In a decision of Friday 15 May 2020, the Dutch Supreme Court confirmed that fixed-to-floating rate perpetual equity securities (“perpetual securities”) should not be considered a “participation loan” (deelnemerschapslening) for Dutch tax purposes. Under Dutch tax law, characterization of a debt instrument as a “participation loan” implies that such instrument is deemed equity for Dutch corporate income tax purposes. Characterization of the perpetual securities as a participation loan would have meant that the interest would have been regarded non-deductible dividend.
What is a “participation loan”?
In a landmark ruling of 27 January 1988, the Supreme Court ruled that the civil law form under which funds are provided, is in principle decisive for determining whether the funds should be considered debt or equity for Dutch tax purposes. One exception whereby a debt for civil law purposes for Dutch tax purposes is re-characterized as equity is a so-called participation loan. This is a debt instrument (based on civil law) provided under such conditions that the creditor effectively participates, to a certain degree, in the enterprise of the debtor. Based on case law, a participation loan is only present if the following (cumulative) conditions have been met: (i) the interest payable on the loan is (entirely or nearly entirely) contingent on the creditor's profit, (ii) the debt obligation is subordinated to all ordinary ranking creditors; and (iii) the debt obligation has no fixed term (or a term exceeding 50 years) and is only payable in case of bankruptcy, suspension of payments or liquidation of the debtor.
Relevant facts and circumstances of the perpetual securities case
The taxpayer concerned was a naamloze vennootschap (‘NV’) and a publicly listed company. In November 2010, NV issued perpetual securities amounting to EUR 500m. The perpetual securities were listed on the Euronext Amsterdam. The NV redeemed the EUR 500m perpetual securities on 21 November 2013. The key terms & conditions (‘T&C’) of the perpetual securities as included in the prospectus included the following:
- The securities, together with interest accrued thereon, constituted direct unsecured and subordinated obligations of the issuer which will at all times ranked pari passu without any preference among themselves.
- The rights of the holders against the issuer in respect of the principal amounts due and any interest due were subordinated and would rank (i) in priority to any distributions in respect of any ordinary shares in the equity of the issuer; (ii) pari passu with the holders of preference shares (if any) issued by the issuer; and (iii) junior to the claims of all unsubordinated creditors (‘parri passu provision’).
- The securities were perpetual securities and had no fixed maturity date. The issuer had the right to redeem the securities, subject to certain conditions.
The NV deducted the interest expenses in relation to the perpetual securities (‘the interest expenses’) in its 2010 corporate income tax return. The tax inspector disputed this.
The Appeals Court Arnhem-Leeuwarden ruled that the interest expenses were deductible, since the perpetual securities were a loan for Dutch civil law purposes. The latter characterization hinged on the existence of repayment obligation of the issuers, without such repayment obligation being illusory. Furthermore, the perpetual securities should not be considered a participation loan, as the interest expenses due, neither formally nor materially, were contingent on the issuer's profit.
The Dutch tax authorities appealed with the Dutch Supreme Court, arguing that the perpetual securities should be considered equity for tax purposes, as (i) the perpetual securities were subordinated to other creditors and (ii) a real repayment obligation was absent, notably due to the pari passu provision included in the T&C. The Supreme Court basically rules that if the funds for Dutch civil law purposes are provided as share capital (i.e. equity), this is respected for Dutch tax purposes. If the funds are not provided as share capital, the starting point is that it is decisive whether a repayment obligation is included in the debt instrument. This should be assessed on basis of the civil law form. If such repayment obligation exists, as a rule, the funds should be considered debt for Dutch tax purposes. This also applies if the repayment obligation is conditional or repayment of the funds is uncertain. The repayment obligation applies too if the debt agreement entails that the creditor, in case of bankruptcy or dissolution and liquidation of the debtor, upon seizing its funds, has a rank equal to preferred shareholders. The Supreme Court confirms that the reasoning of the Appeals Court reflects a correct interpretation of the law and for the remainder, being a matter of fact, cannot be assessed by the Supreme Court.
The tax authorities also took the position that the perpetual securities should be considered a participation loan (i.e. equity for Dutch tax purposes). Specifically they argued that the contractual remuneration is contingent on the creditor's profit as debtor has the right to suspend interest payments without the obligation to repay the principal amount or provide security in combination with the pari passu provision in the T&C. The Supreme Court considers that what has been agreed between parties is decisive for determining whether the funds are subordinated to all ordinary creditors and whether the remuneration for providing the funds is contingent on the profit of the debtor. It should thus be assessed based on civil law criteria. The position that the conditions to qualify as a participation loan should be assessed in substance (that is to say: materially) in general is not acceptable. Upon assessing what has been agreed between the parties, it is relevant to take into account the parties’ purpose for entering into the agreement, for which the factual situation at that time may be of importance. Finally, upon assessing whether funds could qualify as a participation loan, provisions that lack autonomous meaning can be ignored. The Supreme Court confirms that the reasoning of the Appeals Court reflects a correct interpretation of the law and for the remainder, being a matter of fact, cannot be assessed by the Supreme Court.
In the current ruling the Supreme Court essentially clarifies that
- for assessing whether funds should be considered a loan for civil law purposes, the inclusion of a pari passu provision (entailing that the creditor, in case of bankruptcy or dissolution and liquidation of the debtor, upon seizing its funds, has a rank equal to preferred shareholders), does not erode the repayment obligation included in the debt instrument.
- for assessing whether a debt instrument is considered a participation loan, the combination of a debtor’s right to suspend interest payments without the obligation to repay the principal amount and provide security in combination with the pari passu provision, in and of itself does not make the remuneration contingent on the profit of the debtor.