Euro Tax Flash from KPMG's EU Tax Centre

CJEU – The Netherlands – Anti-abuse provisions – Interest deduction limitation – Arm's length principle – Artificial arrangements – Freedom of establishment

On October 4, 2024, the Court of Justice of the European Union (CJEU or the Court) rendered its decision in case C-585/22. The case concerns the compatibility of the Dutch interest deduction limitation anti-profit shifting rule with EU law. In line with the Advocate General’s opinion, the CJEU held that the rule under dispute is permissible under EU law.

In summary, the Court found that, whilst the Dutch interest limitation rule represents a de facto restriction on the freedom of establishment, this restriction is justified as it aims to combat tax fraud and evasion.

On the question of whether loans contracted at arm’s length could still be considered purely artificial or fictitious arrangements, the Court took the view that the CJEU’s decision in case C-484/19 cannot be read as inferring that the mere fact that a loan follows the terms that independent companies would agree upon automatically rules out the existence of a wholly artificial arrangement.

The plaintiff, a Dutch subsidiary (Company X) of a Belgian entity (Company A), acquired shares of an unrelated Dutch entity (Company F), thereby becoming its majority shareholder. The acquisition was financed by a loan granted by another group company (Company C), which was tax resident in Belgium and had received the funds shortly before through a capital injection from Company A. Following the acquisition, the two Dutch companies established a fiscal unity. A dispute arose between Company X and the Dutch tax authorities over the deductibility, for Dutch corporate income tax purposes, of interest expenses related to the intra-group loan.

Under the provisions of the Dutch Tax Code applicable at that time¹, the deductibility of interest expenses incurred with respect to loans contracted from related parties – particularly for internal reorganizations or external acquisitions, was restricted (subject to certain conditions). Two exceptions applied:

• a rebuttal provision allowed taxpayers to deduct the intra-group interest if they could demonstrate that the debt and the related transactions were primarily business-motivated; or
• if the taxpayer could demonstrate that the ‘compensatory tax test’ has been met. Compensatory tax is considered to exist if the creditor is subject to corporate income tax or income tax on the loan interest, with that tax being regarded as fair under Dutch standards. A tax is deemed fair if it results in a tax rate of at least 10 percent on profits calculated in accordance with Dutch standards².

Under settled case-law in the Netherlands, the interest deductibility restriction applied regardless of whether the interest rate was set at a level which would have been agreed between independent parties on an arm’s length basis.

The dispute reached the Dutch Supreme Court (Supreme Court), which tentatively agreed with the position of the Court of Appeal that the rule under dispute was justified and proportionate in light of the aim of combating tax avoidance and preserving the Dutch tax base. However, the Supreme Court expressed doubts about whether this conclusion was in line with the CJEU’s decision in case C-484/19, concerning the Swedish interest deduction limitation rules. In that judgment, the CJEU held that the exception to the 10 percent rule in the interest deduction limitation rules, applicable between 2013 and 2018, was contrary to the freedom of establishment. In the justification assessment, the CJEU placed particular emphasis on the fact that the exception to the 10 percent rule may cover transactions carried out on market terms and which consequently, in the CJEU’s view, do not constitute wholly artificial or fictitious arrangements. For more details, please refer to E-News Issue 124).

Consequently, the Supreme Court referred the case to the CJEU to clarify whether the rule under dispute was compatible with the freedom of establishment, the freedom to provide services and / or the free movement of capital enshrined in the Treaty on the Functioning of the European Union (TFEU).

The Advocate General’s opinion

On March 14, 2024, Advocate General (AG) Nicholas Emiliou rendered his opinion in the case at hand. The AG recommended that the CJEU finds the rule under dispute as permissible under EU law.

On the question of whether loans contracted at arm’s length could still be considered purely artificial or fictitious arrangements, the AG noted that his view departs from the CJEU’s ruling in case C-484/19. In the AG’s view, in that particular case, the Court considered that the purpose for which the loan was concluded is not relevant and distinguished between loans contracted on an arm’s length basis (deemed genuine) and those which are not contracted on such basis (which the Court regarded as artificial). The AG warned against the risk that the arm’s length principle becomes a ‘safe harbour’ for taxpayers and consequently recommended that the CJEU revisits its previous case-law on this topic. For more details please refer to EuroTaxFlash 540.

Applicable fundamental freedom

The CJEU started by analyzing the freedom applicable in the disputed case³. In this context, the Court noted that the Dutch legislation under dispute concerned the tax treatment of interest paid on intra-group debt between companies that may directly or indirectly have a decisive influence on each other’s decisions. Based on these grounds, the CJEU concluded that the Dutch interest deduction limitation rule had to be assessed based on the freedom of establishment - i.e., Article 49 of the Treaty on the Functioning of the European Union (TFEU).

The CJEU recalled that Article 49 TFEU mandates the abolition of restrictions on the freedom of establishment for residents of one Member State within the territory of another Member State. A difference in treatment, leading to a restriction of the freedom of establishment is only permitted if it concerns situations which are not objectively comparable or if the restriction is justified by overriding reasons in the public interest and is proportionate to the aim pursued.

Whether a restriction exists

The CJEU continued by analyzing whether the rule under dispute leads to a difference in treatment that constitutes a restriction on the freedom of establishment. In this regard, the CJEU reiterated that not only direct, but also indirect discrimination, may result in a restriction on the freedom of establishment.

The CJEU acknowledged that the Dutch rules do not entail a direct discrimination based on the residence of the group of companies concerned and went on to analyze whether the rules represent instead a de facto restriction.

In this context, the CJEU assessed whether the criteria in the Dutch interest limitation rules may disproportionately impact cross-border situations. The Court found that the second rebuttal rule (i.e., requiring that interest is subject to fair taxation at the level of the creditor, defined as a minimum tax rate of 10 percent computed according to Dutch standards), could lead to a disadvantageous treatment of cross-border situations. Whilst it is up to the referring court to perform this check, the Court noted that if based on the Dutch tax system, Dutch resident companies receiving interest are taxed at a rate higher than 10 percent, the criterion based on the compensatory tax test can only be failed in cross-border situations – i.e., only Dutch companies that pay interest to affiliated entities established in another Member State may find themselves in a position where the compensatory tax test is not met.

Based on the above, and in line with the opinion of the AG, the CJEU concluded that the Dutch interest limitation rule represents a de facto restriction on the freedom of establishment.

Whether the situations are comparable

In its comparability analysis, the CJEU noted that under Dutch law the ability to deduct interest on intercompany loans when calculating taxable profit is contingent upon ensuring that such interest costs are not artificially generated.

In this context, the CJEU concluded that a company is not in a different situation on the sole ground that the related entity receiving interest is established in another Member State, even if such interest is subject to a rate below 10 percent applied to a tax base computed in accordance with Dutch law. Furthermore, the CJEU reiterated its settled case-law based on which a company established in a Member State that pays interest on an intra-group loan concluded with a related group company established in another Member State is in the same position regarding the payment of that interest as if the recipient were a group company located in the same Member State.

Whether the restriction is justified

The CJEU recalled that restrictions on fundamental freedoms may nevertheless be compliant with EU law when they are justified by an overriding reason in the public interest. In this context, the CJEU noted that the purpose of the rule under dispute was to combat tax fraud and avoidance by preventing the deduction of interest artificially created (i.e., interest on a loan concluded between affiliated entities without any business motives). The fact that the legislation also applies to situations as the one in the case at hand – where entities become affiliated only after an acquisition, does not change the assessment, as the legislation is designed in both situations to combat artificial transactions related to the conversion of equity into debt. Recalling settled case-law under which the fight against tax fraud and avoidance constitutes an overriding reason in the public interest, the CJEU held that the restriction under dispute was justified.

Whether the restriction is appropriate

The CJEU continued by assessing whether the restriction is ‘appropriate’, i.e., whether it is i) suitable to achieving the objective pursued, and ii) genuinely reflecting a concern to attain the objective in a consistent and systematic manner.

The appellant argued that the disputed rule fails to combat artificial intra-group loans in a consistent and systematic manner, as it allows deductions when the interest is taxed at a reasonable rate in the Member State of the lending company, even where the loan and / or the associated transaction lack economic justification.

The CJEU rejected the plea and concluded that the Dutch legislation is suitable to achieve the objective pursued in a consistent and systematic manner. In the Court’s view, the law is designed to neutralize the tax consequences of wholly artificial arrangements created by affiliated entities that do not reflect economic reality and are solely intended to avoid profit tax. This is accomplished by limiting the deduction of artificially generated interest costs and ensuring that such interest is reasonably taxed in the recipient's Member State, thereby preventing the complete avoidance of corporate income tax.

Whether the restriction is necessary

The CJEU further held that the restriction does not go further than necessary to achieve its purpose, on the grounds that: i) it only targets wholly artificial arrangements, and ii) the consequences of a transaction being characterized as such are not excessive.

On the first point, the CJEU recalled its settled case-law based on which the identification of a ‘wholly artificial’ arrangement requires not only an intention to gain a tax advantage but also presence of objective factors indicating that, despite formal compliance with EU law, the objective pursued by the freedom of establishment has not been achieved. The CJEU noted that the Dutch interest limitation rules establish a presumption that interest paid on loans meeting certain criteria (such as being granted by a related party and linked to the acquisition / increase of shareholding in an entity which become related following the acquisition), constitute indications within the meaning of CJEU case-law on the existence of a wholly artificial arrangement.

The Court also noted that this presumption can be rebutted by the taxpayer. This fact limits the denial of interest deductions to cases where the loan was primarily contracted for tax reasons and was not necessary for the achievement of economically justified objectives.

According to the CJEU, whether a loan is concluded on an arm’s length basis or not could represent an objective criterion to determine whether a transaction (partly) constitutes a wholly artificial arrangement. Moreover, the CJEU noted that the assessment of compliance with the arm's length principle encompasses not only the terms of the loan (such as the interest rate) but also the economic validity of the loan and the related legal transactions. This requires evaluating whether the related transaction(s) would have occurred in the absence of the affiliated relationship. In the Court’s view, the lack of economic reality represents a decisive factor in classifying a transaction as a wholly artificial arrangement.

The CJEU also rejected the plaintiff’s plea that the Dutch rules under dispute were not in line with settled case-law, notably case C‑484/19. The plaintiff had argued that Dutch interest limitation rules also targeted legitimate transactions and not only wholly artificial arrangements, insofar as the legislation also applied to interest set in line with the arm’s length principle.

In this context, the CJEU noted that the Dutch interest limitation rule differs from the Swedish legislation under dispute in case C‑484/19, as the purpose of the legislation is not the same. The CJEU also noted that in case C-484/19, the economic validity of the loan and the related transactions were not questioned before the CJEU, and therefore were not assessed by the Court. The CJEU concluded that it can not be inferred from that judgment that the mere fact that loans are concluded on an arm’s length basis, implies that the loan and the legal transactions can not, by definition, constitute a wholly artificial arrangement.

On the second point above, with respect to the consequences of deeming the loan artificial, the CJEU distinguished between two situations:

• the artificial nature of a transaction results from an artificially high interest rate on a loan that, in itself, reflects economic reality. In this case, the Court deemed it proportionate to deny the deduction of any interest that exceeds the arm’s length interest rate;
•  the loan itself is not based on any genuine business considerations and would not have been concluded without the affiliation between the entities and the tax advantage sough. In this scenario, the Court found it consistent with the principle of proportionality to limit the entire interest deduction.

The Court also noted that the rule under dispute does not breach the principle of legal certainty. In this context, the CJEU upheld the AG’s comments and acknowledged that legislation aimed at preventing abusive tax practices must rely on abstract concepts to cover a wide range of tax fraud and avoidance scenarios. Furthermore, the Court took the view that the use of such abstract concepts does not mean that the application of the law is left to the arbitrary discretion of tax authorities, rendering it unpredictable. As such, the Court recalled its previous finding that the Dutch legislation includes clear criteria, thus allowing taxpayers to anticipate its application with sufficient precision.

In light of the above, the CEU concluded that the freedom of establishment should be interpreted as such that it does not preclude national legislation to limit the full interest deduction on a loan that is considered (part of) a wholly artificial arrangement, even where the interest rate stipulated therein does not exceed the interest that would have been agreed upon between independent companies.

The CJEU did not explicitly revisit its judgement from case C-484/19, as was earlier advised by the AG. Instead, the CJEU held that it cannot be inferred from its ruling in that particular case that compliance with the arm’s length principle was sufficient to deem a loan and the related transaction as non-artificial, by which the CJEU provided a nuanced interpretation of case C-484/19.

It is now clear that the deduction of interest can be denied in full, if a loan would never have entered into existence in an at arm’s length situation, notwithstanding the arm’s length interest rate.

In light of the concept of wholly artificial arrangement, the CJEU reiterated their abuse of law principles from settled case-law, among which:

•  A restriction of the freedom of establishment can only be justified by combatting tax fraud and tax evasion, if such restriction prevents the conduct consisting in creating purely artificial arrangements, devoid of economic reality, with the aim of evading the tax normally due on profits generated by activities carried out on national territory.
• The principle of the prohibition of abusive tax practices also applies, when the pursuit of a tax advantage constitutes the essential aim of the transactions concerned.

The fact that a taxpayer pursues the tax regime most advantageous to him, cannot, as such, give rise to a general presumption of fraud or abuse, however a taxpayer cannot benefit from a right or advantage arising from EU law where the transaction concerned is purely artificial in economic terms and is intended to evade the influence of the legislation of the Member State concerned.