Supreme Court clarifies conditions for interest deduction in acquisition structure

Introduction

Recently, the Supreme Court once again ruled on interest deduction in an acquisition structure. The key issue hinged on whether interest deduction could be refused in full or in part under either Article 10a CITA 1969 or fraud of law (fraus legis). Another disputed issue was whether non recurring costs for raising external loans must be capitalised and amortised, or whether a lump sum deduction was allowed.

On 1 February 2011, an investment fund of a Swedish private equity house acquired Dutch X Group for EUR 322.7m. The interested party, an intermediate holding company and an offering company were incorporated to this end. Effective from 1 February 2011, several acquired companies were consolidated into a fiscal unity, with the offering company being the parent company. On 3 February 2011, the offering company itself, in the capacity of a subsidiary, became part of a fiscal unity with the interested party (in the capacity of parent company) and the intermediate holding company.

The investment fund initially consisted of four limited partnerships (LP 1, LP 2, LP 3 and LP 4). Each of them incorporated one Guernsey-based sub-fund (sub-funds I, II, III and IV). After announcing the acquisition in December 2010, these sub-funds incorporated a Dutch cooperative, in which LP 1 had 83.8% of the membership rights. The percentages for the other sub-funds were 4.4% (LP 2), 9.9% (LP 3) and 2.2% (LP 4), respectively. Voting rights were equally divided (25% each). A fifth LP was incorporated in January 2011 (LP 1A), also with a sub-fund in Guernsey (sub-fund V). This fund has no membership rights or voting rights in the cooperative. What’s more, the investors are the same as in LP 1.

The cooperative initially held all the shares in the interested party. However, upon the acquisition 15.51% of the shares was transferred to a family business of the sellers of X Group (FamBV). In November 2011, a further 2.36% of the shares was transferred to a company in which managers of X Group participated (ManBV). The acquisition was partly financed with equity (EUR 81.3 million) and subordinated loans (EUR 135 million) from the investment fund. Sub-fund I did provide equity, but no debt capital, while sub-fund V, on the other hand, provided only loans. The remaining part of the purchase price was borrowed from a banking syndicate. An arrangement fee of EUR 8.4m had to be paid to raise this financing.

Dispute on appeal

The dispute for the year 2011 regards the interest deduction on the subordinated loans and whether the arrangement fee paid can be charged to the profit in one go. The Amsterdam Court of Appeal ruled that although interest deduction cannot be refused under Article 10a CITA 1969, since the subordinated loans were not granted by affiliated entities, it can still be refused on grounds of fraus legis. The Court of Appeal argued that the division of the loans among the sub funds was not based on business motives. Instead, its overriding motive was the avoidance of the affiliation criterion in art 10a CITA 1969. In addition to this, the legislator intended to limit deduction of interest on loans that have no real business function, but are rather aimed at avoiding taxation (norm requirement). The Court of Appeal argued that only the interest on the loan from FamBV is deductible, as this company is not part of the interested party’s group. The Court of Appeal took the position that the arrangement fee should be capitalised and amortised. The interested party lodged an appeal in cassation against this ruling.

Aim and purpose of the interest deduction restriction

Under Article 10a(1)(c) CITA 1969, interest on debts raised with an affiliated entity is not deductible insofar as these debts relate to the acquisition or expansion of an interest in an entity that qualifies as an affiliated entity after that acquisition. This is different if the taxpayer can successfully invoke the rebuttal evidence scheme.

First and foremost, the Supreme Court argued that the first provision aims to prevent erosion of the Dutch tax base by refusing the deduction of interest on debts raised arbitrarily and without any business reasons. The latter is the case if, within a group of affiliated entities, the method of financing a transaction based on business motives is motivated by tax motives to such an extent that it includes unnecessary legal acts, which would not have been carried out without those tax motives. It does need to involve base erosion within a group. Article 10a(1)(c) CITA 1969 generally does not apply if the debt is raised with an entity that is not related to the taxpayer as referred to in Article 10a(4) CITA 1969.

Interest deduction may nevertheless be denied if raising a debt with a non-affiliated entity is part of a complex of legal acts between affiliated entities for the purpose of frustrating affiliation. Otherwise, this would be at odds with the aim and purpose of Article 10a(1)(c) CITA 1969. On this basis, the Court of Appel rightly held that deduction of the interest on the loan provided by sub-fund V should be disallowed despite the fact that it is not an entity affiliated with the interested party. The same investors participate in sub-funds I and V, while it has been established in law that sub-fund I does constitute an entity affiliated with the interested party. Had the loan been granted by sub-fund I, there would have been no interest deduction at all. Successfully invoking the rebuttal evidence scheme is out of the question, as the Court of Appeal found that both sub-fund I and sub fund V are subject to Guernsey profits tax at a rate of nil.

However, with regard to the subordinated loans of the other sub-funds (II, III and IV), the Court of Appeal erred in denying interest deduction. These funds are not affiliated entities of the interested party. Moreover, there is no complex of legal acts to frustrate affiliation. While it is true that corporate income tax is saved, there is no base erosion contrary to the aim and purpose of Article 10a CITA 1969.

Fraus legis

There is no fraus legis in respect of the CITA 1969 either. The Supreme Court argued that it cannot be deduced from the legislative history of this Act that its aim and purpose as a whole have a more far reaching meaning than art. 10a(1)(c) CITA 1969. It is true that the legislator has stated that fraus legis can be at issue if an interest deduction restriction does not apply, but in that case it must be an exceptional situation in which the limit of permissible tax savings is exceeded by a wide margin. The Supreme Court argued that this situation is not very likely to occur in practice, and is also not at issue in this case.

Arrangement fee

Finally, the Supreme Court considered that the arrangement fee paid is deductible as a lump sum, although capitalisation and amortisation thereon during the term of the financing is allowed. The matching principle of sound business practice does not require that one-off costs, such as brokerage or commitment fees, be capitalised. Such costs result from the raising of a loan and are not offset against the availability of a certain sum of money during the term. These expenses leave the taxpayer's assets permanently, regardless of any early repayment of the loan. The above does not change if the loan is used to finance an asset. Even in that case, the link between the one-off borrowing cost and future income is not sufficiently close.

Capitalisation would only then be mandatory if the parties did not intend to agree on a one-off payment for borrowing costs, but essentially agreed to reduce annual interest expenses in exchange for a one-off payment. However, the burden of proof that this is the case rests on the Tax Inspector. The Supreme Court found that the Tax Inspector failed to meet this burden of proof and settled the matter themselves in respect of this matter. Still, the Court of Appeal to which the case is referred back does have to address the question as to what amount of interest is deductible.

Source: HR 22 March 2024, 21/01534, ECLI:NL:HR:2024:469