Notional interest deduction: two forms of artificial transaction in focus

Introduction
Intra-group financing flows
Conversion of shares into receivables

Introduction

Since 2006 Belgian corporate taxpayers have benefited from a deduction for risk capital, known as the 'notional interest deduction'. Pursuant to this regime, a company is treated as if it had borrowed its own funds at an annual interest rate equal to that of the 10-year Belgian government bond. For tax year 2012 (accounting period 2011) the applicable rate is 3.425%. The notional interest thus computed is deductible from the tax base (for further details please see "Notional interest deduction rebalances equity and borrowings").

The measure offers advantageous tax-planning opportunities for both Belgian and foreign entities. In order to tackle abuse of the regime, a number of specific rules apply in addition to the anti-abuse measures that generally apply in Belgian tax law. The authorities recently issued a circular letter that identifies two artificial transactions which, in certain circumstances, may constitute abuse.

Intra-group financing flows

The authorities have confirmed the legitimacy of capitalising a group financing company that benefits from the notional interest deduction regime and subsequently uses this capital to grant loans to group companies - a frequently used form of transaction. The circular letter adds that such an operation is permissible as long as the financing company is not a mere artificial structure, without economic substance and incorporated solely to avoid Belgian tax. The authorities have specified that the group must be consistent in using the Belgian company as a financing company.

However, the capitalisation of a Belgian financing company may be considered artificial if the company, immediately after being capitalised, loans its capitalising parent company an amount that represents a significant part of the contributed capital. In such a transaction the capitalising parent company normally deducts the interest payable to the Belgian financing company in respect of the loan, while the financing company does not pay Belgian tax on all or part of this interest income, depending on the amount of notional interest deduction available to it.

The circular letter requires the tax authorities to verify whether the transaction is a sham or is not at arm's length. This requirement is consistent with the authorities' previous circular letter on the issue. When auditing this type of transaction, the authorities will consider whether:

• the number of companies involved is limited;
• the capitalisation and subsequent loan by the Belgian financing company are simultaneous or nearly simultaneous;
• the terms and conditions of the loan between the Belgian financing company and the capitalising parent company are unusual; and
• the transaction complies with rules on financial assistance.

The circular letter indicates that the authorities should not target good-faith cash contributions to a Belgian financing company by a group company pursuant to the realisation of significant capital gains (eg, following the sale of an activity outside the group) or the reimbursement of a loan if, some time later, the group company that contributed the cash requires financing as a result of a major acquisition or other investment, with the subsequent transactions involving different amounts and being substantiated by underlying contracts.

Conversion of shares into receivables

The circular letter confirms that the authorities consider it normal for group entities to restructure activities, shareholdings or shares in order to enhance the specialist character of financing activities by isolating them from the management of shareholdings. However, if a Belgian group financing company, using the notional interest deduction regime, realises a significant capital gain on the sale of a shareholding to another group company, although the acquiring group company clearly does not have the necessary funds for this acquisition and is not in a financial position to repay the loan to the Belgian financing company, the authorities may consider the transaction to be artificial.

In such transactions the capital gain on the shareholding realised by the Belgian financing company is normally tax exempt. Since shares that qualify as fixed assets reduce the amount of a company's own funds that constitute the basis on which the notional interest deduction is calculated, selling the shares theoretically increases the financing company's basis for this purpose. If the sum of the realised capital gain is incorporated into the company's own funds, this implies an additional increase in the basis. At the same time, the acquiring group company can generally deduct the interest in respect of the loan payable to the financing company; as a rule, the latter will not pay Belgian tax on all or part of the interest income, depending on the amount of notional interest deduction available to it.

The circular letter requires the authorities to verify whether:

• the transaction is a sham;
• the transfer or sales price corresponds to the market value of the assets being transferred;
• the payment terms and conditions (ie, instalments or spread) are typical of the market to avoid an artificial increase in the financing company's own funds; and
• the financing company benefited from transactions which were not at arm's length - in particular, this will be the case if the financing company obtained benefits pursuant to a transaction that took place in unusual circumstances and without an economic rationale, but purely for tax purposes.

The particularly significant factors for the authorities will be whether:

• the financial situation of the acquiring group company was clearly inappropriate to the transaction; and
• the terms and conditions of the loan between the Belgian financing company and the acquiring group company differ significantly from those that would normally apply between independent parties.

The authorities should identify which party bears the risk of the transaction. If it is clear that the acquiring group company would have been unable to finance the acquisition of the shareholding without a loan (which is not at arm's length) from the Belgian financing company, the latter bears the total financial risk with respect to the transaction.

For further information on this topic please contact Henk Verstraete or An Kuijpers at Liedekerke Wolters Waelbroeck Kirkpatrick by telephone (+32 25 51 15 15), fax (+32 25 51 14 14) or email ([email protected] or [email protected]).