On 3 March 2023, the Dutch Supreme Court ruled that the interest expense due on a loan was deductible for Dutch income tax purposes if the lender could be qualified as an “active group financing center.” The case involved a loan owed by a Dutch company to a foreign group company where the loan was used to acquire shares in a subsidiary that qualified for the participation exemption. For more insight on the case, read on.

Facts of the case and legal context

A Dutch intermediate holding company (DutchCo) is a subsidiary of a Swedish top holding company (TopCo). TopCo holds approximately 71 percent of the shares in an Italian company (Target). The shares in Target are listed on an Italian stock exchange and the remaining 29 percent of the shares are owned by third parties.

In 2004, the group announced that it intended to delist Target from the stock exchange. For this purpose, an Italian bidding company (ItalCo) was established into which DutchCo contributed €237 million in capital. DutchCo financed this capital contribution with a loan (Loan 1) from TopCo. After public offers, ItalCo acquired approximately 23 percent of the shares in Target. The remaining 6 percent was directly acquired by DutchCo, financed with another loan of €51 million from TopCo (Loan 2). Subsequently, DutchCo contributed the 6 percent in Target to ItalCo.

The Dutch tax authorities refused the interest deduction on Loan 1 and Loan 2 on the basis of article 10a of the Dutch Corporate Income Tax Act 1969 (CIT Act). Article 10a CIT Act targets base erosion and profit shifting by denying any deduction of interest expenses, forex losses and costs related to group loans whose proceeds are used to acquire shares or to contribute capital to subsidiaries. Generally speaking, this article only applies if the Dutch taxpayer holds a minimum one-third share interest in the subsidiary and the lender also has at least a one-third holding in the Dutch taxpayer.

An exception applies to the above main rule if the taxpayer demonstrates that (i) the interest income is subject to a reasonable profit tax in the hands of the recipient or (ii) the (a) acquisition of shares or capital contribution (transaction) and (b) that the taking up of an intra group loan are both predominantly based on sound business reasons.

In the case at hand, DutchCo claimed the “sound business reasons” exception. The Dutch tax authorities had challenged the soundness of the business reason for taking up an intra group loan, and therefore denied the interest deduction. The authorities further argued that, should the court allow the interest deduction under article 10a CITA, it should still refuse the deduction on the basis of the general anti-abuse doctrine (fraus legis). DutchCo argued that TopCo acts as an active group financing center; thus, it was not a “pass-through” actor (without playing a relevant role in the financing, such as with back-to-back loans). For that reason, it should not matter how Loan 1 and Loan 2 were financed by TopCo. Regardless, the court of appeal agreed with the Dutch tax authorities and ruled that DutchCo had not sufficiently demonstrated how TopCo had sourced Loan 1 and Loan 2. Because of this, DutchCo also failed to demonstrate that the TopCo’s financing of Loan 1 and Loan 2 had not been artificially re-routed within the group.

Decision of the Supreme Court

The Supreme Court ruled that the interest expenses are deductible if DutchCo can demonstrate that TopCo functions as an active group financing center, unless the tax inspector can demonstrate that TopCo functioned as pass-through for Loan 1 and Loan 2. If DutchCo succeeds in demonstrating TopCo’s active group financing center function and at the same time the tax inspector fails to demonstrate a pass-through arrangement, then there is no artificial re-routing of funds within the group, and the taking up of the loan can be regarded as being predominantly based on sound business reasons. The Supreme Court set out certain criteria to determine the existence of an active group financing center:

1. The group lender is primarily engaged in the execution of financial transactions for the group, such as borrowing from group companies and third parties, and on lending these monies to group companies and managing the group’s excess cash.
2. The group lender is independent in its day-to-day activities, including the granting and management of intercompany loans and excess cash.
3. The group lender has sufficient and skilled personnel at its disposal to perform the financial functions.
4. The group lender properly documents its transactions within its administration.

The Dutch Supreme Court overruled the appellate court’s decision, finding that the appellate court had incorrectly interpreted the earlier artificial rerouting decision of the Supreme Court. The case has now been referred to another appellate court with instructions to determine whether TopCo can be regarded as an active financing center. If that appellate court concludes that TopCo is an active group financing center, the interest due on Loan 1 and Loan 2 should be deductible.

The Supreme Court also ruled that if DutchCo demonstrates that both the transactions as well as the group loan financing are predominantly based on sound business reasons, the interest deduction cannot be denied on basis of the general abuse of law doctrine (fraus legis) because in such case there is no decisive motive to avoid Dutch corporate income tax.

Our observations

Although the “active group financing center” exception is not new, the Supreme Court shows how this exception must be interpreted when it is unclear how the active group financing center received the funds it lent to the Dutch taxpayer; whether or not these funds are re-routed within the group is in such case irrelevant. For an active group financing center, such movement of funds is not artificial; it is an essential element of getting funds to the active group financing center, whose role it is to grant loans to the group.

The Supreme Court has also provided guidance on how to assess whether a group financing center is active or not. This case may therefore serve as a useful guide for businesses looking for clarity on how the courts will interpret the sound business reason test.