By Jian-Cheng Ku, Gabriël van Gelder, & Mehdi el Manouzi, DLA Piper Nederland N.V., Amsterdam
In a ruling published May 15, the Netherlands Supreme Court has considered whether perpetual loans should be viewed as debt or equity for tax purposes.
The Supreme Court has upheld the Court of Appeal’s judgement, finding fixed-to-floating rate perpetual capital securities are debt for Dutch tax purposes.
As part of a financing arrangement to acquire an external group, a Dutch energy network company issued fixed-to-floating rate perpetual capital securities for a total amount of EUR 500 million on Euronext Amsterdam.
The perpetual securities were ranked on an equal footing (pari passu) with preference shares, had no fixed maturity date, and the interest remuneration did not depend on the profit of the borrower.
The Dutch tax authorities disallowed the deductibility of the interest costs connected with the perpetual securities on the basis that they should be considered as an equity contribution and not debt.
Furthermore, the Dutch tax authorities stated that the perpetual securities should be considered as a profit participating loan due to the perpetuality, subordination, and the possibility for the debtor to suspend interest payments.
Dutch tax treatment of debt and equity
In general, subject to (non-)statutory restrictions on interest deduction, costs related to debt financing are deductible for Dutch tax purposes; payments related to equity financing are non-deductible for Dutch tax purposes.
Consequently, companies arrange the financing of their operations in such a matter to meet the qualification as debt for Dutch tax purposes to assure the benefit of tax deductibility.
Established Dutch case law has set out a defined framework on how financial instruments are classified as debt or equity for Dutch tax purposes.
In principle, whether a financial instrument is considered as debt or equity is determined based on its civil law classification. The determining characteristic to qualify a financial instrument as a loan is the existence of a repayment obligation by the debtor.
Hence, if the recipient of financing is not obliged to repay the amount, the financial instrument is, in principle, not considered to be a loan for Dutch tax purposes.
However, the following three exceptions exist that re-characterise the loan to equity for Dutch tax purposes. These exceptions are sham loans (schijnlening), loss financing loans (bodemlozeputleningen), and profit-participating loans (deelnemerschapslening).
Therefore, a loan qualifying as debt for Dutch civil law purposes which is not a sham loan, a loss financing loan, or a participating loan, is considered debt for tax purposes.
A loan is considered to be a profit participating loan (deelnemerschapslening) if the loan has a term that is indefinite or longer than 50 years, the loan is subordinated to ordinary creditors, and the interest is depended almost entirely on profits of the debtor.
With respect to equity financing, it follows from case law that financial instruments that qualify as equity for Dutch civil law are treated as equity for Dutch tax purposes without any exemption to re-characterise equity to debt for tax purposes.
Dutch Supreme Court ruling
The Netherlands Supreme Court has upheld the Court of Appeal’s judgement, considering the perpetual securities as a loan for Dutch tax purposes.
The Supreme Court reasoned that the loan qualifies as debt for Dutch civil law purposes due to the repayment obligation. Therefore, the classification of debt should be followed for Dutch tax purposes even though the term of the loan is perpetual.
With respect to the Dutch tax authorities’ second argument that the loan (materially) qualifies as a participating loan, the Dutch Supreme Court holds a strict formal interpretation of the requirements as set out in case law (see above) and concludes that the conditions are not met to requalify the perpetual securities as equity for tax purposes. Consequently, the interest payments in connection with the perpetual securities are deductible for Dutch tax purposes.
The Dutch Supreme Court ruling is welcome and reaffirms that conditional repayment obligations and possible uncertainties do not impact the long-established rule that financial instruments that qualify as loan for Dutch civil law purposes should, in general, be considered to be debt for Dutch tax purposes.