The Curia

as a court of review

judgment

Case number: Kfv.V.35.306/2021/9.

Members of the Chamber:

Dr. Péter Darák Chairman of the Chamber

Dr Stefancsik Márta, Judge-Rapporteur

Dr Demjén Péter, Judge

Dr Drávecz Margit Gyöngyvér, Judge

Ms Ságiné Dr Márkus Anett, Judge

Applicant: Applicant

Representative of the applicant: Dr. László Nyanyista Law Office

(Administrator: Dr. László Nyanyista, lawyer)

(address2.)

Defendant: National Tax and Customs Board of Appeal

(address3)

Representative of the defendant: Dr. Georgina Feketéné dr. Németh, Bar Counsel

Subject-matter of the proceedings: administrative action against a decision of the tax authority

Party requesting the review: Applicant No 14

Final decision sought: Judgment of the Metropolitan Court of Budapest No 8.K.707.713/2020/12 of 28 May 2021

Operative part

Sets aside the judgment of the Metropolitan Court of Budapest in Case No 8.K.707.713/2020/12, annuls the contested part of the defendant's decision No 2234179463 and orders the defendant to commence new proceedings.

Orders the defendant to pay to the applicant, within 15 days, the combined costs of the proceedings at first instance and on appeal amounting to HUF 2,000,000 (i.e. two million).

The application and review fees shall remain payable by the State.

There shall be no further appeal against the judgment.

Reasoning

The facts on which the review is based

[1] The applicant was incorporated as a successor company on 3 January 2011 under the name G.K. Ltd, the only member in 2010 being G.I.H.L., a company registered in the United Kingdom. On 29 December 2010, the applicant, as debtor, entered into a loan agreement in English with an affiliate of G.B.BV., a Dutch resident ('BV'), under which BV, as lender, granted the applicant a subordinated loan of HUF 3 billion, subordinated to other creditors' claims, with a maturity date of 31 December 2060, at a fixed annual interest rate of 11.32%.

[2] According to clause 1.3 of the contract, the fulfilment of the plaintiff's present and future obligations towards third parties precedes the fulfilment of the contractual obligation towards the creditor. The creditor undertook to disclose to the third party, on request, the subordination of the loan in this sense. Under clause 3.2 of the contract, interest accrues and becomes payable only when the applicant earns a 'net income' from its activities as defined in clause 3.5. According to clause 3.5, 'net income' is based on the debtor's financial statements at the end of the relevant financial year; it is equal to the debtor's profit after tax, excluding interest payable in the relevant loan period, and is calculated in accordance with International Financial Reporting Standards (IFRS) or any local Generally Accepted Accounting Principles (GAAP). According to clause 3.7 of the contract, no capitalisation of late payments will be made in respect of the interest due. According to clause 5.2 of the contract, in the event of default, the creditor shall send the debtor a notice of the obligation to repay immediately all or part of the amount of the loan, together with interest and costs. The parties have agreed (clause 10.1) to act in accordance with Dutch law. No security has been provided in the loan agreement.

[3] The applicant used the loan to repay a debt under a loan agreement concluded with a Dutch bank in 2006, repaid the loan early in 2017 and repaid it in March 2018.

[4] The applicant charged the interest paid under the contract as an expense to its pre-tax profit of HUF 347,146,667 in 2011 and HUF 345,260,000 in 2012.

[5] In accordance with Netherlands tax law, BV did not include the interest income as a taxable liability in its tax return, and it was subject to the objective so-called participation exemption.

[6] The National Tax and Customs Administration's (NAV) Directorate General for Taxation and Customs ('the first instance authority'), in the context of a new procedure, carried out a post-clearance audit of the corporate tax returns for the years 2011-2012, based on the results of the 2018 tax year. By decision No 2141224582 of 17 January 2018 ('the first instance decision'), the Commission assessed a tax deficit of HUF 127,514,000 against the applicant, of which it classified HUF 88,014,000 as a tax deficiency, and ordered the applicant to pay the tax deficit, a tax penalty of HUF 43,419,000 and a late payment penalty of HUF 5,979,000.

[7] The defendant, acting on the applicant's appeal, upheld the decision of the first instance by decision of 7 June 2018, registered under No 2234179463.

[8] The decision - in the scope of the action - was based on § 1(7), § 2(1) - (2), § 6/C. § (3) to (4), Article 165(1) to (3), Article 170(1) to (2), Article 171(1), Article 178(3) and Article LXXXI. (hereinafter referred to as the "Tao. tv."), § 1 (2), (4) and § 8 (1) (d) of the Act on Corporation Tax, Income Tax and Dividends, § 10/1988 (III. 10.) MT Decree (hereinafter referred to as "the Convention"), Articles 10(5), 11(3), 1. 65, the Constitutional Court decisions in cases 724/B/1994 AB and 219/B/2002 AB and C-425/06 (Halifax) of the Court of Justice of the European Union (CJEU) and Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (hereinafter 'the Interest Royalty Directive').

[9] According to that reasoning, a contract concluded by a member of a group of companies for a term of more than 50 years, with an interest payment condition other than that of a normal loan and without capitalisation of interest in the event of default, does not constitute a loan but a capital contribution for tax purposes. This is indicated by the fact that it is subordinated to all other creditors, that the payment of interest is conditional on the debtor's business performance and that no security is required. The Dutch tax authorities have confirmed that in the Netherlands the transaction is an informal capital injection and that the interest paid to the lender is tax exempt income under the 'participation exemption'.

[10] It referred to the prohibition of double taxation under the Convention: under Articles 10(5) and 11(3), BV was entitled to recognise the interest received under the contract as dividend income in the Netherlands without increasing the tax base, taking into account that the loan was an informal capital contribution, but that the recognition of the interest paid as an expense would lead to 'double non-taxation'. In its view, the interest paid cannot be deducted from the tax base, the parties intended the transaction to achieve a tax advantage and the applicant cannot reduce the tax base by the amount of the profit share in the capital contribution of the Dutch partner.

The application and the defendant's defence

[11] By its application, the applicant seeks the amendment of the defendant's decision in so far as it relates to the loan transaction, the annulment of the findings, in the alternative, the annulment of the decision at first instance in so far as it relates to that part of the decision, an order that the defendant be re-instructed and, in the further alternative, the annulment of the decision in so far as it relates to the tax penalty and an order that the defendant be re-instructed.

[12] It stressed that the true content of the contract was a loan, that it had properly applied the

The contract's real substance was a contract, and the lawfulness of the contract was not affected by the provisions of the Convention or the Interest Charges Directive.

[13] In its defence, the defendant sought dismissal of the action on the grounds set out in its decision.

[14] By order No Kfv.I.35.350/2019/25 of 29 March 2019, the Curia set aside the judgment of the court of first instance dismissing the action in Case 7.K.33.552/2018/17 and ordered the court of first instance to conduct new proceedings. It stated that the application of Article 2(2) of Art. 2, which had not yet entered into force in the period under review, was unlawful and that the court of first instance had not carried out a review of the legality of the tax authority's decision on the merits. According to its order for a new procedure, the court of first instance is obliged to examine the possibility of applying the bilateral international treaty [the Convention], multilateral conventions [the OECD Transfer Pricing Guidelines, the OECD Model Conventions], the related commentaries and the EU Directive [the Interest-Rate Directive] on the basis of the binding nature of the relevant legislation and the possibility of its applicability. It must then be examined whether the plaintiff and the transaction in question are covered by their personal and material scope. In the next step, it must be determined, by assessing the characteristics of the transaction challenged by the tax authority, whether the reference to an abuse of rights by the authority (Art. 2(1), Tao Law, Art. 1(2)), the reclassification of the contract as a tax law (Art. 1(7), Tao Law, Art. 1(4)) and the deduction of its legal consequences in the decision challenged in the action were lawful.

The final judgment

[15] The Court of First Instance dismissed the applicant's action by a final judgment in the repeated proceedings.

[16] It held that, by virtue of Articles 1 to 2 of the Convention, the subject-matter and scope of the Convention covered the transaction at issue. Articles 10(5) and 11(3) classify as dividends income from claims conferring a right to participate in profits, and specifically exclude from interest income from claims conferring a right to participate in the debtor's profits. The income from the transaction at issue was not taxable in the Netherlands, the claimant accounted for the interest as an expense, thus creating a situation of 'deduction/no inclusion', i.e. double non-taxation. The Netherlands is entitled under the Convention to tax interest income from Hungary, and the Hungarian tax authority could not derogate from the qualification of the transaction by the Dutch tax authority.

[17] It noted that the defendant had applied the OECD Transfer Pricing Guidelines not as legislation but as a legal aid in its proceedings. According to paragraphs 1.64, 1.65 and 1.66 of the OECD Transfer Pricing Guidelines, if the economic form of a transaction differs from its substance, the tax authority may reject the stated characteristics of the transaction and assess the substance of the contractual relationship between associated enterprises. If, for example, an investment in an associated enterprise is made by means of a loan with an interest charge, whereas, taking into account the circumstances of the borrowing company, in unrelated circumstances, the investment would not be structured in this way. It is in the interests of legal certainty for companies to be taxed only once, while it is in the interests of national economies not to generate global income that is not taxed in any one country because of so-called hybrid structures. In this case, it is appropriate for the tax administration to classify the transaction according to its economic substance, which may have the result of treating the credit as a capital investment if the characteristic of the transaction is derived from the relationship between the parties rather than from normal commercial terms and conditions, and the taxpayer may have structured it in this way to avoid or reduce tax. It concludes that, regardless of the fact that the transaction in this litigation was not subject to a transfer pricing assessment by the defendant, its qualification is governed by the criteria set out in the OECD Transfer Pricing Guidelines. The defendant could have challenged the interest rate on the related party transaction, but did not see any reason to do so because of the unlawfulness of the entire transaction.

[18] It explained that the OECD Model Convention and its Commentary also serve as a legal interpretative guide, being the authentic source of the concepts used in the Convention and of the interpretation of the various provisions. The applicant referred to the OECD Model Convention in its observations on the record, the tax authority recorded its reasoning in relation to it and therefore considered that the applicability of the OECD Model Convention to the transaction at issue was not in dispute between the parties.

[19] On the basis of Article 1 and Article 4(1) of the Interest-Rate Directive, it took the view that Hungary exempted interest from withholding tax on condition that it was taxable in the Member State of residence of the beneficial owner. If the interest is not taxed in the host State, loans between domestic parties are discriminated against and Hungary taxes the income. Article 4 of the Interest Rent Directive also provides for an exemption from withholding tax if the conditions listed therein can be met.

[20] On the basis of Art. 1(7), Art. 2(1), Art. 1(2) and (4), Art. 8(1)(d) of the Tao. tv. and the principle of qualification according to content, the Court found that the contract at issue was not a loan but a capital contribution: repayment was conditional on the debtor's business performance, the parties had not provided security, the claim was subordinated and the maturity was atypical (50 years + 2 days). It was established that the financing under the contract had been carried out, the irregularity consisting in the tax advantage improperly obtained and not in the sham financing.

[21] It found that the interest rate on the loan from BV was several times higher than the interest rate on the loan taken out, so that it was not more favourable to the applicant, and that the applicant had no independent intention to enter into the transaction, since it was in fact only one of its members, Ltd, which, through the merger of the companies, must have known the real purpose of the transaction within the group, which decided to enter into the contract. The payment of interest by the applicant was in substance equivalent to the payment of dividends: the applicant was obliged to pay interest at the rate of 11,32 % only if it was profitable, and the payment had to be preceded by the performance of the applicant's obligations towards third parties. Both the payment of the dividend and the borrowing of the loan were decided by the general meeting of members, which also supports the classification as a capital contribution.

[22] The Curia, referring to its judgment in Case No. Kfv.35.178/2013/7, explained that under Article 2(1) of the Art. 2 and Article 1(2) of the Tao. tv. the tax advantage is not only excluded if the legal transaction is aimed exclusively at obtaining a tax advantage, but also if it is aimed predominantly at obtaining an advantage.

[23] The CJEU, in the context of its judgment in Case C-648/15 (Austria v Germany), cited by the applicant, emphasised that the contract at issue in that case did not contain a clause providing that a party was to pay interest only if it made a profit, unlike the case at issue. On the contrary, under clause 3.2 of the contract underlying the transaction at issue, interest was payable only in the event of a positive pre-tax result and did not impose an obligation to pay interest for the year in which a loss was incurred.

[24] It held that the Dutch note annexed by the applicant could only be taken into account as the applicant's position.

[25] Finally, it stated that the tax penalty was not unlawful.

[26] In conclusion, he held that the defendant had unlawfully based the contested decision on Article 2(2) Art.

The application for review and the counterclaim

[27] By its application for review, the applicant sought to have the final judgment set aside and the defendant's decision annulled, to order the tax authority to initiate new proceedings, or, in the alternative, to set aside the final judgment and to order the court of first instance to initiate new proceedings and to issue a new decision.

[28] In its view, the court of first instance erred in law in finding that there had been a breach of the principle of the protection of the real substance and of the proper administration of justice and in misapplying the Convention and the Interest-Rate Directive to the applicant. § 1(1), § 4(21), § 6(1), § 78(2), § 84(2), § 85. § 84 (1), (3) (b), § 86 (1), § 346 (4) - (5) of Act CXXX of 2016 on Civil Procedure (hereinafter referred to as "Civil Procedure Act"), is contrary to Article 1, Article 2 (1), Article 10 (5), Article 11 (3) of the Convention, and Article l (1), Article 3 (b) and Article 4 of the Interest-Rate Directive.

[29] It submits that the Court of First Instance erred in law in finding that the real substance of the transaction was an 'informal capital injection'. There was a genuine repayment obligation under the transaction, which was fundamentally at odds with the definitive and irrecoverable nature of the capital injection. The transaction is also regarded as a loan under Dutch tax law, and only the legal fiction of the so-called 'participation exemption' makes the income from it tax-free.

[30] He contested the findings of the final judgment in the context of an abuse of rights. On the one hand, the Court of First Instance erred in law in its assessment of the accounting treatment of interest expense under the Tao Law. 5(l), 4(21) and 6(l) of the Tao tax law were fulfilled. On the other hand, the fact that a transaction results in a so-called economic double non-taxation does not constitute an improper exercise of law. The Hungarian State may, at its sovereign discretion, regulate tax exemptions leading to double non-taxation [e.g. Section 28(2) and (4), Section 7(1)(k), Section 29/Q(3) of the Tao Act 2009-2010], which are based on tax policy considerations. In the present case, it was a sovereign decision of the Dutch legislator to grant BV a tax exemption for interest income. An abuse of a right cannot be established if the transaction has a genuine economic purpose (Kfv. 35.720/2015/8; Kfv.VI.35.575/2012/8), nor if the transaction has not caused damage to the budget (Curia Kfv.35.720/2015/8; Kfv.VI.35.575/2012/8). .110/2017/4., Kfv.1.35.720/2015/8., Kfv.1.35.275/2012/5., Kfv.1.35.594/2016., Kfv.1.35.028/2018., Kfv.35.098/2020/4., Kfv.35.404/2019/4.).

[31] In his case, the conclusion of the loan contract with BV made real economic sense: the loan taken out was used to pay off his debt to the Bank, the loan granted by BV had more favourable terms than the previous bank loan: the short-term bank loan was replaced by a long-term loan, thus maintaining his solvency in the long term, as the risk of indebtedness to the affiliated company was lower than to the independent bank. In the case of groups of companies, there is a legitimate economic interest in obtaining financing from within the group and not from an external bank, as recognised by the Curia in several decisions (Kfv.I.35.720/2015/8., Kfv.I.35.417/2014.). The borrowing took place because it needed external financing and not because it wanted to obtain a tax advantage by charging interest. From a tax point of view, the loan from the affiliated company did not put it in a more favourable position than it was in when it was owed the loan by the unrelated bank. It paid BV interest at the normal market rate, which it documented in its transfer pricing records and which was accepted by the defendant. The loan was not secured by its parent company, so the equity investment would not have been an appropriate form of financing because it did not fit the circumstances of the applicant (for example, the applicant's ownership structure would have had to change), and the equity injection would therefore have had a completely different economic outcome.

[32] The court of first instance, contrary to the requirement of Art. 2(3) Art. 2(3) and point 1.65 of the Transfer Pricing Guidelines, did not determine the tax liability in the case of a proper exercise of rights, and the final judgment does not comply with the principles developed in the case law of the Curia (ECJ 2016.K.31.). On the basis of due process of law, the court could only have concluded that it would have recognised interest expenses even if it had not taken the loan from BV.

[33] It stressed that, in the context of the assessment of an abuse of a right, it is irrelevant that a tax advantage arose in the Netherlands. On the one hand, because the tax advantage obtained by BV in the Netherlands does not give rise to a Hungarian tax liability vis-à-vis the Hungarian taxpayer, and it is not for the Hungarian tax authority to examine the legality of the tax advantage obtained in the Netherlands. On the other hand, it is clear from the reply of the Netherlands tax authority and the Netherlands legal opinion that BV made lawful use of the tax exemption in the Netherlands, in accordance with the intention of the Netherlands legislature, irrespective of whether the interest expense was accounted for in the source State.

[34] It also submitted that the Court of First Instance had misinterpreted the international and Community legislation on withholding tax and so-called legal double taxation. Legal double (non-) taxation must be distinguished from economic double (non-) taxation. In the former case, the same income or assets of the same taxpayer are subject to over-taxation or non-taxation, whereas in the latter case, two different taxpayers are (or are not) subject to tax on the same income or assets.

[35] The scope of the Convention and the Interest-Rate Directive is the taxation of income and the personal scope is the taxation of the person who receives the income. It does not lay down rules on the deductibility of expenses, but deals only with the taxation of income. Since the applicant did not receive any income from the transaction, the withholding tax and residence tax liability cannot be interpreted. On the other hand, at the time of the litigation, the Hungarian corporate tax legislation did not apply withholding tax to interest paid from Hungary, so that an exemption from withholding tax or a refusal to exempt interest from withholding tax cannot arise. Third, the Convention and the Interest-Royalty Directive deal with the issue of legal double taxation and non-taxation. In the case at hand, this legislation is therefore irrelevant, as the court of first instance challenged the economic double non-taxation (the Hungarian party accounts for interest expense, whereas the interest income of the Dutch party is not taxable). The OECD Model Convention is a model contracting document. The commentary states that if two states wish to solve the problem of economic double taxation, they should do so through bilateral negotiations.

[36] In relation to the application of the Interest Royalty Directive, it pointed out that the applicant had not charged the interest expense to the Tax basis on the basis of the Directive, but on the basis of the general rules of the Tax Law, and that therefore the charging of interest as an expense could not be refused on the basis of Article 4 of the Directive. The Interest Rent Directive is also not applicable because it only covers associated enterprises where one company holds at least 25% of the capital or voting rights of the other, or where a third company holds at least 25% of the capital or voting rights of both companies. Neither the applicant nor BV had a direct shareholding in the other company, nor did any third company have a direct shareholding in both companies, and the personal scope of the Interest Rent Directive does not therefore extend to the applicant and BV in respect of the transaction at issue. The Court of First Instance did not examine that condition and conceptually misapplied the international and Community tax rules on so-called legal double (non-) taxation to him, since no legal double non-taxation could be established against him.

[37] He also complained that the court of first instance had determined the amount of the interest charge in an unduly documented and unreasonable manner.

[38] It claimed that there was no tax evasion or abuse of rights in connection with the transaction at issue, and that the court of first instance erred in failing to assess the fact that the tax authority did not object to the transaction with BV during the 2010 investigation (BH2016.218).

[39] In its cross-appeal, the defendant requested that the final judgment be upheld. The court of first instance qualified the transaction on the basis of its true content and its decision complied with the procedural rules.

[40] It emphasised that the tax practice applied by the applicant was in breach of the Convention and the Interest Rewards Directive, according to the following regulatory principles: avoidance of double taxation and prevention of tax evasion; the source State waives taxation of the interest so that the income is taxed in the beneficial State, thus avoiding double taxation; if the interest is not taxed in the host State, Hungary taxes the income [Art. Article 2(1), OECD Model Tax Convention Commentary]; Article 4 of the Interest Royalty Directive provides for the possibility of an exception to the exemption from withholding tax under the conditions listed therein, the basic principle of which is reflected in Art.

Decision of the Curia and legal reasoning

[41] The application for review is well founded.

[42] Against the final judgment of the Court of Appeal, the decision of the Court of First Instance is appealed. 115 (1) of the Court of Justice on the grounds of an infringement of law. In accordance with Art. 115(2) of the applicable Code of Civil Procedure. Pursuant to Section 108 (1) of the Kp. Pursuant to Section 120 (5), there is no place for taking evidence in the proceedings, the Curia decides on the basis of the documents and evidence available at the time of the final decision when examining the application for review.

[43] According to Section 85. § Article 85(2) of the Accounts Act states that interest payable and interest expenses must be shown in the annual accounts, regardless of whether they are payable to a credit institution, another entity or an individual: (a) the amount of interest payable (due) on loans, borrowings, debts arising from the issue of bonds and other debt securities, notes payable and included in long-term liabilities and short-term liabilities, respectively, except interest included in the cost of assets; (b) the amount of interest payable (due) on subordinated liabilities (subordinated loan capital).

[44] The interest paid, including on subordinated liabilities, is therefore recognised as an expense in the accounts and is taken into account in the recognition of profit before tax.

[45] Under Section 6(1) of the Tax Law, the basis of assessment for corporate income tax for resident taxpayers and non-resident entrepreneurs is the profit before tax, as amended by Sections 7, 8, 16, 18 and 28 and Chapter VII.

[46] Pursuant to Section 8(d) of the Tax Act, the pre-tax profit is to be increased by the amount of expenses not incurred in connection with the business activity of generating income.

[47] The tax authority did not dispute that the applicant had taken out the loan for the purposes of its business activities, subject to a repayment obligation, but found that the applicant had entered into the contract with BV in order to obtain an unlawful tax advantage, because BV had not in fact granted a loan but capital, so that the interest paid could not be recognised as interest expense in the pre-tax result and thus not in the determination of the taxable amount, given that BV had not paid interest tax, and thus a double non-taxation situation had arisen.

[48] According to Section 1 (2) of the Tax Act, "A rule or tax advantage (tax exemption, tax benefit) affecting the tax liability or tax or resulting in a reduction thereof may be applied or enforced to the extent that the content of the underlying legal transaction or other similar act achieves the purpose of the rule or tax advantage. The burden of proving applicability or enforceability shall lie with the person for whom it is intended. If the content of the legal transaction shows that its purpose is only a tax advantage for one of the parties or the parties, the costs or expenses incurred under the legal transaction are not considered to be costs or expenses incurred in the interest of the enterprise and no tax advantage is claimed."

[49] According to the Tax Law, the recognition of interest incurred in the interest of the enterprise as an expense is therefore lawful if, on the basis of an examination of the substance of the transaction, it can be established that the recognition of the interest achieves the purpose of its recognition as an expense, but cannot be recognised as an expense incurred in the interest of the enterprise if the purpose of the contract was solely or mainly to obtain a tax advantage for the parties or one of the parties. Pursuant to Art 1(7) Art 1(1) of the Tax Act, which is applicable under Art 1(1), contracts, transactions and other similar acts must be classified according to their true content. An invalid contract or other legal transaction is relevant for tax purposes to the extent that an economic result can be established. Pursuant to Article 2(1) of the Art. 2 in force during the period under review, rights in tax relations must be exercised in accordance with their intended purpose. For the purposes of the Tax Acts, a contract or other legal transaction intended to circumvent the provisions of the Tax Act does not constitute the proper exercise of rights.

[50] The case-law on the interpretation of those provisions has established that an abuse of rights may be established not only where the sole purpose of the transaction is tax evasion, but also where, in addition to the real economic substance of the transaction, the purpose which dominates the conclusion of the transaction is tax avoidance or the obtaining of an unlawful tax advantage.

[51] It should be noted that the tax authority did not claim that the interest rate was higher than the normal market rate, but took the view, on the basis of the subordination of the loan, the absence of a security, the duration of the loan, the fact that the interest was payable in the event of a positive after-tax result, the fact that it was to be calculated only for profitable years and the tax exemption applied in the Netherlands, that the sums paid by the applicant did not constitute interest and could not therefore be deducted as an expense.

[52] In support of its position, it relied on the relevant provisions of the Convention, the Interest-Rate Directive, the OECD Model Convention and its Commentary, and the Curia therefore examined the extent to which these international instruments were applicable to the accounting of interest in the proceedings.

[53] The Curia examined, first of all, the applicability of the OECD Transfer Pricing Guidelines and the Commentary cited by the defendant and the court of first instance, as well as the OECD Model Conventions.

[54] The OECD (Organisation for Economic Co-operation and Development) is a global co-ordinating organisation whose purpose is to coordinate the economic, commercial and financial activities of the Member States. It has no financial resources, no supranational powers, no sanctioning power, takes decisions by consensus and assists governments of participating states in formulating and evaluating the best possible economic and social policies by providing a global intergovernmental consultation facility. The OECD Model Convention is designed to enable states to conclude their bilateral international conventions with a view to ensuring that these conventions contain identical provisions on many issues. Hungary became a member of the OECD in 1996, [Act XV of 1998 on the proclamation of the Convention of the Organisation for Economic Co-operation and Development (OECD), its Protocols and the Declaration of Accession] it can be reasonably assumed that the Model Convention was used by governments in the drafting of the provisions of the Convention with the Kingdom of the Netherlands. The Model Convention is accompanied by guidelines in two priority areas - transfer pricing and a report on the determination of profits attributable to the establishment.

[55] According to Article 31(2)(a) and (b) of the Tax Law, the Act contains rules in accordance with the OECD Convention, its Protocols and Declarations of Accession, taking into account the Model Tax Convention on Income and on Capital and the Guidelines for International Enterprises and Tax Authorities on the Adjustment of Intercompany Rates.

[56] The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Authorities - 2010, referred to in the lawsuit, is an unofficial Hungarian translation of the 1995 Guidelines and their amendments, commissioned by the Hungarian Chamber of Accountants, and as such is a reference work, as is the Commentary. No tax liability can be directly based on their content, the content deemed relevant by the legislator is reflected in the Tax Law.

[57] Pursuant to Section 1(4) of the Tax Law in force in the period under review (2011-2012), the provisions of an international treaty apply if an international treaty promulgated by law or government decree contains provisions that differ from those of this Law. There is also room for derogation from this law on the basis of reciprocity, but the application of reciprocity must not result in an extension of the tax liability of the taxpayer compared to the provisions of the law. The Minister responsible for tax policy shall issue a ruling on the question of reciprocity.

[58] In the light of the primacy of an international treaty, it is necessary to consider whether the Convention applies in determining tax liability in a dispute, and if so, whether it contains any provisions on the subject-matter of the dispute and what they are. In its application for review, the plaintiff claimed that the International Tax Convention with the Kingdom of the Netherlands was not the applicable law for the purpose of deciding the legal issue in the dispute, and the defendant and the court of first instance took a contrary view.

[59] The purpose of the Convention is to prevent a company from being taxed twice on the same income, i.e. to eliminate the so-called legal double taxation. The possibility of double taxation may arise where a Hungarian company receives income from abroad and where a foreign company receives income from Hungary. It also aims at eliminating the non-tax deduction of income in both countries and preventing tax evasion. It must be emphasised that the Convention does not contain any separate provisions on tax evasion. The court of first instance correctly held that the Convention covers corporate tax and that the applicant and BV are subject to the Convention by virtue of the income they have earned. However, the Court of First Instance ignored the fact that the issue to be decided was the calculation of the basis of assessment for the Tax and that the applicant had not earned any income from the transaction in the years in question, whereas the Convention is intended to regulate the taxation of income and wealth between two States. Articles 10 to 11, relied on by the tax authorities and the court of first instance, deal with the taxation of interest and dividend income.

[60] Article 10(1) of the Convention provides, as a general rule, for taxation of dividends in another State, in this case the Netherlands. The possibility of taxation in Hungary, and the maximum amount of tax, are governed by paragraph 2.

[61] In the case at issue, the tax authority classified the interest paid by the applicant as a dividend, but its findings related not to the taxation of the dividend but to the deductibility of the costs, that is to say, the basis of assessment for the tax. The dividend is paid by the company out of its taxable income, and the deductibility of the interest as an expense must be distinguished from the taxation of the dividend. The determination of the taxable amount precedes the consideration of the taxation of the dividend, and Article 10(4) of the Convention expressly provides that the provisions of paragraph 2 are without prejudice to the taxation of the company on the profits out of which the dividend is paid. Therefore, the provisions of Article 10, including paragraph 5 on the concept of dividends, as indicated by the court of first instance, are not relevant in determining the taxable amount in the present proceedings.

[62] Article 11 of the Convention applies to the taxation of interest income:

"1. Interest arising in one State and paid to a resident of another State shall be taxable in that other State only if that person is the beneficial owner of the interest. 3. The term 'interest' as used in this Article shall mean income from debt claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular income from government loans and from bonds or debentures, including premiums and prizes attaching to such loans, bonds or debentures. (4) The provisions of paragraph 1 shall not apply if the beneficial owner of the interest, being a resident of one State, carries on business in the other State from which the interest is derived, by means of a permanent establishment situated therein, or by means of a fixed establishment situated therein, in a liberal profession, and the debt-claim in respect of which the interest is paid is effectively connected with such establishment or fixed establishment. In this case, the provisions of Article 7 or Article 14, as the case may be, shall apply. 5. If special relations exist between the person paying interest and the beneficial owner of the interest or between both of them and another person and if, as a result, the amount of interest in respect of the debt-claim in respect of which it is paid exceeds the amount which the person paying interest and the beneficial owner of the interest would have agreed upon in the absence of such relations, the provisions of this Article shall apply only to the latter amount. In that case, the excess amount shall be taxable in accordance with the laws of each State and subject to the other provisions of this Convention."

[63] The subject-matter of the dispute was not the taxation of interest income, but the determination of the taxable amount, and Article 10, which concerns the taxation of interest income, is therefore irrelevant. Article 10(2) requires States to agree on the manner in which they will waive taxation of the income from which the interest is derived. The case did not reveal any evidence of such consultation between the Contracting States. The Court points out, however, that the Convention states in Article 25(3), in the context of equal treatment, that 'Except where the provisions of Article 9(1), Article 11(5) or Article 12(5) are invoked in order to prevent the application of the provisions of Article 9(1), Article 11(5) or Article 12(5), the Convention shall not apply to the same person. interest, royalties and other expenses paid by an enterprise of one State to a resident of another State shall be deductible in determining the taxable profits of that enterprise under the same conditions as if they had been paid to a resident of the first-mentioned State." Accordingly, the taxable amount with respect to the subject transaction could be adjusted if the same treatment were given to interest paid to resident persons under the same conditions.

[64] On the basis of the foregoing, the Curia held that the applicant had been well founded in its claim that the taxable events in the Convention were not identifiable with those in the dispute and that the provisions of the Convention could not be relied on as a basis for tax liability in the case. Accordingly, the tax liability of the applicant under Section 1(4) of the Tax Law was to be determined on the basis of the provisions of the Tax Law, not on the basis of the bilateral international treaty, i.e. the Convention.

[65] When applying the Tax Law, it should be borne in mind that corporate taxation in the European Union is in principle not a harmonised direct tax, where Member States are sovereign to determine their own provisions for the taxation of company profits. However, as regards the common system for the taxation of interest and royalty payments between associated companies in different Member States, the Interest Royalty Directive has been established to ensure fair taxation of payments between associated companies in different EU countries and to avoid double taxation. The Directive is an act addressed to EU countries [Article 11], which Member States had to transpose into their national law by 1 January 2004. The provisions of the Interest Rent Directive have been transposed in accordance with Article 31(1)(c) of the Tax Law.

[66] According to the Directive, "Interest and royalty payments arising in a Member State shall be exempt from any taxes levied in that State on such payments, whether by deduction at source or by assessment, provided that the beneficial owner of the interest or royalty is an enterprise of another Member State or a permanent establishment situated in another Member State of an enterprise of a Member State" [Article 1(1)].

[67] Article 4 states that "(1) The source State shall not be obliged to grant the benefits of this Directive in the following cases:

(a) payments which are treated as payments of profits or repayments of capital under the law of the source State;

(b) payments resulting from claims which carry a right to share in the debtor's profits;

(c) payments on claims which entitle the creditor to substitute his right to interest for the right to share in the debtor's profits;

(d) payments on claims which do not include any cover for the repayment of principal or where repayment is due more than 50 years after the issue.

(2) Where, because of a special relationship between the payer and the beneficial owner of the interest or royalties, or between one of them and another person, the amount of interest or royalties exceeds the amount which the payer and the beneficial owner would have agreed in the absence of such a relationship, the provisions of this Directive shall apply only to the latter amount."

[68] The provision set out in Article 4(1) allows for the taxation of interest by the source State on payments of claims which are not secured by repayment of the principal or where repayment is due more than 50 years after the issue. However, the Tax Law does not provide, on the basis of the authorisation in Article 4(1)(d) of the Interest Rent Directive, that it does not provide for exemption from withholding tax on interest payments on claims which are not secured by a guarantee for the repayment of the principal or where repayment is due more than 50 years after the issue. Article 4(2) provides for different rules in the case of associated enterprises: where, because of a special relationship between the persons entering into the transaction, the amount of interest or royalties exceeds the amount which the payer and the beneficial owner would have agreed in the absence of such a relationship, the exemption is granted only on that higher amount. However, the tax authority did not find that the applicant had agreed with its associated company an interest rate higher than the normal market rate. The provisions of Article 4 are therefore without prejudice to the question whether those payments also constitute interest.

[69] In the absence of transposition into national law of the withdrawal of the exemption, the applicant cannot therefore be held liable to tax under the Interest Rent Directive.

[70] The CJEU recognises the direct vertical effect of directives in certain cases in order to protect the rights of individuals, and accordingly the CJEU has held in its case law that directives also have direct effect if (1) they are unconditional, (2) they are sufficiently clear and precise, (3) and (4) they have not been transposed into national law within the time limits laid down [Case 41-74 (Van Duyn)]. However, according to the case-law of the Court of Justice of the European Union [Cases 148/78 (Tullio Ratti), 152/84 (Marshall), C-8/81 (Ursula Becker)], the reverse vertical direct effect of the Directive is precluded, i.e. a Member State or its body cannot rely directly on the Directive against a private party, nor can the State impose an obligation on a private party on the basis of the Directive. The exemption from withholding tax under the Interest Rent Directive would not be denied to the claimant on the basis of Article 4(1)(d) and (2) even if interest had been subject to withholding tax in the relevant period.

[71] The Directive does not, however, preclude the enforcement of domestic or convention-based rules necessary to prevent fraud and abuse: EU countries may withdraw the benefits of the Directive or refuse to apply them to transactions where the main motive or one of the main motives is tax evasion, avoidance or abuse [Article 5(1) and (2)]. However, this provision allows for the refusal to exempt interest and royalties where fraudulent conduct is proven. It should be stressed, however, that the subject of the dispute was the admissibility of the amount of interest as an expense. As a consequence, the tax authority could not legitimately base its decision on the Community provisions on the possible taxation of interest income, since the disputed transaction did not give rise to income for the applicant but for the Dutch BV. Consequently, the question of law to be decided in the present proceedings had to be determined on the basis of the provisions of national law and not of Community law.

[72] In the assessment of abusive conduct within the meaning of Paragraph 1(2) of the Tax Law, an analysis of the substance of the transaction is necessary. Only taxpayer conduct where the sole or essential purpose of the transaction is to avoid tax is abusive.

[73] According to the facts, which are not disputed, the applicant took out the loan from BV to repay its outstanding debt to the Bank and the loan agreement was therefore concluded for a genuine economic reason. According to point 3.2 of the contract, interest accrues and becomes due only when the applicant has achieved the 'net income' from its activities, as defined in point 3.5. For the purposes of clause 3.5, 'net income' means the profit after tax based on the applicant's accounts at the end of the relevant financial year, excluding interest payable in that period. Clause 3.7 of the contract provides for the exclusion of capitalisation of interest, but this does not affect the contractual clause on the determination of the due date of interest. However, the Court of Cassation held that the interest did not constitute a dividend payment or a profit-sharing claim, since its amount did not vary according to the amount of the debtor's annual profits and the rate of interest was constant. In the case at issue, the determination of the due date of the interest was merely a contractual interest rate linked to profit, which did not give rise to any tax advantage for the applicant, since it used the loan to redeem the loan from the Bank, and the interest on the bank loan was also accounted for as an expense. In addition, in the absence of profit, the amount of interest was not included in the applicant's pre-tax result and therefore not in its tax base, the applicant did not incur any expenditure in the loss years and therefore did not reduce its tax base by such an amount, and the budget could not have suffered any loss in the loss years.

[74] BV claimed the tax exemption under Dutch law on its interest income. Under the provisions of the Interest-Rate Directive and the Convention, the Dutch party is liable to pay income tax on the interest, but the Dutch State has granted a so-called 'participation exemption' in respect of the contractual terms. This exemption was not the result of the Convention or the Interest Directive, but of a sovereign decision of the Dutch legislator. Hungary did not impose a withholding tax obligation, and therefore the exemption of interest from withholding tax was not affected by the contractual terms or the application of the participation exemption.

[75] The Court of First Instance's view that, in the Convention, the Hungarian State waived withholding tax on the interest in order to have the interest taxed in the Netherlands is incorrect. The Convention is in fact intended to avoid double taxation (the same person should not be taxed on the same income in the two States) and avoidance (a person should not be taxed on his income in either State), and does not regulate economic double taxation (different persons being taxed on the same income) or non-taxation. The latter is not among the stated objectives of the Convention. Under the Convention and the Tax Law, the jurisdiction of the States is determined by the residence of the taxpayers, so that the Hungarian tax authority's jurisdiction to tax can only extend to the plaintiff. The Hungarian legislature did not impose withholding tax on domestic transactions either, but taxed only the income, the plaintiff did not earn any income from the interest on the transaction, so that there is no connection, as the court of first instance assumed, which can be inferred from the Convention, between the non-application of withholding tax and the absence of taxation in the Netherlands, and between the interest being chargeable as an expense and the Dutch income being subject to the participation exemption.

[76] The Curia wishes to point out that the Invoice Act treats interest as an expense, irrespective of the duration of the debt or other contractual conditions imposed by the parties. The expense is allowable if it is incurred in connection with the economic activity of the taxpayer. As a consequence of the present transaction, in the case of a negative after-tax result, the interest did not fall due and was therefore not recognised as an expense, and the applicant therefore only recognised interest which it actually paid under the loan agreement. There was therefore no damage to the budget and no damage to the State's public finances as a result of the fact that the applicant recognised as an expense the obligation to pay interest under the loan agreement in question, as it would have done under the transaction with the bank which disbursed the loan in question or with any other domestic person.

[77] The general purpose of the recognition of interest as an expense is to enable an undertaking to charge the costs of borrowing to its income in the same way as other costs incurred in connection with its economic activity. This purpose was not infringed in the transaction at issue and no abuse or misuse of rights can therefore be established.

[78] The Court of First Instance took the view that the two tax authorities of the parties were in agreement in their assessment of the transaction, that the Dutch tax authorities also classified it as an informal capital contribution and that the plaintiff's payment was therefore exempt from income tax for BV. In contrast, the Dutch tax authorities' reply shows that the amount paid by the claimant was considered to be interest, but that it was exempt from tax in view of the duration of the interest, its subordination and its profit-related maturity. It may reasonably be assumed that BV was also aware of the possibility of claiming tax exemption at the time the transaction was concluded. The contract allowed the applicant to make early and final repayments, which it took advantage of and repaid in 2018. The assessment of whether the purpose of the tax exemption claimed by BV was achieved in such circumstances is not a matter for the Hungarian tax authority or court, as the Dutch tax authority is entitled to apply the lawfulness of the tax exemption claimed under the transaction and the possible legal consequences under the transaction actually carried out, as set out in paragraphs 1.65 and 1.66 of the OECD Transfer Pricing Guidelines. However, the applicant had actually used the funds of his associated company to redeem the bank loans, and his intention to enter into the transaction was influenced by that factor and was subject to a repayment obligation. The duration of the loan and its subordinated nature did not affect the true substance of the transaction, which the Court of Appeal found to be a loan. The amount recognised as an expense was incurred in connection with the applicant's business activities, the Hungarian accounting and corporate tax rules did not contain any exclusionary provisions regarding its recognition as an expense or the obligation to adjust the tax base, there was no budgetary damage to the Hungarian State, and the applicant therefore lawfully recognised the amount of interest paid as an expense in its profit and loss account, the amount of which cannot be used to increase the tax base, also in view of the requirement of equal treatment.

[79] On the basis of the above, the Curia found that the contested part of the tax authority's decision and the final judgment were unlawful. As a consequence, the decision of the Court of First Instance of the Republic of Hungary was annulled. 121(1)(b) of the Tax Code, the final judgment was altered, the contested part of the defendant's decision was annulled and the defendant was ordered to commence new proceedings.

[80] In the new proceedings, the defendant is required to adopt the decision closing the tax audit in accordance with the judgment of the Curia.

Content of the decision in principle

[81] One of the conditions for establishing the existence of an abuse of rights is proof of an unlawful tax advantage

Concluding part

[82] The Curia ordered the defendant to pay the costs of the proceedings at first instance and on review of the proceedings, which were certified in accordance with the IM Decree 31/2017 (XII.27.) on the list of costs for the charging of litigation costs and determined in accordance with the IM Decree 32/2003 (VIII.21.) on the attorney's fees that may be assessed in court proceedings, pursuant to § 3 (2), (5) and (6) of the IM Decree 32/2003 (VIII.21.) on the list of costs for the charging of litigation costs. 115(2) and 99(3) of the Code of Civil Procedure, the costs of the proceedings and the costs of review and appeal shall be borne by the defendant. (1) of the Civil Procedure Act of 2016 CXXX of 2016 (Civil Procedure Act) (Pp.) pursuant to Section 83 (1).

[83] The Curia applied Section 5(1)(c) of Act XCIII of 1990 on Fees (Act XCIII of 1990 on Fees) and Section 5(1)(c) of Act XCIII of 1990 on Fees (Act XCIII of 1990 on Fees). § 35 (1) of the Pp. 102(6) of the Court of First Instance, the Court of First Instance ruled that the fees at first instance and the fees for review proceedings remain the responsibility of the State.

[84] The Curia dismissed the application for review on the basis of the provisions of the Kp. The Court of Cassation held a hearing on the appeal pursuant to Article 107(1) applicable pursuant to Article 115(2).

[85] The further review of the judgment is subject to the provisions of the Kp. 116(d).

Budapest, 2 December 2021.

Dr. Darák Péter sk.

President of the Chamber

Dr. Márta Stefancsik s.k. Dr. Péter Demjén s.k.

Judge-Rapporteur Judge

Dr. Drávecz Margit Gyöngyvér s.k. Ságiné Dr. Márkus Anett s.k.

Judge Judge