The decision of the European Court of Justice in the Lexel AB case raises questions whether the valid business reason exception of article 10a of the 1969 Dutch corporate tax act (CTA), an interest deduction limitation provision, is partly incompatible with EU law.

Lexel AB case

Lexel AB is a Swedish company that is part of the Schneider Electric group. Lexel AB acquired 15% of the shares in a Belgian affiliate. The funds for the acquisition of the shares were borrowed from Bossière Finance SNC, a French affiliate. Interest on the loan was included in Bossière's taxable income, but no tax was actually paid because of net operating loss carry forwards.

The Swedish tax authorities denied Lexel AB a tax deduction for the interest on the basis that the Substantial Benefit Exception applied. Swedish tax law provides that interest paid to affiliates is deductible, if the creditor is taxable at a rate of at least 10%, unless the loan gives rise to a substantial tax benefit which is the case if it is mainly (75% or more) entered into for tax reasons (the Substantial Benefit Exception). The Substantial Benefit Exception could not have applied if Bossière had also been resident in Sweden because, in that case, the debtor and the creditor could have compensated profits and losses through the Swedish system of group contributions.

The Swedish high court submitted a preliminary question to the ECJ whether the Swedish system is compatible with the freedom of establishment provided for in article 49 TFEU. The ECJ held that the Swedish tax system is discriminatory, because it treats payments of interest to a debtor resident in Sweden and payments to a non-resident debtor, which are comparable situations, differently and thus that the Substantial Benefit Exception infringes article 49 TFEU. The infringement cannot be justified on the basis of the argument that the rule is intended to fight against tax evasion and tax avoidance because it does not target only purely artificial arrangements. It applies to all situations in which 75% or more of the reason for entering into a loan is saving tax, including transactions meeting that threshold that have been entered into on arm's length terms and that are not purely artificial arrangements. The infringement can also not be justified by the need to safeguard the allocation of the power to impose taxes between the Member States because the Substantial Benefit Exception is aimed at avoiding the erosion of the Swedish tax base, which is not the same as the preservation of a balanced allocation of taxing rights as defined by the ECJ. The prevention of a reduction in tax revenue is not a justification for an infringement of article 49 TFEU. Furthermore, the ECJ took into account that the interest would be deductible if the debtor and the creditor were unrelated.

Interest deduction limitation provision in the CTA

In the Netherlands, article 10a CTA denies a deduction for interest on related party loans incurred in certain specifically designed transactions, such as the acquisition of shares (from a related or unrelated party) or the repayment of capital. By way of exception, a deduction is not denied if the taxpayer establishes that the loan and the transaction financed with the loan are predominantly based on business reasons (Business Reason Exception). Generally speaking, one can say that the Business Reason Exception is not met, if the transaction would not have happened in the absence of the tax benefit. The Business Reason Exception intends to codify Dutch Supreme Court case law on the application of fraus legis to loans created on internal shares sales and capital repayments that resulted in erosion of the Dutch tax base. It is, however, generally believed that, like the Swedish rules, the Dutch rules including the Business Reason Exception would deny interest deductions not just in the case of wholly artificial structures, but that many transactions which are not wholly artificial would not qualify under the Business Reason Exception either. Article 10a CTA applies to cross-border and domestic transactions alike. As a practical matter, however, the application of article 10a CTA rarely, if ever, leads to the denial of an interest deduction in domestic situations because article 10a CTA is not applicable if the interest is subject to Dutch corporate income tax. This means that, like in the Lexel AB case, interest incurred on a loan predominantly entered into to achieve a tax saving but that is otherwise at arm's length and not wholly artificial would not be deductible under article 10a CTA. It is hard to see why this would not be an infringement of article 49 TFEU in accordance with the reasoning of the ECJ in Lexel AB.

PS: the situation is probably different if the affiliated creditor has net operating losses against which the interest income is offset, because in that case interest is also disallowed in a domestic situation and there is no difference in treatment with a cross-border situation.