Introduction
The preliminary ruling request is seeking clarity on a crucial legal issue: whether articles 49 TFEU, 56 TFEU and/or 63 TFEU allow tax authorities in a Member State to deny a company belonging to a cross-border group the right to deduct interest paid on a loan debt from its taxable profits.
The AG suggests that the purpose of a loan should be the determining factor rather than whether the loan was contracted on an arm’s length basis. In his view, intra-group loans put in place without any valid commercial and/or economic justification but solely to create a deductible debt constitute wholly artificial arrangements. Consequently, the ECJ should revisit the approach taken in the Lexel case and consider that the purpose of the loan should be the decisive factor.
The Dutch Legislation Under Scrutiny
The Dutch corporation tax rules allow a company to deduct the interest on its debts from taxable profits, reducing its tax liability.
However, Article 10a (1) (c) of the Law on Corporation Tax (“CITA”) limits this possibility for intra-group loans. This provision presumes that such loans are wholly artificial arrangements meant to erode the Dutch tax base, and interest on such loans cannot be deducted from taxable profits.
Nevertheless, Article 10a (3) of the CITA provides a way to challenge this presumption and deduct the interest on intra-group loans by demonstrating that the loan was based on commercial considerations or that a reasonable profit or income tax was levied on it.
Facts Concerned
A Dutch company obtained an interest in another Dutch company from a third party. As a result of the transaction, the two Dutch companies became related. The company borrowed funds from a Belgian finance group company to acquire the interest. The Belgian finance company benefited from the Belgian coordination centre regime, which taxed it at a low effective tax rate. The funds were made available from the capital contributions received from the Belgian parent company, which was also the parent company of the Dutch company.
However, the Dutch tax authorities denied the deduction of interest based on the anti-base erosion rule of Article 10a of the CITA. The funds were considered artificially rerouted because of the capital contribution by the Belgian parent company immediately before making the loan available. The Dutch corporate taxpayer argues that denying arm’s-length interest expenses on an intercompany loan related to an external acquisition violates EU Law.
The lower courts agreed with the tax authorities that the main reason for rerouting the funds via the Belgian finance company was tax saving and that the double business motive test previewed in the Dutch Law was not met. Hence, such courts dismissed any concerns that the interest deduction limitation could breach EU Law.
The case was then appealed to the Supreme Court, which referred three preliminary questions to the CJEU to get clearance on whether the Dutch anti-base erosion rule, which denies interest deductions on arm’s-length interest expenses, violates EU Law. A similar Swedish rule was found to violate EU Law in the Lexel Case.
Questions Referred In the Preliminary Ruling Request[1]
In the aim of the preliminary ruling on the compatibility of Article 10a of the CITA with the EU treaty freedoms, the Dutch Supreme Court referred the following questions to the ECJ:
- For the purpose of answering questions 1 and/or 2, does it make any difference whether the relevant acquisition or extension of the interest relates (a) to an entity that was already an entity related to the taxable person prior to that acquisition or extension, or (b) to an entity that becomes an entity related to the taxpayer only after such acquisition or extension?
The Starting Point – ECJ’s Ruling in the Lexel Case[2]
The Lexel case involved a Swedish company within the Schneider Electric group that acquired an intragroup interest in a Belgian company funded by a French-affiliated company loan. The Swedish tax authorities denied the interest deduction, claiming that the loan arrangement had no underlying commercial justification and was designed to receive a substantial tax benefit. However, the ECJ ruled that the Swedish interest deduction limitation provision was discriminatory and incompatible with EU Law.
The ECJ concluded that related transactions at arm’s length are not entirely artificial; therefore, no rights abuse can be established. Consequently, a national anti-abuse provision that obstructs such transactions may not be justified based on the fight against tax evasion and tax avoidance. The ECJ also ruled that a domestic measure aimed at preventing tax evasion or tax avoidance by restricting interest deduction is allowed if it targets purely artificial arrangements, i.e., arrangements without any underlying commercial justification. However, the principle of proportionality requires that the denial of a deduction of interest should be limited to the proportion exceeding the arm’s-length interest rate.
The ECJ found that the Swedish interest deduction limitation rule was incompatible with the freedom of establishment in Article 49 of the Treaty of the Functioning of the European Union. Such a rule that aims to counteract wholly artificial transactions may be incompatible with EU Law. The ECJ stated that the exception in the Swedish law seeks to prevent the erosion of the domestic tax base and that such an objective cannot be confused with the need to preserve the balanced allocation of the power to impose taxes between the Member States. The ruling suggests that affiliate transactions are at arm’s length if commercial prices are charged and should not be obstructed by national anti-abuse provisions.
This verdict passed by the ECJ has garnered a mixed response. While some have welcomed the ECJ’s reiteration of the arm’s length standard as a haven for taxpayers, others remain sceptical, contending that the arm’s length reference should not be read as a new arm’s length haven.
The Dutch Case – Case C-585/22
In the case under analysis, the Supreme Court found the Dutch anti-base-erosion rule mostly compatible with EU law. However, the Court also recognised that the Lexel case had created uncertainty regarding whether interest deduction limitation rules could violate EU Law if they counteracted wholly artificial transactions, such as intragroup loans, conducted on arm’ s-length terms.
As a result, the Dutch Supreme Court asked the ECJ to clarify how to interpret Lexel and whether the Dutch anti-base-erosion rule could breach EU Law. Additionally, the Dutch Supreme Court wanted to clarify if it violated EU freedoms to limit interest deduction for a loan that was part of a wholly artificial construction, regardless of whether the loan was considered at arm’s length. Finally, the Supreme Court asked the ECJ if the outcome would differ if the intercompany loan were used for an external or internal acquisition.
The AG’s Guidance– Sail Away From the Safe Harbour
The Dutch Supreme Court has posed three questions, which should be dealt with together, according to the AG.
As usual, the AG established the fundamental freedom applicable to the case, subsequently assessing whether the Dutch provision restricts the relevant freedom before considering whether such a restriction is permissible under EU Law.
The AG opined that Article 10a of the CITA falls under the scope of the freedom of establishment. The Court’s case law has established that national rules pertaining solely to relationships within a group of companies primarily impact the freedom of establishment under Article 49 TFEU. Similarly, national law intended to apply exclusively to shareholdings that enable the holder to exert a definite influence on a company’s decisions and activities also falls within the scope of that same EU Law provision. Consequently, the AG examined the national law and responded to the referring court’s questions solely in light of Article 49 TFEU.
The AG compared the case to the Court’s ruling in Lexel, which concerned the impossibility under Swedish law for a Swedish company to deduct the interest on a loan debt contracted with the group’s internal bank located in France. The court recognised the difference in treatment and, consequently, the existence of a restriction.
However, he understood that the restriction was justified under analysis by an overriding reason relating to the public interest. Hence, such a restriction was deemed appropriate in achieving its legitimate objective while ensuring it stayed within the necessary range for attainment.
The AG agreed that Article 10a (1) (c) of the CITA prevents the creation of artificial arrangements that allow companies to avoid paying taxes on profits generated by activities in the Netherlands. This restriction is justified because it helps fight abusive tax avoidance. The objective is to stop companies from presenting their funds as borrowed funds by a Netherlands entity in the group and then deducting interest on the loan from their taxable profits.
In this context, the AG underlined that if such a loan and associated transaction are economically justified, loan interests may be deducted under Article 10a (3) (a). This rule confirms that the purpose of prohibiting interest deduction for intra-group loans is to prevent tax avoidance, an overriding reason relating to the public interest in taxation, as previously mentioned. Therefore, since Article 10a (1) (c) of the CITA genuinely pursues this objective, it may be justified.
Regarding the appropriateness of the restriction, according to the Court’s established case law, any limitation on freedom of establishment must be considered appropriate if two cumulative criteria are verified. The first criterion is that the measure in question should be regarded as suitable to contribute to the pursued objective. The second criterion is that the restriction should genuinely reflect a concern to attain this objective and be implemented consistently and systematically. The AG asserts that both requirements were fulfilled in this case.
Finally, according to the AG’s understanding, the limitations imposed by the disputed provisions of Dutch law are not excessive and necessary to serve their legitimate purpose. In the Opinion issued, the AG concluded that the restrictions under analysis apply only to wholly artificial arrangements, and the consequences of identifying such transactions as such are not disproportionate.
Based on the above considerations, according to the AG’s opinion, the ECJ should answer the questions referred by the Supreme Court of the Netherlands as follows:
“Article 49 TFEU must be interpreted as meaning that it does not preclude national legislation under which the interest on a loan contracted with an entity related to the taxable person is not deductible when determining the profits of that person, where the conclusion of that loan was predominantly motivated not by commercial considerations, but by the objective of creating a deductible debt, even where the interest rate stipulated therein does not exceed that that would have been agreed upon between companies which are independent of one another. In that situation, the deduction of the interest shall be disallowed in full.”[3]
What Now?
To sum up, according to the Lexel ruling —from which the AG’s Opinion departed—transactions that adhere to market-based conditions should not be deemed to be entirely artificial (because of the TP-based functional analysis-substance-based safe harbour) and, therefore, should not be subject to restrictive domestic anti-tax abuse provisions. If a commercial justification for any legal structure entered is not available, a proportional deduction limitation measure must only apply to the part of the interest payments that are not conducted at arm’s length.
However, using the arm’s length principle as a guiding principle in the anti-avoidance test is potentially ambiguous since it might be argued that the arm’s length standard alone is insufficient to tackle multinational corporations’ tax avoidance, considering that this principle is not a mechanism devised to regulate tax avoidance.
In this context, the AG’s opinion on intra-group loans was expected to clarify the Lexel ruling or confirm that a distinction should be made between loans which were contracted at arm’s length and those which were not.
As explained above, the AG disagreed with the ECJ’s approach in the Lexel case and considered that the loan’s purpose should be decisive. In the AG’s view, whether an intra-group loan is contracted at arm’s length is generally not conclusive on the existence of abuse. Hence, intra-group loans without valid justification to create a deductible debt might still be considered wholly artificial arrangements.
Nevertheless, it should be noted that the impact of Dutch legislation and companies operating within the Netherlands will only be significantly affected by the ECJ’s final decision. The AG’s Opinion does not have a binding effect on the ECJ, which bears the ultimate responsibility for determining whether the Dutch anti-base erosion rules comply with EU Laws and regulations. Once the ECJ issues its final decision, it might have far-reaching consequences, namely providing clarity on the interpretation of interest deduction limitations in other Member States.
If the ECJ adopts the AG’s Opinion, it could signify a shift in how interest deductions on intra-group loans are denied. In contrast, the interest on a third-party loan under the same terms and conditions would remain deductible. The determining factor would be whether the loan’s overall entry lacks economic and/or commercial justification and whether its sole (or primary) purpose is to generate (deductible) interest payments at the borrowing firm.
Either way, the AG’s Opinion visibly demonstrates that the interpretation of EU Law in the context of the abuse of law doctrine is unclear in this case, leaving room for uncertainty. In this context, considering the ECJ’s CILFIT doctrine (acte claire), the Superior Courts of EU Member States are obliged to make references for preliminary rulings on the interpretation and operation of the abuse of law doctrine under EU Law in cases where the transfer pricing is at arm’s length, and the courts are confronted with doubts in this regard. Only by fulfilling this obligation will the courts ensure the consistency and uniform application of EU Law across the Member States.
Dalila Mendes Leal
March 2024
[1]Request for a preliminary ruling
[2]Judgment of the Court (First Chamber) Case C‑484/19 https://curia.europa.eu/juris/document/document.jsf?text=&docid=236681&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=4536399
[3]Opinion of Advocate General Emiliou delivered on 14 March 2024
https://curia.europa.eu/juris/document/document.jsf;jsessionid=595e9c7027c93c6ed9f356b90638fe6e?text=&docid=283839&pageindex=0&doclang=en&mode=req&dir=&occ=first&part=1&cid=1775777