Recent case law illustrates the need for companies to carefully consider the risk of interest deductions being disallowed if they use a related party debt to fund an acquisition through a Dutch holding company. On 5 June 2015, the Supreme Court rendered a significant decision on the Dutch base erosion rules. These rules seek to disallow interest deductions by a Dutch company where, for tax reasons, it borrows from a related party in connection with a capital contribution, dividend distribution or acquisition. The Supreme Court rejected specific arguments supporting an interest deduction in this type of situation. It ruled that even in the case of an acquisition outside the group, the borrowing from the related party should be based mainly on commercial considerations.
Dutch base erosion rules
For Dutch corporate income tax purposes, interest charged to a resident taxpayer is not deductible if the interest accrues on related party debt and the related party debt is connected with certain transactions in equity instruments, such as capital contributions, dividend distributions or acquisitions. An exception applies, however, if the taxpayer demonstrates that both the borrowing from a related party and the capital contribution, dividend distribution or acquisition are mainly motivated by commercial reasons. In that case, the interest deduction is allowed.
Acquisition funding through Mauritius
The case before the Supreme Court involved two Dutch resident taxpayers that are part of a South African media group. In 2007, the media group’s listed parent company issued shares. The parent company lent a part of the share issue proceeds to its subsidiary, a South African resident holding company. This South African holding company then contributed the funds to a Mauritian resident holding company (HoldCo). HoldCo on-lent the same funds to the media group’s Mauritian resident financing company (FinCo).
In 2007, the two Dutch resident taxpayers carried out various acquisitions, financed in part by borrowing the funds held by FinCo as a result of the share issue. The Dutch resident taxpayers financed the rest by funds that were available to HoldCo, such as dividend income from HoldCo’s subsidiaries.
As a result of the financing structure, the Dutch resident taxpayers took on related party debt in connection with their acquisitions. They claimed an interest deduction for the borrowing from FinCo, arguing that both the acquisitions and the borrowing were mainly motivated by commercial reasons.
Interest deduction for FinCo funding denied
Before addressing the Dutch resident taxpayers’ arguments in favour of an interest deduction, the Supreme Court emphasised that it is up to the taxpayer to demonstrate that commercial reasons predominantly motivated the decision to borrow from a related party and to enter into the acquisitions. In this respect, the Supreme Court ruled that this burden of proof is not met by merely considering the taxpayer’s reasons for entering into the transactions. The reasons of all parties involved in the transactions have to be considered when determining whether the transactions were indeed motivated by commercial reasons. This means that a taxpayer cannot successfully claim the interest deduction by arguing that it had no alternative but to accept the offer from a related party to extend a loan.
This does not mean, however, that debt financing is more ‘suspect’ for Dutch corporate income tax purposes than equity financing. The Supreme Court reiterated its recent case law that a parent company may freely decide to fund its subsidiary by debt or equity. In particular, if a taxpayer borrows funds directly, instead of indirectly through a low-taxed group finance company, the Dutch legislature has to accept the tax consequences of choosing debt financing over equity financing, notably the interest deduction reducing the taxpayer’s taxable profits.
After this preliminary discussion, the Supreme Court turned to the Dutch resident taxpayers’ arguments. The first argument relied on case law of the Supreme Court concerning its abuse of law doctrine (fraus legis). The taxpayers argued that the acquisitions from third parties as well as the funding of the acquisitions by related party debt were predominantly motivated by commercial reasons. The Supreme Court dismissed this argument, ruling that the case law is not relevant to the Dutch base erosion rules.
The second argument relied on legislative history. The taxpayers asserted that obtaining related party funds had been based on commercial reasons because the debt arose from a share issue and the share issue proceeds were not diverted through FinCo with a view to a specific acquisition but only with a view to engaging in acquisitions in general. The Supreme Court also dismissed this argument. It ruled that the particular moment when a taxpayer decides to perform a specific acquisition is not decisive in establishing commercial reasons (if any) for borrowing related party debt.
The Supreme Court denied the interest deduction for the acquisition funding through FinCo and referred the case to a different lower court to determine whether commercial reasons had duly motivated the acquisition funding provided by HoldCo.