Netherlands: Landmark Decision on Scope of Anti-base Erosion Rules and Applicability of Abuse of Law Doctrine

On 22 February 2018, the European Court of Justice (ECJ) issued its decision in the joined Cases C‑398/16 and C-399/16. The decision regards the compatibility of the Dutch fiscal unity regime in the Dutch Corporate Income Tax Act with the freedom of establishment in the Treaty on the Functioning of the European Union. The former case (C-398/16) concerned a Dutch company (DutchCo) which received a loan from its Swedish parent company (TopCo), loan 1, which was used to make a capital contribution in an Italian subsidiary (ItalianSub).

ItalianSub used this capital contribution to acquire part of the listed shares in an Italian group entity (SpA). The non-listed shares in SpA were held by TopCo. Subsequently, DutchCo directly acquired the remaining part of the listed shares held by third parties in SpA after the public bid. The purchase price of this shares were also financed by DutchCo with a loan obtained from TopCo (loan 2).

Case C-398/16 dealt with compatibility of the fiscal unity rules during the tax year 2004. Today (3 March 2023), the Supreme Court issued a decision in case 21/00299 that addresses the Dutch tax treatment of DutchCo in later tax years. The Dutch tax authorities again tried to deny the tax deductibility of the interest costs in respect of both loan 1 and loan 2, invoking the anti-base erosion rules of section 10a of the Dutch Corporate Income Tax Act (CITA).

Section 10a CITA stipulates that interest on debt is not deductible if such debt is due to an affiliated entity where that debt is related to (inter alia):

• a capital contribution to an affiliated entity (like here DutchCo contributed to ItalianSub), or
• the acquisition or extension of an interest in an entity that is an affiliated entity after such acquisition or extension (like here DutchCo also acquired shares in the affiliated SpA).

An exception to the non-deductibility pursuant to Section 10a applies if the taxpayer makes it plausible that both the debt and the related transaction are predominantly based on business considerations. For purpose of these rules, also loans entered into under arm's length conditions can be treated as not being based on business considerations.

In today's decision the Supreme Court considers that with regard to the examination of the motives for the relevant transactions (the acquisition of the SpA shares and the contribution to ItalianSub) and debt (loan 1 and loan 2), it is to be understood that only the considerations underlying those transactions and debt are relevant. In that examination, it is important that it is inherent in the system of the CITA that the taxpayer in principle has freedom of choice in the method of financing a company in which he participates. To the extent that the anti-base erosion rules infringe this freedom of choice by not allowing a tax-deduction of interest owed, these rules must be interpreted restrictively.

The Supreme Court also considers that in addition to the freedom of choice as regards financing, a taxpayer, and in the present case a group of companies, has the freedom to locate its economic interests and (financial) resources in a company residing in the Netherlands (i.e., to 'use' a Dutch resident company) even if that choice is determined by tax considerations. The anti-base erosion rules are not aimed at limiting this second freedom. According to the Supreme Court that freedom applies to the set-up of a group, meaning that no provision of the CITA or any principle underlying it contains norms as to where within the group activities are placed and where holding and intermediary activities or financing activities are carried out.

For purpose of the anti-base erosion rules an external acquisition – like here the direct acquisition by DutchCo of shares in SpA held by third parties – should in the vast majority of cases be considered being based on sound business considerations. The Supreme Court considers that a debt is in principle predominantly based on business considerations if the funds used for granting the loan have not been diverted from another party via the actual lender of record. This also applies, according to the Supreme Court and contrary to the Dutch tax authorities' view, to a debt related to a transaction other than an external acquisition, which falls within the scope of section 10a of the CITA- such as the capital contribution by DutchCo to ItalianSub - if predominantly business considerations underlie the other transaction.

The Supreme Court decides that from the parliamentary history of Section 10a it follows that a debt from an affiliated party may be predominantly based on business considerations if the affiliated lender has sufficient substance and, through its financing activities, performs an active financing function within the group of entities affiliated with the Dutch taxpayer (hereinafter: financial pivot function). According to the court it is consistent with fulfilling such a financial pivot function, and thus an arm's length, non-tax consideration, that this financing entity raises funds from group entities and from third parties and then uses these funds to make loans to other group entities (such as the taxpayer).

In other words, in principle, a debt is predominantly based on commercial considerations if the affiliated entity from which the taxpayer obtained the debt performs financing activities in such a way that it thereby performs a pivotal financial function. Under such circumstances, funds cannot be said to have been diverted in a non-business-like way. This is not different if the affiliated lender obtained the funds used for that loan from another entity belonging to the same group. On the contrary, according to the court, performing a pivotal financial function within the group will often give rise to this. Therefore, if the affiliated entity performs a pivotal financial function, successful reliance on the rebuttal mechanism of Section 10a will not require to establish a link between the funds outstanding - from time to time - in the form of loans granted (the asset side of the lender's balance sheet) and the funds raised - from time to time - in the form of loans taken up and deposits obtained (the liability side of the lender's balance sheet).

When assessing whether an affiliated entity performs a pivotal financial function through its financing activities, the circumstances of the case must be considered in context. Central to this is that the entity or independent business unit performs an active financing function within the group of entities related to it. Furthermore, the entity or independent business unit in question must be mainly engaged in carrying out financial transactions on behalf of entities belonging to the group, such as borrowing and lending money and managing excess group resources. Furthermore, that (business unit of the) entity will have to be independent in the day-to-day conduct of its business, including the management of outstanding funds, and for that purpose it will have to have sufficient and competent staff and, if it is an independent business unit, its own administration. If that (business division of the) entity is bound by a centrally determined strategy for the group, this mere circumstance does not prevent it from being independent.

Finally, the Supreme Court also addressed the tax authorities' position that if deductibility of the interest costs can not be based on Section 10a, that such deductibility would have to be refused based on abuse of law considerations. According to the court this position, which has been defended by the tax authorities ever since these anti-base erosion rules were introduced in 1996, is not possible. The prevailing doctrine is that two cumulative conditions must be met for abuse of law (fraus legis) to apply. First, tax avoidance must have been the overriding motive for carrying out the transaction(s), the motive requirement. This is a subjective requirement. Second, the act(s) must be contrary to the purpose and spirit of the law, also known as the norm requirement. This is an objective requirement. If interest costs are tax-deductible on the ground that the taxpayer has made it plausible that the loan and the related transaction are predominantly based on business considerations, this excludes the fulfilment of the motive requirement for application of abuse of law doctrine in respect of this same loan and transaction, according to the Supreme Court in today's decision. This means that the deduction of interest in that case cannot still be refused on the basis of the Dutch tax authorities reliance on this doctrine.

Conclusion

From today's decision it follows that:

• as decided before, the CITA does not prevent an international group of organizing its group in a certain way (including the use of a Dutch entity), unless specific rules apply;
• as decided before, the CITA does not require a Dutch taxpayer to be financed in a certain manner or to finance specific transactions in a certain manner, unless specific rules apply;
• if a transaction is based on business considerations and a Dutch taxpayer obtains a loan from an affiliated party that performs a pivotal financial function within the group, such taxpayer should be able to successfully apply the rebuttal rule under Section 10a, causing the tax-deductibility of the interest costs not to be restricted based on the anti-base erosion rules;
• if a Dutch taxpayer successfully applies the rebuttal rule under the anti-base erosion rules, there is no room for the Dutch tax authorities to deny the tax deductibility of the interest costs based on the general abuse of law doctrine.

Clearly, today's decision is welcomed by many taxpayers. Obviously, other elements of the CITA and other Dutch tax laws need to be considered before any decision about the structuring of a transaction, and its financing, can be taken.