On 4 October 2024, the European Court of Justice (the “ECJ”) (Case C-585/22) ruled that Article 49 of the Treaty on the Functioning of the European Union (the “TFEU”), which guarantees the freedom of establishment, does not preclude national legislation from fully denying the deduction of interest paid on loans from related entities used to acquire or increase a stake in another entity, which is or becomes, following that acquisition or increase, a related entity, provided that such debt constitutes a wholly artificial arrangement or is part of one, even if the debt is on arm’s length terms and the amount of interest does not exceed that which independent undertakings would have agreed upon.
Facts
In the case at hand, a Dutch company (the “DutchCo”), wholly owned subsidiary of a Belgian company (the “ParentCo”), received arm’s length loans from a Belgian direct sister company (the “SisterCo”) benefiting from a special tax regime as a “coordination center” under Belgian tax law, to finance the acquisition of a majority stake in an unrelated Dutch entity (the “Target”).
The Dutch tax authorities refused to deduct the interest payments made by DutchCo to SisterCo under the Article 10a of the Netherlands Corporate Tax Law (the “Article 10a”), which foresees the non-deduction of interest paid by an entity subject to tax and resident in the Netherlands on intra-group loans used for, inter alia, acquiring or increasing an interest in an entity, which is or becomes a related entity following that acquisition or increase, unless if it can be demonstrated, inter alia, that one of two exceptions is met: (i) economic justification: commercial / economic rationale behind the transaction or (ii) sufficient taxation: a reasonable profit-based tax of at least 10% per the Netherlands criteria is levied by the lender’s jurisdiction on the interest income, without offset with carried-forward losses or charges resulting in no tax (except if the loan offsets losses or charges which arose during the year or will arise in the short term).
DutchCo challenged the refusal first before the competent District Court and subsequently before the Court of Appeal in the Netherlands. The latter held that the Article 49 of the TFEU does not preclude the application of Article 10a, unless one of the two exceptions is satisfied. Following this decision, DutchCo lodged an appeal before the Supreme Court of the Netherlands, which referred questions to the ECJ for a preliminary ruling. The ECJ was asked, in essence, to determine whether this national legislation is compatible with Articles 49, 46, and 63 of the TFEU, which guarantee the freedom of establishment, free movement of services, and free movement of capital, respectively.
Reasoning of the ECJ
The ECJ recalled that any difference in treatment (between an entity of a Member State and an entity of another Member State) resulting from a national legislation to the detriment of companies exercising their freedom of establishment is permissible, only if it relates to situations which are not objectively comparable, or if it is justified by an overriding reason in the public interest and is proportionate to that objective.
The three-step reasoning of the ECJ started first by analysing whether there is effectively a difference of treatment, then whether the situations were comparable and thirdly whether the difference of treatment may be justified by an overriding reason in the public interest and whether it is proportionate to that objective.
The difference of treatment
The ECJ considered that even though the two conditions of the Article 10a under which such a deduction is possible, is applicable without distinction to national and cross-border situations, the referring Court was of the view that the criteria of Netherlands law, requiring a taxation of at least 10% of the taxable profit determined in accordance with Dutch rules, nevertheless has the effect of placing cross-border situations at a disadvantage. Indeed, the referring Court considered that the condition at issue is generally satisfied for a resident entity while it is less often fulfilled for a non-resident entity due to potential discrepancies between the foreign profit determination rules and the Dutch ones.
Although the EU judges deferred to the referring Court as to assess and interpret the national legislation, it considered that if a taxation at a rate of less than 10% was not practised under the Netherlands tax regime, the condition at issue affects only cross-border situations. Hence, they held that this national legislation involves a difference in treatment which is liable to affect the exercise of freedom of establishment and examined subsequently whether the situations are not objectively comparable.
The comparability of the situations
The EU judges ruled that, regarding tax advantages, such as deducting interest on intra-group debts, a taxpayer's situation does not differ based on whether the recipient entity is in the same Member State or another with more favourable tax treatment. They concluded that a taxpayer is not in a different situation solely because the recipient entity is established in another Member State, where the interest is taxed at a rate not exceeding 10% on a taxable profit determined in accordance with Dutch rules.
Justification
The ECJ, after identifying a difference in treatment, examined whether it could be justified by an overriding reason of public interest and whether it was proportionate to that objective.
Justification by overriding reason of public interest
In accordance with its constant case-law, the ECJ emphasized that the objective of preventing tax fraud and tax evasion as well as combatting wholly artificial arrangements lacking economic substance (aimed at avoiding taxes on profits generated within a national territory) constitutes overriding public interest, justifying a restriction on the freedom of movement guaranteed by the TFEU.
The EU judges found that the legislation at hand intends to address the artificial nature of transactions arising from the redirection and conversion of own funds into loan capital and this, regardless of whether the taxpayer and its subsidiary are already or become related following the acquisition or increase in ownership.
The proportionality with the objective pursued
The ECJ first assessed whether the legislation effectively achieves its anti-abuse objective in a consistent and systematic manner without exceeding what is necessary.
It concluded that to pursue such a tax anti-abuse objective, national legislation can establish a presumption of tax abuse if there is prima facie evidence or objective indicators of fraud, provided that taxpayers can rebut this presumption by demonstrating the transaction’s economic substance. In the present case, borrowing loans from a related entity for the acquisition or increase of an interest in an entity which, following that acquisition or increase, is or becomes a related entity were considered indicators of artificial arrangements, with taxpayers allowed to rebut the presumption by satisfying the conditions outlined in Article 10a.
The ECJ then addressed whether intra-group loans agreed at arm’s length terms could avoid classification as artificial arrangements. It clarified that non-arm’s length loans trends toward an objective element of an artificial arrangement, without inferring that compliance with arm’s length terms alone does not automatically rule out an arrangement being artificial. It highlighted that the assessment relates not only to the terms of the loans but also to the overall economic reality of the transaction, beyond its formal conditions.
The ECJ reiterated that EU law cannot be used to obtain a right or advantage when the transaction is purely artificial economically and designed to circumvent the application of the national legislation.
It emphasized proportionality in the treatment of intra-group loans: where interest rates are exceptionally high but reflect economic reality, only the portion exceeding market rates may be disallowed. However, loans not economically justified that exist only due to the relationship and because of the tax advantages being sought, denying the full deduction is appropriate to prevent wholly artificial arrangements.
Therefore, according to the EU judges, when a purely artificial arrangement lacking economic substance is established and aimed at circumventing the national legislation, denying the deduction of all interest expenses resulting from such an arrangement is proportionate under EU law, regardless of whether the loan was concluded on arm’s length terms.
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