This case concerns a private equity takeover structure with apparently an intended international mismatch, i.e. a deduction/no inclusion of the remuneration on the provision of funds. The case was (primarily) decided by the Court of Appeal on the basis of non-business loan case law.
The facts are as follows:
A private equity fund [A] raised LP equity capital from (institutional) investors in its subfund [B] and then channelled it into two (sub)funds configured in the Cayman Islands, Fund [C] and [D] Fund. Participating in those two Funds were LPs in which the limited partners were the external equity investors and the general partners were Jersey-based [A] entities and/or executives. The equity raised in [A] was used for leveraged, debt-financed acquisitions of European targets to be sold at a capital gain after five to seven years, after optimising their EBITDA.
One of these European targets was the Dutch [F] group. The equity used in its acquisition was provided not only by the [A] funds (approximately € 401 m), but also (for a total of approximately € 284 m) by (i) the management of the [F] group, (ii) the selling party [E] and (iii) co-investors not affiliated with [A].
1.4 The equity raised in the [A] funds was converted into hybrid, but under Luxembourg law, debt in the form of preferred equity shares: A-PECs (€ 49 m) and B-PECs (€ 636 m), issued by the Luxembourg mother ( [G] ) of the interested party. G] has contributed € 43 million to the interested party as capital and has also lent or on-lent it approximately € 635 million as a shareholder loan (SHL). The interested party has not provided [G] with any securities and owes [G] over 15% interest per year on the SHL. This interest is not paid, but credited. The SHL and the credited interest are subordinated to, in particular, the claims of a syndicate of banks that lent € 640 million to the target in order to pay off existing debts. That syndicate has demanded securities and has stipulated that the SHL plus credited interest may not be repaid before the banks have been paid in full.
The tax authority considers the SHL as (disguised) equity of the interested party because according to him it differs economically hardly or not at all from the risk-bearing equity (participation loan) c.q. because this SHL is unthinkable within the OECD transfer pricing rules and within the conceptual framework of a reasonable thinking entrepreneur. He therefore considers the interest of € 45,256,000 not deductible. In the alternative, etc., he is of the opinion that the loan is not business-like, that Article 10a prevents deduction or that the interested party and its financiers have acted in fraudem legis. In any case he considers the interest not deductible.
According to the Court of Appeal, the SHL is a loan in civil law and not a sham, and is not a participation loan in tax law, because its term is not indefinite, meaningless or longer than 50 years. However, the Court of Appeal considers the loan to be non-business because no securities have been stipulated, the high interest is added, it already seems impossible after a short time to repay the loan including the added interest without selling the target, and the resulting non-business risk of default cannot be compensated with an (even) higher interest without making the loan profitable. Since the interested party’s mother/creditress ([G] ) is just as unacceptable as a guarantor as the interested party himself, your guarantor analogy ex HR BNB 2012/37 cannot be applied.
Therefore, the Court of Appeal has instead imputed the interest on a ten-year government bond (2.5%) as business interest, leading to an interest of € 7,435,594 in the year of dispute. It is not in dispute that 35,5% of this (€2,639,636) is deductible because 35,5% of the SHL was used for transactions not contaminated (pursuant to Section 10a Vpb Act). The remaining €4,795,958 is attributable to the contaminated financing of the contaminated acquisition of the [F] Group.
The Court of Appeal then examined whether the deduction of the remaining € 4,795,958 would be contrary to Article 10a of the Dutch Corporate Income Tax Act or fraus legis. Since both the transaction and the loan are tainted (Article 10a Corporate Income Tax Act), the interested party must, according to paragraph 3 of that provision, either demonstrate business motives for both, or demonstrate a reasonable levy or third-party debt parallelism with the creditor. According to the Court of Appeal, it did not succeed in doing so for the SHL, among other things because it shrouded the financing structure behind [G], in particular that in the Cayman Islands and Jersey, ‘in a fog of mystery,’ which fog of mystery remains at its evidential risk. On the basis of the facts which have been established, including the circumstances that (i) the [A] funds set up in the Cayman Islands administered the capital made available to them as equity, (ii) all LPs participating in those funds there were referred to as ‘[A] ‘ in their names, (iii) all those LPs had the same general partners employed by [A] in Jersey, and (iv) the notification to the European Commission stated that the Luxembourg-based [H] was acquiring full control of the [F] group, the Court formed the view that the PECs to [G] had been provided by the [A] group through the Cayman Islands out of equity initially contributed to [B] LP by the ultimate investors, and that that equity had been double-hybridised through the Cayman Islands, Jersey and Luxembourg for anti-tax reasons.
The interested party, on whom the counter-evidence of the arm’s length nature of the acquisition financing structure rested, did not rebut that presumption, nor did it substantiate a third-party debt parallelism or a reasonable levy on the creditor, since (i) the SHL and the B-PECs are not entirely parallel and the interest rate difference, although small, increases exponentially through the compound interest, (ii) the SHL is co-financed by A-PECs, whose interest rate differs from the SHL by more than 2 percentage points and (iii) the third party has shrouded in mystery exactly who is behind which PECs and with which money. As a result, that remaining interest is also non-deductible, except to the extent payable on the SHL portion originating from investors other than the [A] group.
For that part of the SHL, the Inspector did not claim that the money had been diverted without good faith and the Court therefore considered a rebuttal requirement for that part unreasonable. Given its opinion on the scope of Article 10a Corporate Income Tax Act, the Court of Appeal saw no room for fraus legis.
This decision was appealed to the Supreme Court by the tax authorities.
In a preliminary ruling, the Advocate General advises the Supreme Court to
“I suggest you declare principal ground (v) well-founded, declare all other grounds unfounded and refer the case back to the court for a factual investigation into the (un)businesslike motives of the investors involved in the shareholder loan at issue, other than the [A]-funds, with the burden of proof lying on the interested party, unless you refer to the court because of the purpose of principal ground (vi) instead of principal ground (v), in which case the burden of proof of predominantly anti-fiscal motives of these other investors for the manner of financing lies with the Inspector. ”
“Principle plea (v) and incidental plea (3) consider that the Court of Appeal’s understanding of the ‘non-business diversion’ is too narrow and too broad respectively. The State Secretary is of the opinion that the Court of Appeal has wrongly considered diversions only insofar as the financing of the compromised legal act originated from the [A] funds. The interested party, on the other hand, believes that the Court of Appeal has wrongly included in its assessment of detours flows of funds through entities other than ‘affiliated entities’ within the meaning of Section 10a(4) of the Corporate Income Tax Act. HR BNB 2016/197 (Italian Telecom) holds that, in principle, a group of companies has freedom of financing, but that Section 10a of the Dutch Corporate Income Tax Act limits this freedom. In my opinion, the concept of ‘non-business diversion’ is not limited to diversions along a physical (geographical) tax haven, but also includes synthetic tax havens. The imprudence of the flow of funds may also lie in intermediary commercially senseless legal acts that can only be explained antifiscally. In my view, hybrid elements, such as the double hybrid nature of the acquisition financing structure (hybrid entities and hybrid money lenders) in this case, can also contribute to the finding of a non-business diversion. Partly in view of HR BNB 2015/165 (Mauritius), I believe that, when assessing whether a non-business diversion has occurred, the reasons for entering into the SHL of all parties involved may be of importance and that equity cannot only be diverted via ‘affiliated entities’ within the meaning of Section 10a(4) of the Dutch Corporate Income Tax Act to debt, but can also take other non-business diversions. Like the Court of Appeal, I believe that the ‘affiliated entities’ in Section 10a of the Dutch Corporate Income Tax Act concern the debtor and creditor of the compromised loan, and that the ‘parties involved’ and ‘group’ in your case law may concern a wider group of affiliates, such as the [A] fund conglomerate in this case. On the basis of the facts that were established, the Court could, in my opinion, formulate a presumption that the PECs to [G] were provided by the [A] conglomerate via the Cayman Islands, from equity that was initially contributed to [B] LP and that this equity was diverted via the Cayman Islands, Jersey and Luxembourg for antifiscal reasons. The interested party, on whom the burden of proof rested with regard to the arm’s length nature of this confusing acquisition financing structure, did not, according to the Court of Appeal, disprove this suspicion and this evidentiary judgment is, in my opinion, by no means incomprehensible, also in view of its apparent nebulousness with regard to the configurations in the Cayman Islands behind the PECs.
1.15 In view of the division of the burden of proof resulting from Section 10a(3) of the Dutch Corporation Tax Act, the State Secretary has rightly argued in the alternative in my plea in law (v) that even if the Inspector has not claimed that the funds from investors other than the [A] funds have also been re-directedzakelijk, Section 10a(3) of the Dutch Corporation Tax Act places the burden on the interested party to prove that for all parties involved in the SHL there were business reasons for its conclusion, so that the Court has incorrectly divided the burden of proof in this respect. The funds of the other investors apparently did not pass through misty funds and LPs with GPs in Jersey, nor through the Cayman Islands, but the other investors held hybrid PECs which passed through Luxembourg and thus apparently did not make their own funds available to the interested party directly as debt. I therefore believe that the Court of Appeal’s judgment on this point is legally incorrect due to an erroneous allocation of the burden of proof or is insufficiently reasoned, so that ground (v) leads to cassation to this extent and the case must be referred to the Court of Justice for the submission and assessment of rebuttal evidence.”