On 15 May 2020, the Dutch Supreme Court issued an important decision on the debt classification rules for Dutch corporate income tax (CIT) purposes (case ECLI:NL:HR:2020:874).
The case, brought before the Supreme Court, concerned a Dutch company (Issuer) that had issued Fixed-to-Floating Rate Perpetual Capital Securities (perpetual securities) in connection with the financing of an acquisition. The perpetual securities were listed on Euronext Amsterdam.
The main characteristics of the perpetual securities were as follows:
- the perpetual securities had no fixed maturity date. Only in case of the Issuer’s liquidation would the securities become immediately due and repayable at their principal amount, together with any accrued interest (including any arrears of interest). The holder of a perpetual security could initiate an Issuer’s liquidation if the Issuer defaulted on one or more of its obligations under these securities.
- the perpetual securities, together with interest accrued including any arrears of interest, constituted direct unsecured and subordinated obligations for the Issuer, which at all times ranked pari passu without any preference among themselves.
- the rights and claims of the holders and coupon holders against the Issuer under the perpetual securities in respect to the principal amounts due and payable on redemption and any arrears of interest and any other sum payable in respect to or arising from the perpetual securities were subordinated on a liquidation. They ranked:
- in priority to any distributions in respect to any ordinary shares in the capital of the Issuer;
- pari passu with the holders of preference shares (if any) issued from time to time by the Issuer; and
- junior to the claims of all unsubordinated creditors, present and future, of the Issuer and to all subordinated creditors of the Issuer other than those whose claims (whether only in the event of the winding-up of the Issuer or otherwise) ranked pari passu with or junior to the claims of the holders of the perpetual securities.
- the rates to be applied to calculate the interest on the perpetual securities were not linked to the Issuer’s profits, but were instead determined based on certain other unrelated criteria. The perpetual securities’ terms and conditions provided for a certain step-up rate to be applied after a certain period, making the financing obtained by the Issuer through the issue of the perpetual securities more expensive.
- the Issuer could elect to defer any payment of interest on the perpetual securities, unless it decided to make dividend or similar distributions, in which case any and all deferred interest instalments would become immediately payable.
- the Issuer was entitled to redeem the perpetual securities under certain specified circumstances, including if it would become clear that, in short, the perpetual securities would have to be labelled as equity for Dutch CIT and dividend withholding tax purposes.
Issue at stake
The Dutch tax authorities brought forward two alternative arguments to refuse the Issuer the tax deductibility of the interest on the perpetual securities:
- the perpetual securities qualified as equity for Dutch CIT purposes; and
- if the courts were to decide that the perpetual securities constituted debt, the Dutch tax authorities adopted the position that the perpetual securities qualify as profit-participating loans (PPL).
A PPL is a loan that meets the following cumulative conditions:
- it is subordinated to the claims of all other ordinary creditors; and
- it bears interest that is entirely or almost entirely dependent on the borrower’s profits; and
- it does not have a fixed maturity or one that amounts to more than 50 years, without the obligation for the borrower to repay at an earlier stage except in case of its liquidation or bankruptcy or in case it is being granted moratorium of payment.
Supreme Court decision
In its 15 May decision, the Supreme Court provided an extensive overview of the criteria to be applied to determine whether a financial instrument has to be qualified as equity or debt for Dutch CIT purposes and how the PPL conditions must be read. In this respect, the court also referred to previous decisions relating to these topics.
The Supreme Court held that, as a rule, the civil-law form of the provision of money is decisive for the purpose of labelling a provision of money as equity for CIT purposes. If, according to civil-law standards, the provision of money is to be regarded as a provision of share capital, it should be regarded as a provision of equity for CIT purposes. If, according to civil law, the provision of money is not to be regarded as a provision of share capital, the starting point for the CIT classification of that provision of money is whether there is an obligation to repay. This should be assessed in accordance with the civil-law form selected for the provision of money. In case of a repayment obligation, the party to whom the money has been granted then has a debt to the lender in accordance with the civil-law form selected, as a result of which the provision of money cannot as a rule be regarded as the provision of equity for CIT purposes.
With respect to the conditional nature of the repayment obligation in case of the perpetual securities, the Supreme Court ruled that a (decisive) repayment obligation also exists if it is conditional and the repayment is uncertain. As far as the perpetual securities’ subordination was concerned, the Supreme Court ruled that this does not alter the conclusion about the existence of a conditional repayment obligation, not even now that these securities ranked equal with Issuer's preference shares in case of the Issuer’s liquidation.
The Supreme Court concluded that as long as a provision of monies does not constitute a contribution of equity for civil-law purposes, it is to be labelled as debt for Dutch CIT purposes in case such a provision is subject to a repayment condition, be it conditional or not. Applying these criteria, the Supreme Court concluded that the perpetual securities indeed qualified as debt for CIT purposes, unless one of the three previously formulated exceptions to this main rule applies. These exceptions are:
- sham loans, being loans that are only presented as such while parties have intended to provide equity (schijnlening);
- loss-financing loans, being loans that an unrelated party would not make because it is clear from the outset that the loan will never be repaid (bodemlozeputleningen); and
- profit-participating loans (deelnemerschapslening).
Therefore, a financing instrument, not qualifying as equity for Dutch civil-law purposes, which is not a sham loan, a loss-financing loan, or a participating loan, qualifies as debt for Dutch CIT purposes.
With the perpetual securities, the remaining issue at stake was whether these could be qualified as PPLs. As stated, a loan is considered to be a PPL if the loan has a term that is indefinite or longer than 50 years, the loan is subordinated to ordinary creditors, and the interest is depended almost entirely on the profits of the debtor.
The Dutch tax authorities argued that the perpetual securities qualified as PPL in view of:
- the securities’ unlimited duration;
- the securities’ full subordination;
- the contractual remuneration for the grant of money having to be considered profit dependent because of the possibility for the issuer to suspend payment of interest without being obliged to redeem the principal or provide security, this in combination with, in short, the subordination.
The Supreme Court ruled that to answer the question whether the debt is subordinate to all unsecured creditors consideration must be given to what has been agreed to by the parties. After all, the decisive factor is the conditions under which the financial instrument was made available, which must be assessed according to civil-law standards. What has been agreed in this respect is also decisive for the profit-dependent nature of the remuneration and the term of the debt. According to the court ruling, it cannot be accepted in general that the conditions for the existence of a participating loan must be assessed based on a substance-over-form approach. This assessment needs to occur based on the joint intention of the parties at the time of concluding the agreement.
While the perpetual securities satisfied the first two PPL conditions, parties were divided about whether the interest on these securities was profit dependent. The Supreme Court ruled that because the interest on the perpetual securities was to be determined based on criteria independent from the Issuer’s profits, the interest did not qualify as profit dependent. The possibility to defer payment of this interest read in combination with the subordinated nature of the holders’ rights under these securities was considered irrelevant.
With this decision, the Supreme Court has affirmed the following clear criteria that must be applied for CIT purposes when labelling a financial instrument:
- for CIT purposes the equity nature of a financial instrument that qualifies as a capital contribution for civil law is respected, regardless of the existence of a (conditional) repayment obligation;
- if a financial instrument does not qualify as an equity contribution for civil-law purposes, then the existence of a repayment obligation should in principle be decisive for the debt or equity classification of the financial instrument, even if such a repayment obligation is conditional and subordinated;
- in case of a repayment obligation, the PPL nature of a financial instrument is to be determined based on the instrument’ exact terms and conditions. This requires a legal analysis, rather than an economic approach since a borrower not being able to pay interest in case of lack of profits can result in the interest becoming de facto profit dependent.
The application of the above classification framework should be straightforward in most instances. Obviously, there will be instances in which uncertainty will continue to exist. We would also expect the courts to be willing to apply a substance-over-form interpretation in case of examples of clear misuse.
For more information on this ruling and how it could affect your business, contact your regular CMS advisor or local CMS experts.