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Dutch Supreme Court clarifies the Non-Arm’s Length Loan Doctrine
In a recent ruling, the Dutch Supreme Court (the "Court") clarified the conditions for write-offs with respect to intra-group loans. The Court ruled that a tax deduction is denied if the lender assumed a non-arm's length credit risk on the loan. A credit risk is considered non-arm's length if the interest payable on the loan is viewed as non-arm's length and the only way to adjust to an at arm's length interest would have been to make the loan effectively profit-sharing. The Court also ruled that an intra-group loan which is initially regarded as arm's length may lose its arm's length character if the borrower becomes thinly capitalised during the term of the loan and the lender refrains from taking action to secure its rights.
Nevertheless, the Court clarified that the arm's length interest rate for intra-group loans should be the rate that would have applied had the borrower taken out a loan from a third party with a guarantee from the affiliated lender. Taxand Netherlands analyses the Dutch Supreme Court's clarification of the non-arm's length loan doctrine, and highlights what companies involved in intra-group financing activities should be doing to stay in check.Under Dutch case law, a loan will be characterised as equity if it is a profit participation loan, sham loan or bottomless pit loan.
The implications of the re-characterisation are as follows:
- interest may not be deducted by the borrower
- interest is considered a dividend for the lender and will be exempt if the lender qualifies for a participation exemption
- write-offs may not be deducted from the lender's taxable profit.
However, based on a recent ruling, the Court decided that a write-off made in respect of a loan that is not re-characterised will nevertheless be denied a deduction if the lender accepted a non-arm's length credit risk by providing the loan. The ruling contains five elements as follows:
A loan is considered a non-arm's length loan if the interest rate on the loan is not arm's length and the only way to adjust to an at arm's length rate would have been to make the loan effectively profit sharing. For example, a parent company transfers a EUR5 million portfolio of passive investments (stocks and bonds) to a subsidiary, which financed the purchase wholly with an intra-group loan. Assuming that the subsidiary has no other assets, the lender assumes an asymmetric credit risk under such situation as the fulfilment of debt obligations by the subsidiary as a borrower is entirely dependent on the underlying assets' performance. As the lender does not share the positive performance of the underlying assets, the only way to adequately remunerate the lender for the credit risk assumed is to make the loan a profit-sharing loan. However, the Court ruled that such an adjustment would materially change the transaction and is therefore not possible under Dutch law.
2. Write-offs for the lender are not deductible
The Court ruled that a write-off made on a non-arm's length loan is not deductible for the lender. However, if the lender holds shares in the borrower, the non-deductible loss may be added to the historic cost price of the shares. In the event of the subsidiary's liquidation, the loss will generally become deductible as a liquidation loss.
3. A normal loan may 'change' into a non-arm's length loan during its term
An intra-group loan which is initially regarded as being an arm's length loan may lose its arm's length character if the borrower becomes thinly capitalised during the term of the loan and the lender refrains from taking action to secure its creditor's rights.
4. The interest to be imputed on a non-arm's length loan is established at the rate that would have applied, had the borrower taken a loan from a third party with a guarantee from the lender
The interest imputed will be deductible for the borrower and taxable for the lender at the regular Dutch corporate tax rate (i.e. 20-25% for corporations). For example, a parent provides a EUR1 million non-arm's length loan to its subsidiary and the subsidiary would be able to obtain the same loan from a third party bank at 6% interest if guaranteed by the parent. In this case, the rate of 6% will be considered the arm's length interest rate. In Dutch literature it was argued that the rate should be the risk-free rate (normally lower than the market rate with guarantee).The Court, however, ruled that this would lead to structural losses for the lender, if the lender itself finances the non-arm's length loan to the affiliated borrower with a loan taken from a third party. The lender would then pay an interest based on its own credit risks (6% based on the example above) and would receive a lower risk-free interest from the borrower.
5. A non-arm's length loan cannot be split
A non-arm's length loan cannot be split between an arm's length part and a non-arm's length part. It has been argued by various parties that taxpayers could make such split, which would make a write-off partly deductible. The Court however ruled against such split.
The decision made under this recent ruling would likely result in the increased scrutiny of the Dutch tax authority with respect to write-offs on intra-group loans, especially if the borrower is thinly capitalised. In addition to establishing the arm's length character of an intra-group loan when it is granted, arm's length covenants should also be included into the loan agreements. Intra-group loans must also be continuously monitored to ensure that interest rates applied are arm's length and that other arm's length adjustments can be made on a timely basis if the borrower becomes thinly capitalised (e.g. due to losses) during the term of the loan.
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