard to the one-third holding condition, it is important to note that the cases concern tax years prior to 2017. With effect from 2017, article 10a was amended to provide that in determining whether the minimum one-third interest holding is met, the holdings of the parties involved should be aggregated. With the Supreme Court rulings, it is explicitly confirmed that this aggregate holding rule does not apply for tax years prior to 2017.
In addition to the application of article 10a, the Supreme Court also addressed non-businesslike loans. In general, if a creditor runs a credit risk that independent parties would not have accepted in return for a fixed interest, such loans are considered non-businesslike and write-offs on the non-businesslike loans are not deductible for tax purposes. Loans considered non-businesslike also affect the interest rate that is taken into account for tax purposes, with the Supreme Court previously ruling that the interest rate on a non-businesslike loan is the rate that the debtor would have paid if it had taken the loan from an independent third party under guarantee of the actual creditor (guarantee interest). In the latest rulings, it is clarified that a debtor can deduct the nominal amount of the accrued guarantee interest, unless it is certain or almost certain that the interest does not need to be paid or will not be paid. Further, a subsequent decrease in value of the accrued guarantee interest is not tax-deductible in the hands of the creditor, nor taxable at the level of the debtor.
Note, the Dutch tax authority also claimed that if article 10a did not apply to limit the deduction of interest in these cases, then the abuse of law ("fraus legis") principle should apply. The abuse of law principle would essentially allow for a denial of interest deductions where unnecessary legal acts are used with the primary purpose of realizing the tax benefit of interest deduction in the Netherlands. However, the Supreme Court did not rule on the application of the abuse of law principle, with the cases referred to the Courts of Appeal to rule on this argument.