In December 1996 bill number 24 696 was adopted by Dutch parliament. The new legal provisions apply as of the calendar or financial year commencing on or after January 1, 1997. The new legal measures can be divided into two categories. The first is a category of regulations aimed at the improvement of the Netherlands business climate. The second category of measures is directed against improper erosion of the taxable base.
On the one hand the published parliamentary documents are very detailed (especially where the group finance facility is concerned) but on the other hand they do not always provide full clarity. Furthermore, a number of essential issues still need to be regulated by the Ministry of Finance. This applies in particular to the functional currency facility.
A. MEASURES IMPROVING THE BUSINESS CLIMATE
1. Risk Reserve For Internationally Operating Enterprises Active In The Netherlands
An entity pertaining to an internationally operating group may upon request form a risk reserve for the specific risks associated with operating as an international group. The entity should be resident in or conduct a permanent establishment in the Netherlands. The risk reserve is intended for risks relating to finance activities, from holding participations to running a business abroad through a permanent establishment. In order to qualify for the facility it is not required that the entity is specifically or solely involved in finance activities or has been established for that purpose. Yet the finance activities should only be performed by the entity from the Netherlands. Pursuant to the text of the law and the parliamentary explanatory notes it is irrelevant whether the group has other finance companies established abroad. In practice, however, the tax authorities take a critical look at the existence of European group finance companies before approving the request. A group finance company resident in the Netherlands may form part of a fiscal unity.
To qualify for the facility, the entity should meet a number of criteria: a substance criterion, an activity criterion, a country criterion as well as an income criterion.
The Substance Criterion
In order to form a risk reserve, the entity should be able to operate independently and should have a certain level of substance. An entity which primarily fulfils a conduit function within a group will not be allowed to form a risk reserve.
The Activity Criterion
The entity must develop finance activities and the activities must benefit the group. The concept finance activities is broadly interpreted and comprises e.g. the financing of participations (irrespective of whether they qualify for the participation exemption or not) and the running of a foreign enterprise with the aid of a permanent establishment. Among the other qualifying activities are financial and operational lease, financial administrative services and/or controller's activities in the financial area as well as the trade in and operation of patents, licences, etc. All these activities must involve intra-group financing. Investing and performing finance activities outside the group do not qualify. However, financing ordinary supplier credits with a maximum term of three months is not regarded as a finance activity outside the group. Also banks and insurance companies may this favorable regime for internal financing.
As regards the operation of intangible assets the parliamentary documents add that if the company which intends to operate these assets within the scope of the risk reserve has itself developed the assets, corporate income tax must first be paid on the economic value of these assets. If this involves intangible assets in the Netherlands, it is intended that this tax can be paid gradually rather than in a lump sum.
The Country Criterion
The entity should carry out finance activities on behalf of group companies which are resident in at least four countries or two continents. The term qualifying continents refers to North America, South America, Europe, Africa, Asia and Australia. If this criterion is not met in any year, this will have the effect that the risk reserve formed must be added in full to the normally taxable profit.
The Income Criterion
An additional requirement (whereby a restricted measure of result-pooling is possible) under the four-countries test is that the income per country should in principle form at least 5% of the entity's taxable gross income in the Netherlands. Under the two-continents rule, the income per continent should amount to at least 10% of the entity's taxable income in the Netherlands. If these thresholds are not attained in any year, it is impossible to add to the reserve for that year. The finance activities may also be directed at Dutch group companies. However, certain ratios do have to be considered. For instance, the total capital used for the finance activities of the group should not exceed 10% of the Dutch group companies. To the extent this 10% standard is exceeded, the facility will not apply to the related group financing.
Allocations To The Reserve
In principle, an annual amount of 80% chargeable to the profit may be allocated to the reserve out of the group's financing profit taxable in the Netherlands, the proceeds from certain participations, certain permanent establishments and the proceeds from short-term investments held for the purpose of financing the purchase of participations and the acquisition of enterprises which are carried on in the form of a permanent establishment (the so-called acquisition fund). The size of the acquisition fund can be determined on the basis of objective criteria in form of so-called safe harbour ratios. Yet the taxpayer must be able to demonstrate with respect to the acquisition fund, on the basis of so-called objectified intentions, that the fund is maintained by the entity for the purpose of acquiring participations which are compatible with the size of the fund and in line with the group's activities.
Currency profits which form part of the group financing profit and of the proceeds from the acquisition fund can be fully allocated to the risk reserve.
The 80%-addition to the reserve is a maximum. The taxpayer is free to apply a lower percentage. The concept group financing profit does not include the benefits which fall under the participation exemption or to which a relief for the avoidance of double taxation applies. Nor does this concept include the profit obtained with that part of the capital which is derived from payments on (cumulative) preferential shares.
The maximum annual allocation is 80% of the entity's taxable amount.
No maximum has been stipulated for the aggregate amount of the reserve, albeit that the inspector may attach conditions to secure collection of a possible tax claim on the reserve.
Reduction Of The Reserve
The reserve can be reduced in several ways.
a. Taxable reduction
Losses relating to the risks for which the reserve has been formed (for instance, write-downs of loans provided, liquidation losses on participations, losses from foreign enterprises which are conducted with the aid of permanent establishments, and currency losses) will cause a taxable release of the reserve.
b. Tax-free reduction
In a number of specific situations the legal regulation provides for a tax-free release of the reserve.
- If, for instance, the entity has invested in a participation, it may reduce the reserve by 50% of the amount of the capital contribution or the cost price of the participation (relevant for the calculation of future liquidation losses). A condition to such a tax-free release, however, is that this should involve an essential extension of the group's participations.
- The amount of a capital contribution which relates to a liability claim on the group for a risk arising at an entity pertaining to the group and which cannot be borne by that entity itself may even be released 100% free of tax from the reserve.
- The same applies to the acquisition costs for a participation whose activities or the place of activity involves extraordinary risks, in the opinion of the Minister of Finance.
The order of allocations and reductions is such, that first an allocation to the risk reserve is calculated for any year and subsequently the (taxable or tax-free) withdrawals are made chronological order.
c. Voluntary discontinuation
In addition, the legal regulation provides for the possibility of voluntary discontinuation of the reserve. In that event the reserve must be allocated to the profit in equal parts over a period of five years and taxed at a special rate of 10%. During this period the company must, however, continue to meet the legal conditions and those stipulated by the inspector. The entity should therefore continue to carry out finance activities and meet the country-criterion. If this condition is not met, then corporate income tax will as yet have to be paid at the normal rate. This also applies to the parts of the reserve released at a rate of 10%. During the five-year run-down period no more additions to the reserve may be made. The group financing profit in this period is therefore taxed at the normal rate.
Offsetting Foreign Withholding Taxes
Any withholding tax related to financing income which cannot be fully offset in any year, cannot be carried forward to subsequent years.
Competent Inspector
To be able to from a risk reserve, the taxpayer should first of all address a request to the competent inspector. The inspector will consult with a so-called coordinating group existing of inspectors from both the tax administration and the Ministry of Finance. If the request is honoured, the inspector will demand further requirements to be met. In principle, these conditions are applicable for a period of 10 years.
2. Return In Functional Currency
Upon request and under conditions to be further stipulated, the taxable amount may be declared in so-called functional currency. This facility also applies to both Dutch subsidiaries and permanent establishments located in the Netherlands of foreign taxpayers. There is no transitional arrangement and consequently the functional currency can be applied in existing situations as well. Furthermore, it will be possible to replace the functional currency by the guilder at any time. The conditions regarding the functional currency have not been published yet.
3. Extension Of The Participation Exemption
Loss-making subsidiaries in which a minimum stake of 25% is owned can be written down to the debit of the taxable profit during the first 5 years after acquisition. This concerns newly-incorporated companies as well as acquired participations. The amount by which the economic value of the participation declines below the cost price of the participation may be charged to the profit. This facility offers a temporary benefit only, since the amount of the write-down must be gradually added to the taxable profit within a certain period.
Currency results on loans relating to the acquisition of foreign participations will qualify for the participation exemption (future currency profits on such loans are therefore exempt; currency losses on the other hand are no longer deductible). Benefits obtained by instruments which serve to hedge currency results related to qualifying participations may also qualify for the participation exemption on request. There is no transitional arrangement for this new regime and therefore these provisions may also be applied in existing situations. The write-down of participations is only available for value decreases relating to book years which commence on or after January 1, 1997.
B. ANTI-ABUSE PROVISIONS
1. Protection Of The Netherlands Tax Base
General
This first of all involves the disallowance of interest deduction if the loan relates to certain legal transactions (new article 10a of the 1969 Corporate Income Tax Act). In this respect the creditor's domicile is of no relevance.
The following situations are specifically mentioned:
1. the taxpayer owes dividend, a restitution of paid-up capital or a capital contribution subject to interest;
2. the taxpayer takes out a loan from an associated entity or an associated individual in connection with a profit distribution or a restitution of paid-up capital to an associated entity or individual;
3. the taxpayer takes out a loan from an associated entity or associated individual in connection with the acquisition of an associated entity (so-called intra-group "repositioning"); in the opinion of the Ministry of Finance this provision also applies if a fiscal unity is formed with the repositioned participation); no disqualifying repositioning is assumed in as far as a change is made to the eventual stake or the eventual control over the acquired participation;
4. the taxpayer or a Netherlands-resident associated entity or individual makes a capital contribution(or employs capital otherwise) to the entity or for the benefit of the entity or the individual to whom the loan is owed. According to the parliamentary documents, the latter rather cryptic sentence concerns, inter alia, the following situations:
- a Dutch entity incorporates another entity and provides this entity with equity capital which it subsequently borrows in return in form of debt capital;
- a Dutch entity acquires the shares in a foreign finance company, whereupon this company grants a loan to a Netherlands-resident associated entity.
Proof To The Contrary
In the situations described at 1 through 4 it is up to the taxpayer to prove the contrary. In situation 1 the interest may be deducted if the taxpayer can demonstrate that the transaction was mainly prompted by arm's length considerations. An example of an arm's length consideration given for an outstanding dividend is to reduce the value of shares for the purpose of a share transfer. It is not clear yet how this issue will be dealt with in practice. In situations 2 through 4 the taxpayer has to demonstrate arm's length considerations both for the transaction and the group loan. As an example the situation has been mentioned where the associated entity providing the loan with which taxpayer finances the "internal repositioning" has itself borrowed the money from a third party.
In situations 2 through 4 the interest can also be deducted if, according to Dutch standards, a reasonable level of taxation can on balance be levied from the recipient of the interest. However, a reasonable level of taxation is not considered to exist if effectively no tax needs to be paid as a result of fiscal loss compensation or the compensation of input levies (either domestic or foreign).
No facilitative measures are made for existing situations. The only transition arrangement provided is the following. Interest which is not deductible will not, under a transition measure, be included in the taxable income of the (domestic) creditor up to and including the year 2001.
Fiscal Unity
The deduction of interest payments which are not affected by the above-mentioned rules to restrict the deduction can nevertheless be limited on the basis of a specific provision concerning fiscal unities (article 15, paragraphs 4 and 5 of the 1969 Corporate Income Tax Act). Interest owed to an associated entity (whether or not resident in the Netherlands) in connection with the acquisition of shares in a company to be included in the fiscal unity is deductible only during an eight-year period, provided the debtor obtains sufficient taxable profit on its own.
There are no transitional measures for existing situations.
There are two exceptions to this rule.
1. The restriction does not apply if the acquiring group has borrowed funds to finance the acquisition of the shares from non-associated entities.
2. If the takeover holding company can demonstrate that the stake in the subsidiary it has taken over has changed substantially and an individual - or a group of cooperating individuals - owns a direct or indirect stake (e.g. via a personal holding company) in the takeover holding company of at least five percent, the other shareholders each have a stake of less than one third part and one or more of the individuals receive income from employment at the takeover holding company or the subsidiary, then the rules to restrict deduction of interest do not apply.
In addition, the shareholding requirements stated at item 2 may vary according to the value of the subsidiary taken over.
These are the only exceptions to the restriction. The arm's length nature of the transaction and the extent of taxation on the interest at the creditor are irrelevant.
A possible restriction on deduction of interest ceases to exist on the expiry of a period of eight years following acquisition of the shares in the subsidiary. In principle, the interest related to the period subsequent to this term is again fully deductible.
2. Participation exemption, foreign group finance companies
The participation exemption will with respect to foreign finance companies only apply if these companies are actively involved in financing the group and there is no question of a situation which can be qualified as a portfolio investment. In the 1971 Corporate Income Tax Implementing Order six cumulative requirements are described which must be met in order to avoid application of the restriction which are the following:
1. The entity must be more than simply incidentally involved in arranging and executing financial transactions on behalf of companies pertaining to the group;
2. the entity must have access to at least 20% capital actually borrowed from third parties;
3. the entity must not have a liquid equity function (certain ratios are mentioned in the explanatory notes);
4. the entity must employ appropriately qualified personnel;
5. the entity must have its own office equipped with the facilities customary in the financial sector;
6. the entity must carry out the relevant transactions via its own bank accounts.
Under certain conditions the participation exemption may nevertheless apply if the requirement stated at item 2 is not met but an active group finance company is involved in all other respects. In that case the taxpayer must demonstrate, among other things, that the need of the group entities on whose behalf the entity performs finance activities for debt capital actually borrowed from third parties is less than 20% of the economic value of the entity's assets, and that the above group entities themselves have not actually borrowed debt capital from third parties.
In cases where it appears from the assessment administration in the year 1996 that the participation exemption applies to shares in companies which, according to the new criteria, qualify as passive finance companies, the participation exemption continues to apply for two years following the enactment of the bill.
A shareholding of 25% or more (whether or not together with an associated entity) in a passive finance company which no longer qualifies for the participation exemption will have to be valued annually at fair market value. The amount of the revaluation profit which is attributable to the period when the participation exemption still applied to the share ownership will not, however, be included in taxation on the grounds of the compartmentalization doctrine.
The parliamentary documents announce the intention of making these conditions similarly applicable to the 1989 Decree for the Unilateral Avoidance of Double Taxation in the context of granting double tax relief with regard to so-called passive finance permanent establishments. If this is the case then instead of the exemption method the tax credit method will apply. Also in this connection a two-year transitional period is proposed. The Netherlands will endeavour to include a similar provision on (re-)negotiation of tax treaties.
C. MEASURES IN THE COMPLIANCE AREA
As of 1997 also several measures in the area of compliance have been implemented, partly within the scope of the improvement of the business climate. In practice, the most important measure deals with the possibility to apply a so-called available equity allocation reserve in determining whether interest relates to a foreign participation. On this basis the means available at the company which have not been financed with debt capital can be identified. The available equity allocation reserve is an aid in demonstrating that a participation has been financed with equity. Yet it will not be possible to apply an available equity allocation reserve in cases where it is evident that a loan will be contracted in order to acquire a foreign participation. In the past it was already possible to make arrangements on this point with the tax authorities (e.g. the banking facility or the so-called single-purpose account). What matters is that these arrangements will cease to apply with effect from the financial year commencing on or after January 1, 1997. Until that time existing arrangements should be observed. If no arrangements were made in the past with the tax authorities, the available equity allocation reserve can be applied with respect to previous years which have not yet been finalized (unless this concerns years commencing before January 1, 1990).
Further information can be obtained from Mr P. te Boekhorst, KPMG Meijburg & Co, Amsterdam (Netherlands); fax 31 (20) 656 1247.
Keywords: Netherlands / Europe / EC / European Union / KPMG Meijburg & Co / Finance Activities / Finance Companies / Finance Reserve / Participation Exemption / Functional Currency / Anti-abuse / Interest deduction / fiscal unity / Compliance
Note: The content of this contribution is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
