Thin Capitalisation in the Netherlands - Part 2: Understanding and Escaping the Group Debt-to-Equity Ratio
In part one of this article we illustrated that the newly introduced Dutch thin capitalisation regulations can have a substantial impact on the deductibility of interest cost on related party debt obtained by Dutch companies (also referred to as ‘taxpayers’).
In part two, we will address:
As illustrated in part one, the thin capitalisation rules limit the deductibility of interest cost on ‘excessive’ related-party debt financing. The excess of liabilities in this respect is determined by applying a 3:1 debt-to-equity ratio. This ratio is determined on an annual basis by calculating the average equity and average debt in the fiscal year.
This triggers the question how ‘debt’ and ‘equity’ are defined for the purposes of this calculation.
‘Equity’ is defined as fiscal equity. The amount of equity is determined in accordance with Dutch tax law and does neither include tax-allowable reserves1 nor hybrid debts. The average amount of equity is deemed to be at least EUR 1.
‘Debt’ is defined as the balance between loans payable and loans receivable. It is not entirely clear what is covered by the term ‘loan’. According to the parliamentary history, loans receivable for thin capitalisation purposes include banking deposits and purchased debt securities. Loans payable include credit provided by a bank and issued debt securities.
Short-term trade liabilities are not regarded as loans payable and tax refunds are not regarded as loans receivable. The term ‘loans’ only includes loans on which the interest – disregarding the application of the thin capitalisation and interest temporisation rules – is tax deductible. As a consequence, so-called ‘tainted’ debts2 and ‘hybrid’ debts3 are not included in the calculation of the debt-to-equity ratio.
Based on parliamentary history4, financial leases are not included in the loans payable for thin capitalisation purposes. Tax rulings are available in which Dutch tax inspectors have confirmed this viewpoint.
The comments above can be further illustrated on the basis of examples. In our examples below we assume that all figures are in kEUR, the interest rate on all interest bearing debt and receivables is 5% and that equity and debt in all balance sheets represent annual averages.
| Taxpayer’s fiscal balance sheet | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
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| Equity | 1,000 | |
| Debt | 9,000 + 4,000 -/- 2,000 -/- 4,000 | 7,000 |
| Excessive debt | 7,000 -/- 3 * 1,000 -/- 500 | 3,500 |
| Total interest cost | 5% * (9,000 + 4,000) | 650 |
| Restriction based on 3:1 ratio | 3,500 / 7,000 * 650 | 325 |
| Maximum restriction | 450 -/- 200 | 250 |
| Non deductible interest cost | 250 |
Since tax-allowable reserves are not included, the amount of equity for thin capitalisation purposes amounts to kEUR 1,000.
For application of the thin capitalisation regulations, the amount of the liabilities is defined as the balance between the loans payable and loans granted. The purchased securities qualify as loans granted. Since interest-free debt, tainted debt and debt arising from a financial lease transaction are not to be included in the amount of loans payable, the debt for thin capitalisation purposes in this example amounts to kEUR 7,000. Since equity amounts to kEUR 1,000, the excess of liabilities amounts to kEUR 3,500, taking into account the kEUR 500 treshold.
The interest cost on the ‘disqualified’ debt should not be taken into account when calculating the amount of total interest cost for thin capitalisation purposes. On the basis of the debt-to-equity ratio, the restriction of interest deductibility in principle amounts to kEUR 325. However, the amount of interest that will not be tax deductible is maximised by the difference between the amount of interest payable on loans payable to group companies and the interest received on loans receivable from group companies. In this example this maximum restriction amounts to kEUR 450 -/- kEUR 200 = kEUR 250. Consequently, kEUR 250 of the interest costs are not tax deductible as a result of the thin capitalisation regulations.
As mentioned in part one, a higher ratio than the 3:1 ‘safe harbour’ debt-to-equity ratio may apply at the request of the taxpayer if the group to which the Dutch taxpayer belongs has a higher worldwide debt-to-equity ratio based on the consolidated financial statements.
This alternative may provide a solution to companies that are active in sectors in which a relatively high level of gearing is common or – in most cases – to Dutch top holding companies that exceed the 3:1 ratio.
For this test, the company’s and the group’s debt-to-equity ratio are determined on the basis of the group’s consolidated financial statements. In order to determine the ‘commercial’ debt-to-equity ratio of the Dutch taxpayer, the commercial accounts of the Dutch company are consolidated with Dutch subsidiaries that are included in the same fiscal unity and entities that are considered transparent for Dutch tax purposes.
The example below illustrates the effect of the group debt-to-equity ratio for a Dutch top holding company that holds 100% of the shares in two non-Dutch subsidiaries.
| Taxpayer’s fiscal balance sheet | |||||||||
|---|---|---|---|---|---|---|---|---|---|
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| Equity | 2,000 | |
| Debt | 9,000 | 9,000 |
| Excessive debt | 9,000 -/- 3 * 2,000 -/- 500 | 2,500 |
| Total interest cost | 5% * 9,000 | 450 |
| Restriction based on 3:1 ratio | 2,500 / 9,000 * 450 | 125 |
| Maximum restriction | 450 | |
| Non-deductible interest cost | 125 |
Based on the 3:1 debt-to-equity ratio, an amount of kEUR 125 would not be tax deductible. As a consequence, the company should determine whether it is beneficial to apply the group debt-to-equity ratio.
We assume that the Dutch holding company’s non-consolidated commercial balance sheet looks like this:
| Taxpayer’s non-consolidated commercial balance sheet | |||||||||
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The equity in the taxpayer’s non-consolidated commercial balance sheet is higher than the equity in its fiscal balance sheet since the subsidiaries in the fiscal balance sheet are valued at historical cost price whereas in the commercial balance sheet they are valued at higher equity value. As a consequence, the debt-to-equity ratio based on this balance sheet is 1.5:1.
We furthermore assume that the consolidated commercial balance sheet looks like this:
| Taxpayer’s consolidated commercial balance sheet | |||||||||
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The group debt-to-equity ratio is 5.67:1. Since this ratio is higher than the company’s debt-to-equity ratio based on its non-consolidated commercial balance sheet all interest costs are tax deductible based on the escape of the group debt-to-equity ratio. In this example, the taxpayer should therefore elect to apply the group ratio in its tax return.
Obviously, the possibility of applying for the group debt-to-equity ratio based on the commercial financial statements may provide some planning opportunities to either increase the taxpayer’s equity or increase the group’s debt.
In most cases applying, the group ratio will provide an escape for Dutch top holding companies that have a higher than 3:1 debt-to-equity ratio based on their fiscal balance sheet. There are however some exceptions which we do not have the space to address in this article.
The thin capitalisation regulations may have some unexpected consequences, for example in the following situations:
The thin capitalisation rules only limit the interest cost on loans from related parties. Interest cost on third-party debt will remain deductible. However, all net debt is taken into account when determining the debt-to-equity ratio, so taking up additional third-party debt – for example to invest in assets – increases this ratio and can indirectly restrict the deductibility of interest cost on already existing related party debt.
If loans are obtained from and on-lent to related parties, the debt-to-equity ratio will not change. The same applies to the ratio between the excess of liabilities and the average amount of liabilities. However, in order to calculate the amount of interest deductibility that will be restricted, this ratio will be multiplied by the interest payable on loans. Since the latter amount increases, the amount of interest deductibility that will be denied might also increase. Note however that the amount of interest that will not be tax deductible is maximised by the difference between the amount of interest payable to group companies and the interest received from group companies.
If a Dutch group company relies on the group debt-to-equity as described above for its interest deductibility because the ‘safe harbour’ 3:1 debt-to-equity ratio can not be met, the repayment of external debt by, for example, a US group company might lead to the non-deductibility of interest cost at the level of the Dutch taxpayer.
This will be the case if – as a consequence of the repayment of external debt – the group debt-to-equity ratio based on the consolidated financial statements will become lower than the Dutch company’s non-consolidated commercial debt-to-equity ratio.
On the other hand, if a foreign group company obtains external debt for an acquisition, for example, this might increase the possibility for interest deductibility at the level of the Dutch company.
As the annual averages of equity and debt are decisive to determining the debt-to-equity ratio, the treasurer can still take action now to resolve Dutch thin capitalisation issues for fiscal year 2004.
The actions a treasurer could consider in this respect include the following:
Of course, it should be determined on a case-by-case basis what solution is feasible and the most practical. It goes without saying that when considering any of these alternatives, other Dutch and non-Dutch tax and other consequences, such as possible Dutch capital tax payable, should be addressed.
About the co-author
Frank Elsweier is an international tax specialist with experience on various international tax issues such as participation exemption, corporate reorganisations, and cross-border structured finance. Within the Eindhoven-based Dutch PwC tax team, his special interest is focused on international tax aspects of participation exemption, intercompany financing and currency results. Frank is responsible for tax services to large US, German and Dutch companies.
1 Such as a so-called ‘re-investment reserve’.
2 ‘Tainted’ debt is intercompany debt the interest cost of which are not deductible for Dutch corporate income tax purposes based on article 10a Dutch Corporate Income Tax Act (‘CITA’) because the loan erodes the Dutch tax base whilst there are no underlying business reasons. An example of such debt is a debt of a Dutch BV to its parent company arising from the fact that the BV remains a dividend distribution due.
3 Hybrid debt is debt which is de facto treated as equity for Dutch corporate income tax and dividend withholding tax purposes. The term ‘hybrid debt’ is defined in article 10 sub 2 CITA: whether debt will qualify as hybrid debt depends on the term of the loan, whether of not the loan is subordinated and whether or not the interest is profit dependant or dependant on the distribution of profits.
4 Letter dated 9 December 2003, nr. AFP2003/901M, of the Dutch State Secretary of Finance to the Upper Chamber.
5 Dutch companies that are included in a fiscal unity are treated as a single taxpayer for thin capitalisation purposes. It should be determined on a case-by-case basis whether the formation of a fiscal unity will result in a benefit or not for thin capitalisation purposes.
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