In a legislative proposal published yesterday, the Dutch government sets out the most recent attempt to alleviate the consequences of the Bosal decision. The legislation intends to curb structures that make use of the imbalance in the Dutch Corporate Income Tax Act ("CITA") that grants an exemption for certain shareholdings ("participations") while allowing a deduction for related expenses, including interest expenses. Although it is intended as an anti-abuse measure, it determines whether there is an "excessive and undesirable financing of participations with debt" mostly through formulae, without a general opportunity of rebuttal. Because of such formulaic approach, the application of the rule appears to be a bit wider and less intuitive than one would expect. This makes a review of the effects the proposal has on existing structures necessary.
The proposal is only the latest installment in the series of responses to the decision the ECJ took in the Bosal case on September 18, 2003 and the State Council expects it will not be the last. There is one ray of hope: the government promised to try to abolish the thin capitalization measures – a previous response to the Bosal case – but only if and when budget permits.
Before the ECJ’s decision in Bosal, the deduction of participation-related interest was mostly balanced. Because profit (income and gains) from an equity participation was generally exempt, expenses in relation to that participation (including, for example, interest expenses on acquisition debt) would not be deductible for corporate income tax purposes. There was, however, one crucial exception to this rule: costs were deductible if they were indirectly instrumental in making profits that were taxable in the Netherlands. While this may have made sense in a domestic context, it did not go down well with the ECJ, which decided in the Bosal case that this distinction was not allowed as it presented an infringement of the freedom of establishment that could not be justified.
After the decision, the Dutch government thought itself faced with two alternative responses: disallowing deduction of participation-related expenses altogether or generally allowing deduction of expenses related to all equity participations, domestic and foreign, within the EU. It chose the latter (without, in fact, limiting deductions to participations within the EU) and this decision marked the start of a long process of implementing a series of consecutive studies and measures intended to mitigate the budgetary effects and unintended use of the ECJ’s decision, starting with the introduction of the thin capitalization rules. More recently interest deduction limitation rules for acquisition holding companies were introduced.
The New Proposal
The current proposal aims to disallow the deduction of interest due and expenses made in respect of loans that are deemed to be related to the financing of participations ("participation loans") to the extent such interests/expenses exceed a threshold amount of € 1 million.
Whether loans are deemed related to the financing of participations will be determined by a formula. Loans will only be deemed to be participation loans to the extent the equity of the taxpayer exceeds the acquisition price  of its participations. If the equity is not exceeded, the participations are considered to have been financed with equity only and the measure will not have the effect of limiting the deduction of interest expenses.
Even if there are participation loans under this rule (i.e. the aggregate acquisition price exceeds the equity), loans that generate interest that is not deductible under certain other corporate income tax provisions (the anti-base erosion rules of article 10a of the CITA and the hybrid loan rule of article 10b of the CITA) will be deemed to have been used to acquire the participations to the extent such loans are related to transactions that otherwise increase the participation loans. One could say that participations are first deemed to be financed with equity and next, to that extent, with such tainted loans the interest on which is disallowed anyway. This is to the taxpayer's benefit as the measure will only have effect if the acquisition price of participations exceeds the amount of equity and of related tainted loans.
A final important exception is made for increases in operating activities of the taxpayer's group. To the extent an increase in the acquisition price of participations relates to an increase in such operational activities, such increase will generally be disregarded for the purpose of determining whether there are participating loans (i.e. an excess of participations over the equity of a taxpayer). This would also make the measure less likely to have the effect of disallowing interest expenses. However, the proposal does not contain a definition of operating activities and does contain a number of exceptions for certain situations of perceived abuse, which the measure intends to curb; in short:
- double dips (interest is deducted twice by affiliates);
- different qualification of payments, without an adequate compensating levy; and
- increases in the acquisition price of participations that are mainly done for tax purposes (deduction of interest/expenses).
From the way these exceptions are drafted it appears they might reach further than they should. For a U.S. multinational it may for instance be very relevant which foreign subsidiaries it has checked as transparent for U.S. federal income tax, while that may not be aimed at getting a double dip (nor be successful if that was the aim). The memorandum accompanying the legislative proposal provides a wide range of examples to which these exceptions may apply.
It is interesting to see that the proposal lists the various rules that may lead interest to be wholly of partly non-deductible, it lists seven different rules and misses at least one (the fraus legis doctrine to the extent not yet codified in article 10a CITA). The government notes that one of the existing rules – the thin capitalization rule – is not adequate as it applies too broadly and does not target a well-defined type of abuse. It goes on by stating that it wishes to abolish the thin capitalization rule and will do so once the budgetary room to do so is found. This amounts to a clear conflict between a sensible levy of tax and the reality of a balanced budget, similar to the one that marked the beginning of the Bosal saga. It might have been expected that the budgetary arguments would win in these times of financial turmoil, but after this admission by the government it will only be harder to explain to the taxpayers who are hit by this rule. The State Council suggested that the comment of the government to only abolish the thin capitalization rule if the requisite budgetary room is found shows too low a level of ambition.
The government states that the proposal to alleviate the imbalance caused by the Bosal decision intends to hit only cases of excessive deductions. It tries to do so by introducing a threshold of € 1 million of deductible interest, by assuming participations are financed with equity and otherwise tainted loans to the maximum extent and by providing an escape for debt-financed investments that increase the operating activities of the taxpayer's group.
On the other hand, it contains exceptions (accompanied by many examples) that give the impression that many situations involving different qualifications of entities (including check the box) and of cash streams (e.g. hybrid loans) are suspect. The actual range of the proposals may be a bit wider than expected on first glance.
It is a good development that the government states that the thin capitalization rules should be abolished given the budgetary means and one can only hope such means will be present before the end of this year.