Netherlands joins the interest limitation trend

February 21, 2013

The Netherlands, in common with other EU countries, recently further restricted the deductibility of interest expense.

This article was first published in the Ernst & Young Global Tax Policy and Controversy Briefing, Issue 11, December 2012 (pdf, 4.26 MB)

In its tax budget proposal for fiscal year 2013, on 4 June 2012, the Dutch Ministry of Finance proposed important changes for Dutch corporate taxpayers financed with net debt that currently generates tax-deductible interest. The move is taken in an effort to raise revenue, decrease the deficit and repair any “mismatching” of the Dutch tax benefit system.

The tax budget proposal contains a new provision that limits the deduction of excessive interest paid by a Dutch corporate taxpayer related to interest expense incurred with debts financed to generate income that is exempt under the Dutch participation exemption. On 21 June 2012, the Dutch Lower Chamber of Parliament adopted the proposal, and the new rule will be in effect as of 1 January 2013.

Background

The bill is in response to the ECJ/Bosal case, in which the court affirmed that the disallowance of the deductibility of the financing cost incurred by the Dutch corporation in connection to foreign participation was contradictory to the right to establish companies under the EC Treaty. The judgment of ECJ has decreed that interest expenses related to debts to finance a foreign subsidiary are, in principle, deductible at the level of Dutch (acquisition) entity.

However, the decision resulted in the “mismatching” of Dutch tax benefits. Under the application of the participation exemption, the benefits (such as dividends and capital gains) are tax exempt, whereas the financing costs are deductible. In the explanatory memorandum to the new legislation, it is stated that the new bill was proposed to repair this “mismatching” by limiting the deductibility of “excessive interest” incurred with the acquisition of financing costs related to subsidiaries qualifying for the participation exemption.

Key facts of the new rule

Under the new rule, excessive interest is defined as the amount of interest and costs paid by a Dutch corporate taxpayer for both external and internal debt, times its average amount of participation debt divided by its average amount of total debt. Participation debt is considered present if the cost price of a taxpayer’s participation exceeds the taxpayer’s equity for tax purposes.

The participation debt can never exceed the total amount of debt nor the total cost price of the participations. The participation debt is also lowered with the debt that is subject to other interest deduction limitations (i.e., Article 10a and Article 10b CITA).

Exceptions to the rule

Expansion investment

An important exception relates to “expansion investments,” i.e., investments relating to the expansion of operational activities. If (i) the foreign participation has been acquired or expanded, or (ii) equity has been contributed to the participation for the expansion of operational activities, then the new rule does not apply to this participation.

The expansion can take place at the moment of such acquisition, expansion or contribution as well as in the 12 preceding or following months. The expansion investment escape does not apply if the interest expenses related to the debt used to finance the expansion investment are deducted at the level of another entity within the taxpayer’s group (i.e., double dip) and certain other abusive situations.

Certain group financing activities

Active financing within the group will be excluded from the scope of the new rule. In order to apply for the active financing rule, the taxpayer should demonstrate that the payables and receivables held are related to the active financing activities. Financing activities are considered active if the activities, not being incidental activities, are carried out with regard to arranging and executing financial transactions, for the benefit of the taxpayer and related entities.

In calculating the excessive interest, the interest expense and costs of payables related to any active financing will be excluded from the total amount of interest and cost. Payables related to the active financing will lower the average total amount of debt. As a result the amount of excessive interest will be lower.

Grandfathering rule

An optional grandfathering rule is introduced with respect to subsidiaries that are acquired, expanded or to which contribution was made in a tax year starting before or on 1 January 2006. In the grandfathering rule, 90% of the cost price of the taxpayer’s participation will not be taken into account when calculating the participation debt. The grandfathering rule does not apply in case of abusive situations, such as a double-dip structure.

Thin capitalization rule

The proposal mentions that the Dutch government is willing to abolish the current thin capitalization rule; however, the abolishment of the rule will occur only with the sufficiency and availability of additional budget.

Threshold

The new rule provides a threshold up to €750,000 in deducting the interest expense and related costs incurred with debts to finance the foreign subsidiary.

New rule in effect

The new rule on the limitation on the deduction of interest expense will apply for a fiscal year that starts on or after 1 January 2013.

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