On 2 September 2022, the Supreme Court of the Netherlands requested a preliminary ruling from the Court of Justice of the European Union (CJEU) on whether EU law precludes the application of the anti-base erosion rule in article 10a of the Corporate Income Tax Act of 1969 (CITA).
Article 10a provides that a Dutch company may not deduct interest expense incurred on a loan from a related company if the funds are used for a “tainted transaction.” One example of a tainted transaction is the acquisition of shares in a company, which then becomes related. A taxpayer can avoid forfeiting the interest expense deduction if it is able to demonstrate that there are predominantly sound business reasons for the debt and the tainted transaction; however, simply showing that the loan is on arm’s length terms is insufficient. Other exceptions to the limitation in article 10a may apply but they are not relevant to the case at hand.
Two recent cases decided by the CJEU and the EFTA (European Free Trade Association) court would indicate that at least certain interest expense deduction rules may not be compatible with EU/EEA principles.
In 2021, the CJEU ruled in the Lexel case that a Swedish limitation on the deduction of interest expense similar to article 10a was incompatible with EU law because it did not only target purely artificial arrangements—it also included transactions that were carried out on arm’s length terms and, therefore, should be considered a disproportionate measure to tackle abuse.
More recently, on 1 June 2022, the EFTA court reached a similar conclusion in a case involving Norway’s interest deduction limitation rules (PRA Group Europe AS). The generic interest deduction limitation in question was, with reference to the Lexel case, also considered to be disproportionate as it covered transactions that were carried out on arm’s length terms.
The case before the Dutch court involves a Dutch company that initially acquired a majority of the shares of another company and its Belgian parent company acquired the remainder of the shares; shortly thereafter, the Dutch company acquired the remaining shares from its parent. To finance both acquisitions, the Dutch company obtained a loan from a related Belgium company that applied the now long-abolished Belgian coordination centre regime, under which the interest income was taxed at an effective tax rate of less than 1%. The Dutch tax inspector disallowed the deduction of interest at the level of the Dutch company based on article 10a. Although the loan related to an external acquisition—on its own, a business reason—the manner of the financing was considered to lack business reasons because the funds were contributed by the Belgian parent company to the coordination centre and then loaned to the Dutch company. The Dutch lower courts considered this “re-routing” to be tax-motivated. As there must be sound business reasons for both the transaction and the manner of financing to rebut the restriction on the deduction of interest in article 10a, the interest deduction was disallowed.
Since the Lexel decision, it appears that a limitation on the deduction of interest expense may be incompatible with EU law if the restriction applies to transactions that are carried out on arm’s length terms and are not purely artificial or fictitious arrangements created with a view to avoiding the tax normally due on profits generated by activities carried out in the national territory. This focus on the terms and conditions of the interest expense (whether they exceed an arm’s length amount) is a different focus than article 10a CITA, which focuses more on anti-base erosion due to an (alleged) artificial creation and use of the funds (whether there is a real financing function without artificial re-routing).
The decisions of the CJEU and the EFTA court in the Lexel and PRA Group Europe AS cases, respectively, created sufficient doubt with the Dutch Supreme Court about the interpretation of EU law as regards article 10a, and the court correctly requested a preliminary ruling from the CJEU. Taxpayers whose interest deductions have been disallowed based on article 10a may now object to any open tax assessments and take this development into account in the preparation of their tax returns. Whether the above also applies to the generic interest deduction, or earnings stripping rule, remains to be seen.
Frederik Boulogne
frederik.boulogne@bdo.nl