Dutch unallowable purpose rules not contrary to EU law

The CJEU has held that the Dutch anti-avoidance base erosion rules denying interest deductions for intra-group payments of interest to related (331/3% interest) entities if connected to (intercompany) tainted transactions (such as (external) share acquisitions, capital contributions and dividend distributions) are compatible with the freedom of establishment: X Ltd v Staatssecretaris van Financiën (Case C-585/22). This was despite the fact that they applied to intra-group loans on arm's length terms and that the rules denied a deduction for the entire amount of the interest paid where they applied. The Court accepted that the rules pursued a legitimate objective of preventing artificial arrangements having no commercial justification and in those circumstances the rules were not disproportionate. [Note that the decision is not currently available in English.]

The decision is noteworthy in adopting a wide acceptance of what "wholly artificial" transactions domestic legislation might counter-act in ways that, in principle, give rise to discrimination in conflict with the fundamental freedoms. It is also notable how the Court has adopted concepts, such as "economic reality", from the VAT sphere in, essentially, accepting that Member States are entitled to apply discriminatory rules which are designed to prevent abusive arrangements.

Background

The case concerns the provisions of the Dutch Corporate Income Tax Act which denied tax deductions for certain payments of interest. Article 10a of that Act provided that, in the case of debt owed to a related (331/3% interest) entity and which has been used for tainted transactions (such as (external) share acquisitions, capital contributions and dividend distributions), in the case at hand the acquisition or increase in a holding of a related entity. Essentially, the Dutch tax rules denied a deduction for interest in such circumstances unless the debtor demonstrates that either:

• The debt is predominantly based on commercial reasons; or

• A tax is levied on the interest which is "reasonable according to Dutch standards" (generally a rate of 10%), unless the tax authorities can demonstrate that the debt was advanced in order to realise tax attributes at the level of the lender or the transaction in connection with the debt advanced was not entered into for commercial reasons. 

In this case, X borrowed monies and paid interest to a related entity, C, a coordination centre established in Belgium. As a coordination centre, C benefited from a special tax regime in Belgium. The borrowings were used to acquire a 72% interest in another Dutch company.

The Dutch tax authorities denied a deduction to X for its interest payments on the basis of Article 10a. X appealed against that decision and the Dutch Supreme Court referred questions to the CJEU concerning whether the provisions of 10a were compatible with the fundamental freedoms.

CJEU decision

The CJEU noted, first, that the relevant fundamental freedom in this case was the freedom of establishment. The Dutch provisions applied where the relevant entities were related and this involved a holding, direct or indirect, of 331/3%. Such an interest is sufficient to amount to "definite influence" and as such involves a consideration of the freedom of establishment primarily.

Moving onto the provisions, the CJEU noted that a provision may be incompatible with EU law if there is not only overt discrimination but also where the discrimination is also covert, or indirect. In this case, the Dutch tax provisions objectively applied to all entities, whether Dutch or otherwise. However, it was pointed out that, even though objectively there was no difference, in practice, clearly the second exception is essentially de facto satisfied where the recipient entity is located in the Netherlands. Therefore, in practice, only payments to companies established outside the Netherlands and subject to a tax rate lower than 10% would be caught. Therefore, the Dutch provisions would, in principle, give rise to discrimination and a restriction incompatible with the freedom of establishment.

But could the provision be justified nevertheless? The CJEU noted that earlier case law had held that provisions which are, in principle, discriminatory may still be compatible with EU law if they can be justified. And provisions may be justified where they are designed to prevent tax evasion and avoidance. In particular, the CJEU noted that "a restriction on the freedom of establishment recognised by Article 49 TFEU can be justified ... only if it is specifically intended to prevent conduct consisting in the creation of wholly artificial arrangements, which do not reflect economic reality, and which are intended to avoid the tax normally due in respect of tax profits arising from activities carried out on national territory". In this case, the local referring court had noted that the purpose of the relevant Dutch legislation is undeniably intended to combat tax avoidance and, indeed, the CJEU noted that "loan debts contracted arbitrarily and for no commercial reason constitute wholly artificial arrangements, even if, in isolation, the interest charges on those debts correspond to the interest charges which would have been agreed between independent undertakings".

It is also a requirement for measures to be regarded as justified that they be appropriate to address the tax evasion/avoidance and that they be proportionate. The CJEU considered that the measures were appropriate to deal with the tax evasion/avoidance "in so far as it makes it possible to neutralise the effects of the conduct of two or more related entities consisting in the creation of wholly artificial arrangements which do not reflect economic reality and which are intended to avoid the tax normally due on profits from the activities carried out on national territory, by excluding from deduction artificially generated interest charges or, in any event, by ensuring that that interest is taxed at a reasonable rate in the Member State of its recipient and that tax on profits is not entirely evaded".

However, what of the fact that the legislation might catch interest at arm's length rates and, where it applies, it denies any deduction for interest payments at all? Did that mean that the rules failed the proportionality requirement? The CJEU noted that this legislation was aimed not simply at debts taken out at above arm's length rates or excessive amounts, but also at situations where there was no commercial justification for the loans in the first place. In such circumstances, the CJEU has confirmed that an examination of not only the terms of the loans but also the actual act of taking out the loans and related transactions is tantamount to establishing the economic reality of the transactions. Consequently, an examination of the formal terms (such as the interest rates) would not be sufficient to assess the economic reality.

The CJEU has therefore held that the mere fact that the loans were on arm's length terms is not sufficient to conclude that they do not amount to wholly artificial arrangements. Equally, the fact that all of the interest deductions are denied (not simply part of them) would not be disproportionate in these circumstances where the purpose of the rules is to identify and prevent arrangements where the loans themselves are devoid of economic justification and would not have been granted in the absence of the special relationship.

Comment

The decision of the CJEU takes a broad approach to the concept of a justification for otherwise discriminatory tax provisions in the context of so-called wholly artificial transactions. Not only does it accept that arrangements can be wholly artificial where they are (essentially) entirely tax motivated and without other commercial justification, but the Court has also accepted that interest deductions may be entirely denied in such circumstances.

It is also interesting to see how the Court has taken the concept of "economic reality", which was developed in the VAT sphere and abuse of law, and largely equated it with "wholly artificial" arrangements. Indeed, the Court has essentially equated justification with the abuse of law concept in this situation where it states that: "While it is true that the fact that a taxpayer pursues the tax regime which is most advantageous to him is not sufficient, in itself, to give rise to a general presumption of fraud or abuse, the fact remains that that taxpayer cannot benefit from a right or advantage deriving from EU law if the arrangement in question is wholly artificial, from a commercial point of view, and is designed to circumvent the legislation of the Member State concerned."

This is perhaps widening the normal meaning of "wholly artificial" to arrangements which, whilst legally effective, are simply tax motivated and without commercial motivation (and as such, an abuse of law).  As always, the question of what is an entirely tax motivated transaction (as opposed to taking advantage of a more tax efficient option) will be a difficult one for the local courts to contend with.