Introduction
On 22 March 2024, the Dutch Supreme Court ruled on the deductibility of interest on subordinated internal loans (divided into three facilities) (the ‘Loans’) that were provided by a private equity group to a vehicle (‘BV’) that acquired the shares in a liquid bulk storage operator headquartered in the Netherlands (‘Target’). BV had financed the acquisition with approximately 80% debt (consisting of senior bank loans and the Loans) and 20% with equity.
The Court of Appeal had ruled (i) that the Loans qualified as uncommercial loans and that therefore the interest to be taken into account was only 2.5% (instead of the agreed, much higher rates) and (ii) that even this very low interest was not deductible as the Loans constituted an abuse of the Dutch Corporate Income Tax Act (‘CITA’). The Supreme Court upheld, without further motivation, the judgment of the Court of Appeal that the Loans were uncommercial. The Supreme Court, however, partly overruled the Court of Appeal’s judgment on the application of the abuse of law doctrine, by considering that the Loans were partly abusive; not for the remaining part.
Facts
BV was established for the acquisition of the Target by a Swedish private equity fund (‘Fund’). BV was indirectly held by four limited partnerships (each an ‘LP’, together the ‘LPs’) and each LP established a sub-fund, all being based in Guernsey (each a ‘Sub-fund’, together the ‘Sub-funds’). The Fund also established a fifth Guernsey LP, in which only investors in LP 1 participated as limited partners. This fifth Guernsey LP in turn established its own Sub-fund V. While Sub-fund I held almost 84% of the shares in BV, Sub-fund V did not hold any shares in BV.
The acquisition of the Target was financed by a senior bank facility, equity and the Loans. All Sub-funds contributed equity into BV and – pro rata to their equity contributions – provided debt financing in the form of the Loans, except for Sub-fund I, which only contributed equity and Sub-fund V which only provided a Loan, pro rata to the equity contribution of Sub-fund I. The Loans comprise 10-year facilities A, B and C with principal amounts of € 50 million, € 45 million and € 40 million, and interest rates of 11.5%, 12.75% and 14%, respectively. The Loans were subordinated to the senior bank debt (of which € 168.5 million was drawn) and also subordinated to each other (C to B and B to A). The interest on the Loans was added to the principal amount and payable upon redemption.
The interest rates of the Loans were determined on the basis an offer from a third-party bank for a mezzanine facility of € 36.2 million at an interest rate of Euribor + 12%, which offer was not accepted. At a later point in time, a benchmarking analysis was performed based on the Bloomberg database. As Bloomberg does not publish data on corporate loans with the credit rating at hand (CCC+), no comparables were found and, instead, interest rates on 10-year loans were extrapolated. The conclusion of this analysis was that the arm’s length interest rate would have been at least 10.64% on the Loans.
The Dutch Tax Administration (‘DTA’) disallowed the deduction of interest on the Loans on the basis of various arguments, the most notable being that (i) the Loans qualified as uncommercial and (ii) that funding the acquisition of the Target with the Loans constituted abuse of article 10a CITA as well as of the CITA as a whole. The DTA also disallowed the one-off deduction of the 4% arrangement fee on the senior debt. In this summary, we deal with the uncommercial loan and abuse of law aspects.
Decisions of the Court of Appeal and the Supreme Court
Uncommercial loan
The qualification of a loan as a so-called uncommercial loan means that the lender, by providing the loan, assumed a credit risk that a commercially behaving lender acting at arm’s length would not have accepted, unless at a profit-sharing remuneration.
According to the Court of Appeal, the Loans qualified as uncommercial, because the DTA successfully demonstrated that the credit rating of the Loans was not better than CCC as a result of which, no accurate comparables could be found for purposes of determining an arm’s length (fixed) interest rate.
The Court of Appeal also disagreed with BV’s arguments that the third-party mezzanine loan offer could serve as an internal comparable uncontrolled price (‘CUP’). The Court of Appeal considered the mezzanine loan offer not comparable with the Loans because of the substantial difference in principal amount, and the unavailability of information on the exact ranking of the third-party financing and on which entity would be the borrower of the mezzanine loan.
As a result of this qualification the Court of Appeal determined the applicable interest on the Loans at the risk-free rate of 2.5% (equal to the yield on 10-year German government bonds at the time), instead of the agreed rates (which were much higher).
The Supreme Court considered that the complaints of the taxpayer as to the ‘uncommerciality’ of the Loans cannot set aside the judgment of the Court of Appeal. The Supreme Court exercised its authority to not motivate why it arrived at this judgment. Therefore, the Court of Appeal’s qualification of the Loans as uncommercial has become final.
Abuse of law
As a second step, the Court of Appeal decided that even the risk-free rate was not deductible under the abuse of law doctrine (fraus legis). The Advocate-General advised the Supreme Court to confirm the decision of the Court of Appeal on abuse of law, which he considered to be in line with existing Supreme Court case law. The Supreme Court, however, ruled differently.
First, the Supreme Court considered whether the Loans constituted an abuse of the interest deduction limitation of article 10a CITA. In short, article 10a CITA applies to loans that are provided by ‘related parties’ (in very short, companies holding a direct or indirect interest of 1/3) and used to finance certain ‘tainted’ transactions. Only Sub-fund I qualified as a ‘related party’ within the definition of ‘related party’ of article 10a CITA, but Sub-fund I did not provide any of the Loans to BV. The Supreme Court, however, ruled that the Loans insofar provided by Sub-fund V formed an abuse of article 10a CITA, because LP 1 had provided its share of the funding to BV with the part of the Loans provided by Sub-fund V (instead of through Sub-fund I) with the only reason to avoid that that part of the Loans was provided by a ‘related party’ and would thus be in scope of article 10a CITA, which would make the interest non-deductible. As a result, the Supreme Court held that the interest on the part of the Loans provided by Sub-fund V is not deductible.
Secondly, the Supreme Court considered whether the Loans constituted an abuse of the CITA as a whole. Contrary to its decision in a similar case of 3 years ago, the Supreme Court decided that the Loans provided by the other Sub-funds are not abusive, as these Sub-funds are not ‘related’ to BV (within the meaning of article 10a CITA) and, as a general rule, it is not abusive for a non-related party to finance a Dutch entity with debt even though the lender finances its loan to the Dutch entity out of equity and such lender is not subject to tax on the interest income in its country of residence. According to the Supreme Court, this can only be different in very extraordinary situations, in which ‘the lines of legitimate tax savings are clearly crossed’.
Takeaways
The Supreme Court judgment is important for the Dutch tax and transfer pricing practice involving internal loans, particularly because it addresses the application of the abuse of law doctrine in more detail than it did in previous (high-profile) cases. Unfortunately, no further guidance was provided by the Supreme Court on the concept of the uncommercial loan.
Uncommercial loan
We struggle to follow the Court of Appeal’s analysis that no fixed at arm’s length interest rate for the Loans could be determined, solely due to the unavailability of external CUPs in a database and that this unavailability of comparable loans implies that only a profit-sharing remuneration for the Loans would have been possible. That being said, this judgment reconfirms that database benchmarks are relatively easily rejected as availability of data and comparability often is an issue, even when an analysis is carried out in line with the generally applied transfer pricing practice of using publicly available databases.
It is not clear to what extent BV substantiated any adjustments to the third-party mezzanine loan interest rate to establish the Loans’ interest rates, but it may well have been possible to make accurate adjustments to an internal CUP to sufficiently substantiate that an at arm’s length fixed interest rate would have been possible for the Loans (also considering the substantial equity cushion of approximately 20%). Economically, it clearly makes much more sense to use an internal CUP with adjustments as a reference point for determining the arm’s length interest rate on an internal loan, instead of using the outcome of a benchmark that returns data with a low level of comparability, albeit that in this case the third-party senior facility (which was actually drawn) may have been a better reference than the unused mezzanine loan.
Abuse of law
Although as the result of this decision, in the case at hand, the major part of the interest on the Loans is still not deductible, the decision contains a very important decision on the concept of ‘abuse of law’. The Supreme Court clarified that it is in principle not an abuse of the CITA if a party that is not ‘related’ within the meaning of article 10a CITA provides a loan to a Dutch acquisition company, even though this party is an entity that resides in a tax haven and has financed the loan out of equity. This decision therefore seems to contradict another decision of the Supreme Court of three years ago (in the Hunkemöller case), where such loans (also from unrelated, tax-exempt entities) were considered an abuse of the CITA, because they were considered useless, not to serve any commercial goal and implemented with the main purpose to erode the Dutch corporate income tax base.
What to do?
- If you are currently facing challenges by the authorities about the arm’s length pricing of shareholder loans or other internal debt, we advise performing an economic analysis to review whether the shareholder loan may be qualified as an uncommercial loan and the shareholder loan’s coupon logically relates to the existing external debt’s loan pricing. This is also in line with the opinion of the Advocate-General in a different case. We refer to our previous summary.
- If you are not (yet) facing challenges, similar actions could be taken to allow you to make adequate adjustments, if any, and align the interest coupon of the shareholder loan with the economic analysis.
- If you consider implementing internal loans for the financing of a project or an acquisition, ensure that you align the interest coupon and debt volume with the external debt data by performing a cash flow-based economic analysis.
Contacts
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Stephan Kraan +31 20 247 03 01 |
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Mark van Casteren +31 20 247 03 04 |
