Freedom of establishment and fiscal unity

The ECJ has held that Dutch tax rules that result in certain disadvantages to Dutch companies with foreign subsidiaries (when compared to the treatment of a Dutch company with a Dutch subsidiary) are incompatible with the freedom of establishment: X BV and X NV v Staatssecretaris van Financien (Cases C-398/16 and C-399/16). In particular, Dutch rules which, in practice, restrict interest deductions for an investment in a foreign subsidiary cannot be justified where the restriction can be avoided in a domestic setting by using the fiscal unity regime. However, rules which prevent the deduction of currency losses on a transfer of shares in a foreign subsidiary are not incompatible with EU law where, as here, the Dutch tax rules also exempted any currency gains in the same scenario.

Background

These cases again raise questions over the compatibility of advantageous rules for domestic groups of companies when compared to excluded foreign subsidiaries. Under the Dutch tax regime, this involves the operation of the “fiscal unity” provisions which allow members of a Dutch group to be treated as a single taxable entity.

In its judgment in X Holding, the ECJ recognised, in principle, the compatibility of the Netherlands fiscal unity legislation with EU law in the context of the use of losses. The court held that the exclusion of non-resident companies from the fiscal unity rules in that case was justified in view of the need to safeguard the allocation of the power to impose taxes between the Member States.

However, the scope of the judgment in X Holding was later qualified in the Groupe Steria case, in which the ECJ held that it should not be inferred from the X Holding judgment that "any difference in treatment between companies belonging to a tax-integrated group, on the one hand, and companies not belonging to such a group, on the other, is compatible with Article 49 TFEU". The court clarified that the justification accepted in the judgment in X Holding related only to the provisions of the Dutch rules which allowed losses to be transferred within the tax-integrated group.

Current cases

The first case, X BV (Case C-398/16) involved the treatment of interest expense incurred by a Dutch company investing in an Italian subsidiary. The Dutch company obtained the finance to make the investment from its Swedish parent through an interest bearing loan. It sought to deduct the interest expense in its tax calculations, however the Dutch tax authorities rejected the deduction on the basis of the provisions of Article 10a of the Dutch Corporate Income Tax Act (CITA). These rules prevent a taxpayer deducting interest expenses incurred on a loan from a related entity where the finance is used to acquire a shareholding in a related entity.

The taxpayer complained that the rules were contrary to EU law. Whilst the rules applied, in principle, whether the Dutch taxpayer used the finance to acquire shares in a Dutch or non-resident subsidiary, in practice, the rules could be side-stepped where the Dutch taxpayer acquired shares in a Dutch subsidiary. In such a case, provided the Dutch taxpayer and the Dutch subsidiary were part of a Dutch fiscal unity, the share acquisition was ignored. Since the existence of a Dutch fiscal unity made the investment “invisible”, Article 10a did not prevent the deduction of interest in such cases. The taxpayer contended that the fact they were not able to apply the fiscal unity rules to the Italian subsidiary meant that the rules were discriminatory.

The second case, X NV (Case-399/16) concerned the deduction for currency exchange losses on a foreign shareholding. A Dutch company, which was part of a fiscal unity regime in the Netherlands indirectly held shares in a UK subsidiary. As a result of exchange rate fluctuations, the Dutch company incurred a currency loss on its holding. It sought to deduct as an expense its loss on the shareholding, but no deduction for the currency loss was allowed due to the operation of the Dutch participation exemption (under which neither gains made nor losses incurred on shareholdings are taken into account for the purposes of determining profits).

The taxpayer claimed that, had it been permitted to form a fiscal unity with its UK subsidiary, it would have been able to deduct the currency loss incurred. Because the right to enter in a fiscal unity was however reserved for Dutch resident companies, the taxpayer argued that its freedom of establishment had been restricted.

The Dutch tax authorities argued that the differences in treatment between companies could be justified either by the need to maintain the coherence of the Dutch tax regime, the need to safeguard the allocation of taxing rights and/or the need to prevent tax evasion.

Decision of the Court

The Court recognised that the principles to be applied in these cases had been settled in the earlier cases and that it was clear that it was not possible to consider each and every consequence of limiting the fiscal unity regime to Dutch entities (or PEs) as compatible with EU law. It was necessary to consider each consequence individually and determine if it dealt with situations that were objectively comparable, if it gave rise to a restriction and if so whether that restriction was justified or not.

In relation to the interest restriction, the Court considered that a Dutch company receiving a loan to invest in a Dutch subsidiary and one receiving a loan to invest in a foreign subsidiary were in objectively comparable situations. It was clear therefore that the two comparable situations were treated differently and this amounted to a restriction on the freedom of establishment as the rules made it less attractive to invest in a foreign subsidiary than a Dutch subsidiary. As such, the rules gave rise to an illegal restriction unless it could be justified by any overriding principles. The Court accepted that the purpose of the restriction was to prevent artificial arrangements avoiding Dutch tax. The purpose of the rules was to prevent “own funds of a group from being artificially presented as funds borrowed by a Netherlands entity”. However, this purpose was equally applicable to a situation where such funds were used to invest in a Dutch subsidiary. Accordingly, the existence of this restriction resulting from the interaction of the fiscal unity regime and Article 10a and applying only to investments in foreign shareholdings could not be objectively justified. The Court also rejected the Netherlands government’s arguments seeking to justify the restriction based on the need to maintain the coherence of the fiscal unity regime or the need to safeguard the allocation of taxing rights.

As regards the deduction of currency losses, the Court noted that there clearly was difference in treatment between currency losses suffered on the transfer of shares in a foreign subsidiary (where currency losses were excluded) and in a subsidiary which is part of a Dutch fical unity (where the exclusion does not apply). However, the Court also noted that the Dutch tax rules also exclude from tax any currency gains on a foreign shareholding. This was a situation, therefore, in which the rules operated symmetrically and did not restrict the freedom of establishment. “The disadvantage for a Netherlands company of not being able to deduct the currency loss on its holding in a non-resident subsidiary is inseparable from the symmetrical advantage linked to the absence of taxation of currency gains”. As such, viewed as a whole, the participation exemption is neither advantageous nor disadvantageous.

(The Court also suggested that the circumstances in which a Dutch company might actually be able to sustain currency losses on a shareholding in resident subsidiary which was part of a fiscal unity would only occur in very special cases and even so it was “questionable” if it created any real entitlement to a deduction).

Comment

It is clear that the vexed question as to how far EU Member States might limit the benefits of grouping or fiscal unity schemes to domestic companies (or PEs) remains a difficult one. In particular, the recent case law essentially suggests that each benefit and corresponding disadvantage must be viewed in isolation to determine whether the restriction of the benefit to the domestic setting can be justified.

The decision itself, especially regarding the interest restriction, has been criticised in the literature, since it is questionable whether the Court fully understood the workings of the Dutch fiscal unity regime in comparing an inter-company loan within a fiscal unity with a similar loan in a cross-border situation. For CITA purposes, where there is an inter-company loan to contribute equity to a subsidiary which is part of the fiscal unity, the contribution is deemed non-existent and it is assumed that the single entity takes on a loan to fund its Dutch business. This results in a coherent system whereby Dutch taxable profits are aligned with tax deductible interest. In a cross border situation, however, the inter-company loan is related to an equity contribution to a foreign entity whose profits are exempt in the Netherlands under the participation exemption. However, in the opinion of the Attorney-General this coherency argument was not sufficiently founded by the Dutch government.

Response of Dutch Government

Following the Advocate General’s opinion in these cases, released in October 2017, the Dutch government announced that it would put in place several emergency response measures. The measures consist of applying certain Dutch tax provisions (in particular the application of the anti-base erosion provisions of article 10a, CITA, the application of the participation exemption article 13, paragraph 9-15 CITA, the interest limitation rules of article 13l CITA and loss compensation rules in case of change of control laid down in article 20a CITA) within a fiscal unity as if the fiscal unity does not exist. As a result, the existing favourable treatment for domestic situations will be eliminated.

Following the decision of the ECJ, the Dutch government has now announced that these measures will be implemented into law with retrospective effect from 25 October 2017 (the date of announcement of the measures by the Dutch Government) by legislation to be brought forward in the second quarter of 2018. In a letter dated 22 February, the Dutch Government announced it will present a more robust structural solution as soon as possible. However, it is expected that will take at least two years.