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Box 3 soap

Peter Kavelaars

It surely hasn't escaped many: the Supreme Court added another episode to the Dutch box 3 soap on June 6. It undoubtedly won't be the last ruling. But that is for the future. Let's first look at what has now been decided and what the consequences are. To refresh the memory, a brief look back. Starting in 2001, box 3 was introduced, which was supposed to entail a simple way of taxing income from capital: everyone is fiscally assumed to enjoy a 4% return on their capital, which is then taxed. The actual return is not relevant, and the capital is always measured on January 1 of the tax year. Simplicity and injustice guaranteed. However, this did not eventually break the system. The Supreme Court protected the legislature for a long time, expecting it to come up with a fairer system where real capital income would be taxed. But that system did not come. Just to be safe, in 2017, the legislature introduced a different methodology. In it, the considered return increases with the size of the capital. The idea was that the more capital someone has, the more riskily it is invested, leading to a higher return. However, the core problem was that this did not consider the actual composition of the capital. Someone with a large capital entirely in a savings account was thus taxed for a high return while the interest at that time was little more than nil. The Supreme Court deemed this in violation of the European Convention on Human Rights. Thus, in 2021, that levy fell in the notorious Christmas ruling.

The legislature then put together new legislation under the name Recovery Act. In it, aside from debts, a distinction is made between savings deposits and investments. Each has its own percentage and aligns with recent real returns. The percentages are therefore set anew each year. Moreover, the percentages are applied to the actual composition of a taxpayer's capital. For someone who only has savings deposits, only the corresponding percentage is applied. The legislature assumed that this would sufficiently closely align with the real return. This system would initially apply until the end of 2022, after which a similar system would be applied for 2023-2026. Finally, in 2027, the definitive system should be introduced where real incomes are taxed, and in addition, capital mutations. In the latter, a distinction is made between a capital gains tax for real estate and a capital accretion tax for other investments. The difference is that the latter also taxes unrealized results annually.

Back to the Recovery Act because that is what the June 6 ruling is about. The legislature thought it was on the right track with the new system, but many taxpayers saw it differently. The point remained that income is still determined on a standard basis, and this does not have to correspond at all with the real income. Especially with investments, this is quite likely. Firstly, because investments can yield very different returns for an individual taxpayer than the legally assumed standard return. Secondly, the legislature, in determining the standard return, proceeds from a certain average capital mix. For individual taxpayers, this does not have to match, for example, because one taxpayer only invests in risky stocks, another takes little risk, and a third mainly invests in real estate. In short, the Supreme Court is of the opinion that these taxpayers have a point here: the real return can deviate significantly from the actual return, and in addition, comparable taxpayers can achieve very different real returns among themselves. Yet, under the Recovery Act, they are all taxed equally. This is unacceptable to the Supreme Court. At least for investments. It does not apply to savings deposits because that is a more or less unambiguous product where the interest is more or less the same, and the standard interest considered closely aligns with the real interest. In short: only the investing taxpayers benefit from the ruling.

What does this mean now? If a taxpayer can demonstrate that his investment return in a year is lower than the standard return, he may not be taxed more than the actual return. This applies from 2017 and runs in principle until 2027 because only then will the new system be implemented. The reverse is also not true: if the actual return is higher than the standard return, the tax authority may not levy additional taxes. The government is always the loser. Furthermore, it is important how the actual return should be calculated. In the first place, this naturally consists mainly of dividends and rental income. In addition, however, the value change must also be considered annually, regardless of whether it has been realized. This last is very important for the year 2022 for stocks in particular: they fell strongly in value. For real estate in particular, the Supreme Court made a less pleasant decision: costs may not be deducted. The background to this is twofold: in box 3, only capital components are considered, and if costs are considered, the problem arises that maintenance costs should, but improvement costs should not, be deducted. That distinction is tricky. Because debts in box 3 do come into consideration, financing costs may be taken into account. This latter is particularly important for real estate, of course.

There is therefore work to be done: on the one hand, for investing taxpayers who must calculate their real return, and on the other hand, for the tax authorities that must check this. This will undoubtedly lead to disputes. And so, we must continue with this, at least until 2026.

Peter Kavelaars is Professor of Fiscal Economics at Erasmus University Rotterdam and of counsel at Deloitte Dutch Caribbean.

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