Equity and Acquisition Financing in the Netherlands
A decision of the Court of North Holland shows that debt financing is becoming more and more difficult in the Netherlands for private equity acquisition structures.
In a decision of 27 June 2022 the Court of North Holland, one of 11 first-level courts in the Netherlands, disallowed 80 percent of the deduction of interest paid (about €7.7 million) on loans granted by European related group companies of a Swedish private equity fund for the 2012-2013 tax year (ECLI:NL:RBNHO:2022:6584).
A Swedish private equity firm had launched a Dutch fund in 2007 between four UK non-transparent limited partnerships, which were all managed by the same general partner. Investors participated in the LPs through undertakings to provide capital or loans to the LPs. These loans, for a total committed capital of about €1,7 million, did not carry interest.
In December 2012 the firm set up a Dutch BV to acquire Dutch target BVs. The acquisition by the new holding BV was financed by interest-bearing shareholder loans from the partnerships through a Luxembourg SARL, an intragroup loan from the Belgian NV that was the previous owner of the target BVs, and bank loans. All BVs were included in a fiscal unity so that the interest was set off against profits of the other BVs.
The Dutch tax authorities disallowed all interest deductions in respect of the shareholder loan and the intragroup loan based on article 10(1)(d) of the Dutch Corporate Income Tax Act. Loans can be recharacterized as equity – and interest on such loans can be disallowed - if the loans function as equity.
However, the court did not find this provision applicable because Dutch case law considers that the civil form is determining. For an exception to apply, there would have had to be an indication that the loans were sham loans or profit-participating loans, and this was not the case. When they entered into the agreements, the parties had the intention to repay the loans. Consequently, the loans did not function as equity.
Another argument raised by the tax authorities was that the taxpayer did not provide any transfer pricing documentation that could prove that the interest rate was at arm’s-length in accordance with article 8b CITA. However, pre-2016, Dutch taxpayers were left free in how they recorded the relevant information; the court noted that the taxpayer only used a so-called naked CUP that was not benchmarked with data from another publicly available database.
The court found that the tax authorities had not provided an alternative transfer pricing report substantiating their requested adjustment so that they did not meet their burden of proof.
The court then analysed the shareholder loan in the light of the abuse of law doctrine. The same type of financing could have been achieved with preference shares and if there was no other motive for the structuring than tax savings, this could be seen an abuse of law as the loan is commensurate with equity.
The court found that all the taxpayer’s profits were offset with interest expenses in the respective year and the taxpayer did not show that the interest payments were taxed in the hands of the creditors. Therefore, the court disallowed the interest payments for €4.5 million to the extent that it did not serve the refinancing of existing bank loans.
The events occurred before article 10a CITA was changed with effect from 2017. In the text for the tax years in dispute, that article denied the deduction of interest on acquisition debt from a related party unless the taxpayer demonstrates that the loan was given mainly for business reasons. The shareholder loan met the related-party criterion but did not constitute an undue diversion of funds because a taxpayer is free to choose the form of financing, equity or debt.
However, the court came to a different conclusion for the intragroup loan from the Belgian NV, because the aim of this loan was to bring all entities into the Dutch fiscal unity and this did not constitute a valid business reason. The court disallowed the deduction of interest in the amount of €1.7 million.
The court dismissed any violation of the EU right of free movement of capital because the abuse of law concept applies domestically and the Court of Justice of the European Union had held that EU law cannot serve to cover the abuse of rights.
It is doubtful that this decision will be overturned on appeal. It is in line with other recent decisions and it shows once more that planning debt finances is becoming more and more difficult for private equity acquisition structures, in particular in the Netherlands.
The tax authorities are always trying to get this type of loan recharacterized as an equity contribution with the transfer pricing rules. The OECD transfer pricing guidelines would probably allow this if it can be demonstrated that the loan could or would not have been put in place under similar terms in an unrelated-party setting. Historically, such recharacterization would be possible under Chapter I of the OECD transfer pricing guidelines and more recently in Chapter X. However, the Dutch tax authorities have not been successful with this approach before the Dutch courts in light of the case law of the Supreme Court.
Furthermore, article 10a CITA has introduced a special group interest limitation deduction rule in 2017, and additionally there are the interest deduction rules such as the interest barrier rule based on the EU directive.
Finally, it is to be noted that the court held that Interest expenses on private equity loans used to acquire a group of companies may be at arm’s length, but if they meet the abuse of law doctrine, they are not deductible. In that respect, it is not yet clear in Dutch case law at what level an abuse of law has to be tested because of lacking taxation of interest income. Is that the beneficial ownership one level up or two levels up or even further to the ultimate parent entity or shareholders.