Following my blog on the (non-)amendment of the Dutch participation exemption for substance-less holding companies, this blog considers the Dutch government's announcement that it intends to unilaterally amend the application of the arm's length principle: a downward adjustment in Dutch taxable profits as a result of the application of the arm's length principle will be made conditional on a corresponding amount of income being taxed elsewhere in the group. Draft legislation to this effect is expected to be released in the spring of 2021.
What problem is this trying to solve?
The arm's length principle has always been part of the Dutch tax system. Based on Dutch Supreme Court case law from the 1950s, benefits derived by Dutch companies that have their origin in shareholder relationships are eliminated from the taxable profit calculation. They are treated as so-called informal capital contributions or 'downward profit adjustments'.
In 2002, a provision codifying the arm's length principle of Article 9 of the OECD Model Tax Convention on Income and Capital was included in Dutch corporate tax legislation. At present, a downward profit adjustment may be made under Dutch tax law irrespective of whether the adjustment is picked up as taxable income elsewhere in the group.
A very well-known example of a downward profit adjustment without a corresponding pick-up elsewhere is the imputation of interest on interest free loans made by an Irish affiliate to a Dutch company. Other examples can be found among mainly US multinationals that have used informal capital structures to move high value intangibles offshore. The operations set up in the Netherlands to exploit those intangibles usually justify an arm's length profit that is much smaller than the commercial profits actually realized; the difference is treated as informal capital and is therefore not taxed in the Netherlands.
In today's post-BEPS world, these results are considered problematic by the Dutch government. As a result of the proposed unilateral amendment of the application of the arm's length principle, these structures will lose their attractiveness because a downward profit adjustment will be conditional on a corresponding amount of income being taxed elsewhere in the group.
What to think of this proposed unilateral amendment?
The Dutch government has been very active in combatting international tax avoidance in recent years. From this perspective, one can understand the proposed amendment. When looking at it from a broader perspective, taking into account tax policy objectives of other jurisdictions, a number of critical observations can, however, be made.
The denial of a downward profit adjustment means that the Netherlands would, in essence, be expanding their taxing jurisdiction to profits which would not be taxed there if the arm's length principle was correctly applied. The unilateral amendment is, therefore, a clear deviation from taxation in accordance with the arm's length principle, as agreed upon among all members of the OECD and beyond.
The Dutch government 's view is that provisions in its tax treaties which are similar to Article 9 of the OECD Model Convention do not preclude the unilateral amendment of the application of the arm's length principle. But, while Article 9 OECD Model allows countries in which profits are underreported to adjust the taxable income of its taxpayers (upward adjustment), it is not a license for other countries to tax more than what constitutes an arm's length profit.
If the Netherlands were to tax more than an arm's length profit, this would undermine legitimate policy objectives other countries may pursue with their conscious decision to tax less than an arm's length profit. Furthermore, even if a country under its domestic law taxes less than the arm's length profit of, e.g. a parent company, it may still have an interest in the Netherlands not taxing more than the arm's length profit of a subsidiary of that parent. For example, because on the distribution of a Dutch subsidiary's after-tax profits to the parent company, the parent's country of residence may have to give an indirect credit for taxes paid in the Netherlands by that subsidiary. Or, if granting a credit is not required, the parent may suffer double taxation.
A step towards minimum taxation
The proposed amendment of the arm's length principle is, in a way, a step in the direction of a minimum level of taxation; maybe a small step, but still a step.
The topic of a minimum level of taxation is currently the subject of the Pillar Two discussions within the OECD/G20 Inclusive Framework on BEPS. Pillar One concerns the re-allocation of taxing rights, and both Pillars grew out of the work done by the Inclusive Framework in respect of the tax challenges arising from digitalisation.
The Dutch government is in favour of reaching international agreement on Pillars One and Two and is more generally of the view that international tax avoidance should be addressed through internationally coordinated action, rather than through unilateral measures. The question is whether it would not have been better for the Dutch government to await the outcome of the discussions on Pillars One and Two, rather than unilaterally amending the application of the arm's length principle.
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