In its judgment of 14 April 2023 (ECLI:NL:HR:2023:557), the Dutch Supreme Court issued an important court decision clarifying the scope of the Dutch lucrative interest tax regime. The judgment confirmed the general practice in situations in which incentives using leverage are implemented in an equity structure, a 10 percent criterion has to be adhered to. This is regularly the case for management of a company. In these situations, a so-called lucrative interest only exists if, simply put, the leverage instruments (such as cumulative preference shares) make up 90 percent or more of the capital (both nominal and share premium as well as “informal capital”) and the subordinated capital (generally ordinary shares) make up less than 10 percent of the capital (both nominal and share premium as well as ‘informal capital’).

The judgment is a welcome and long-awaited confirmation of the scope of the lucrative interest tax regime and relevant for all kinds of leveraged investments, such as carried interest, sweet equity and similar regimes.

Background - Dutch tax treatment of lucrative interest

Lucrative interest is interest in a company that offers the possibility of achieving a significant return with a relatively limited investment. This applies to carried interest in (private equity/venture capital) funds, but also to sweet equity structured to incentivize management of targets of such funds.

The Dutch lucrative interest tax scheme aims for such lucrative interest to be taxed in the same way as “substantial interest income,” at a rate of 26.9 percent (2023 rate), in the year the lucrative income is realized. To achieve such immediate taxation, rules are formulated, that -if not followed to the letter- would lead the income to be progressively taxed like employment income at a top rate of 49.5 percent (2023 rate).

The Dutch tax law stipulates that with regard to shares sets out that this kind of interest is present primarily if it concerns shares that are subordinated to other classes of shares and that, in total as a class, make up less than 10 percent of the total nominal capital of the company (the “10 percent criterion”). This requires a structure where there are different types of shares where the class of shares issued as an incentive (the lucrative class) is subordinated to the other classes of issued shares.

Lucrative interest is also present (for example) in case of rights which are economically similar or comparable to the subordinated class of shares referred to above. The main example used in parliamentary history concerned a situation in which, aside from nominal capital, there was also share premium contributed (in which case it would technically be possible to have more than 10 percent nominal capital on the subordinated shares, but far less than the total amount of equity, for instance because nominal capital on the shares amounts to €1,000 per class, but the preferred class of shares has €1 million share premium shares attached to it).

However, due to the relatively broad definition of “economically comparable,” there has been a longstanding debate whether “economically comparable” should be interpreted in a way that the 10 percent applied to all types of incentives in which leverage is involved. Alternatively, this could be interpreted in a broader sense that any leverage instrument other than through nominal capital could lead to a lucrative interest. The latter interpretation (sometimes adhered to by tax authorities) created legal uncertainty and lead various discussions with the tax authorities.

There is concern that these different interpretations could, for instance, lead to lucrative interest discussions in cases of heavily debt-financed structures, even in relatively lightly leveraged situations.

Simplified outline of the case

The taxpayer concerned in this case was an individual employed in a management position at a group of companies. In this capacity, as part of a management incentive plan the manager acquired depositary receipts for ordinary shares in the holding company of the group for a considerable amount. Within a short time the value of those depositary receipts dropped to €1. For tax purposes, the manager regarded the loss on his depositary receipts as a negative result from lucrative interest (of course, if the income is taxable, the loss is also tax deductible). He claimed a deductible loss in his income tax return. The tax inspector did not accept this loss in the tax assessment on the basis that the depository receipts did not qualify as lucrative interest.

In dispute was whether the certificates held by the manager met the definition of lucrative interest within the meaning of the Dutch Income Tax Act 2001. It was undisputed that the shares to which the depositary receipts related made up more than 10 percent of the nominal paid-up capital and more than 10 percent of the total capital of the company, taking into account any share premium.

The manager was of the opinion that, (simply put) since there was leverage, there was lucrative interest. He argued that the share premium represents no economic value and should therefore not be included in the calculation of the value of the ordinary shares when assessing whether there is a form of excessive leverage effect. The tax inspector argued that in order for an equity interest to be regarded as lucrative, the share class must amount to less than 10 percent of the nominal paid-up share capital and must be subordinated to other class shares. Moreover, the tax inspector argued that for the determination of the 10 percent limit, in the context of the application of the catch-all provision, share premium and informal capital should also be included. Accordingly, the 10 percent limit would not be met, and the loss was not deductible.

The Court of Appeal had followed the position of the manager and allowed the deduction of the loss. The Tax Authorities appealed this ruling with the Supreme Court.

Decision of the Supreme Court

Today, the Supreme Court overturned the judgment of the Court of Appeal. The Supreme Court ruled that for the application of the “economic approach” the 10 percent criterion has to be applied, not only the nominal paid-up capital, but also the paid-up share premium and informal capital need to be taken into account in order to determine whether the leverage is “too big” (i.e. too beneficial for management) and therefore lucrative. The Supreme Court thus held that the 10 percent criterion should be applied based on all equity instruments in place and for the full amounts contributed thereon (including share premium and informal capital). As a result, the interest of the manager was not considered a lucrative interest and his loss therefore was non-deductible.

Practical implications

In practice, court procedures concerning lucrative interest taxation are scarce because due to the complex nature of management participation plans the tax consequences are regularly subject to tax rulings or other correspondence with the tax authorities.

The Supreme Court ruling now clearly marks where “normal interest” ends and “lucrative interest” begins. Normal interest, such as “simple shareholdings” in companies benefits from different tax regimes (i.e. the possibility to postpone taxation to later years, or even taxation in “Box 3” at (generally lower) deemed income rates rather than actual income). Also, the court decision reduces uncertainty for existing management participations if no tax ruling has been entered into. We would generally expect that existing tax rulings will not be impacted, but do recommend a brief review to ensure that they still apply.

If you would like to receive more detailed information or to discuss the implications for your business, feel free to contact Marnix Veldhuijzen or Mehdi el Manouzi.

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