Jeroen Janssen and Charlotte Kiès of Loyens & Loeff NV discuss the Dutch participation exemption and to which extent the recent international developments in taxation will impact its scope and functioning.
The Dutch participation exemption provides for an exemption for dividends and capital gains on qualifying participations. It is one of the cornerstones of Dutch corporation tax law and an important feature of the Dutch investment climate. It is also one of the reasons the Netherlands is considered a tax-friendly investment jurisdiction, next to its widespread tax treaty network and advance tax ruling practice. However, the question arises whether and to what extent recent international developments in taxation, such as the changes to the EU Parent-Subsidiary Directive and the OECD BEPS-project, will have impact on its scope and functioning.
In dealing with cross-border activities, from a tax perspective a country can choose either a Capital Export Neutrality (CEN) approach or a Capital Import Neutrality (CIN) approach. Under a CEN approach, the home country levies tax on the total world income, irrespectively of where the income has actually been realised. A credit is granted for any foreign tax levied. The CEN approach is based on the idea that domestic and foreign investments of the resident taxpayer should not be treated differently. In general, a CEN approach is favoured by countries with a large and/or closed domestic market, such as the US. In contrast, the CIN approach is based on the view that investments by foreign entrepreneurs should be taxed at the same level as domestic entrepreneurs. It acknowledges foreign states’ tax sovereignty and does not correct for the domestic tax rate. A CIN approach generally provides for an exemption of foreign-sourced income. CIN countries generally have a small but open domestic market and substantial cross-border trade.
It has been suggested that a CIN system is generally more susceptible for unfair tax competition from tax havens and (aggressive) tax planning by taxpayers. Because of the exemption it allegedly induces taxpayers to structure their income or investments through low-taxed jurisdictions. Especially in today’s world, in which production factors are becoming more and more mobile, this is sometimes considered a serious problem. However, the much-discussed and publicly criticised tax strategies of Apple and Starbucks demonstrate that a CEN bastion such as the US may be seriously susceptible for aggressive tax planning as well. One should therefore not be too quick to blame the system.
The Dutch participation exemption in its most basic form goes back as far as 1894. It aims to prevent economic double taxation on business profits. It can be characterised as having something of a hybrid form, being largely based on a CIN approach with certain CEN elements. This approach is no surprise, considering the Netherlands’ longstanding foreign trade ambitions and its generally small but open domestic market. This purport has been explicitly stated by the legislator as such. It is further important to note that the system of the Dutch participation exemption also builds on decades of case law, developing longstanding concepts and doctrines. It further affects, or is affected by, numerous other articles and regulations of Dutch corporation tax law. Its designation as a cornerstone of Dutch corporation tax law is certainly no exaggeration.
The Dutch participation exemption fully excludes from the corporation tax base all dividends, capital gains and other benefits derived from a (qualifying) equity participation of 5 per cent or more. However, an exception can apply. For income received from low-taxed passive-investment shareholdings, a (limited) credit is received instead of an exemption. This is explicitly an anti-abuse rule, and a rather elaborate and complicated one. There are several “tests” that need to be met, including rebuttal and safe-harbour rules, in order to be able to apply the exemption. These different tests are quite domestically oriented. For instance, the intentions of the Dutch holding company and the question of whether a participation is sufficiently taxed from a Dutch perspective are taken into account. The exemption is generally favourable, but the regime has some complexities.
In July 2013, the OECD, at the request and with the support of the G-20, launched an action plan to develop solutions to fight “Base Erosion and Profit Shifting” (BEPS). The BEPS Action Plan proposes 15 action points addressing identified “weaknesses” in the existing international taxation principles. The BEPS action points should restore the international taxation order, among others by ensuring that profits are taxed where economic activities generating the profits are performed and where value is created. One of these 15 action points, Action 2, strives to develop “model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect of hybrid instruments and entities”.
The OECD published a Discussion Draft on Action 2 in April 2014, and followed with an Interim Report in September 2014. The Interim Report identifies three categories of hybrid mismatch arrangements. These include: hybrid financial instruments and transfers; hybrid entities; and reverse hybrids and imported mismatches. The Interim Report provides recommendations for domestic rules to neutralise the effects of hybrid mismatch arrangements. It further recommends changes to the OECD Model Convention on Income and Capital to ensure that hybrid entities are not used to obtain treaty benefits. The recommended changes to domestic law include the introduction of “linking rules” in cross-border situations: rules linking the tax treatment in one country to the tax treatment in the other country. According to the Interim Report, countries should implement a primary rule and a secondary (or defensive) rule. In principle, the primary rule is to deny the deduction in the state of the payer of a payment giving rise to the mismatch in tax outcome. The secondary rule states that the income should be included in the payee’s tax base if the payer is not denied the deduction. The Final Report is expected in September 2015. The OECD may then issue final recommendations for domestic legislation. There is no legal obligation for the member states to follow such recommendations, although there will be (international) political pressure to do so.
It is also to be awaited whether and to what extent the Netherlands intends to follow the recommendations of Action Plan 2. If it came to implementation of these linking rules in Dutch tax law, especially the secondary rule, it would require (fundamental) changes to the Dutch participation exemption regime. As stated, the exemption applies to dividends, capital gains and other benefits derived from a (qualifying) equity participation. The qualification of the investment, instrument and/or payment (eg, whether the instrument is equity or debt or whether a benefit is considered a dividend or interest) is a question of Dutch (corporate) law. The qualification of the payment or instrument under the domestic law of the country of the payer is irrelevant. This has explicitly been confirmed by the Supreme Court in the so-called RPS case in 2014. Moreover, it has been stated in the parliamentary proceedings that the tax treatment of the payment in the payer country is not relevant for the application of the participation exemption. Even the anti-abuse rule (whereby a credit applies) does not consider the foreign tax treatment of such payment. The Netherlands thus strictly adheres to its CIN approach with respect to benefits derived from a (qualifying) participation. If it would come to implementation of the BEPS Action 2 it would require an overhaul of these principal precepts.
Thinking ahead, several questions arise as to the implementation of these rules in Dutch tax law, especially with respect to the secondary rule and its impact on the participation exemption. For instance how the Dutch tax authorities will effectively verify whether the main rule was applied in the payer’s country, and thus whether the secondary rule should be applied in the Netherlands. In this respect, the division of the burden of proof between the taxpayer and the tax authorities will be of significant importance. Also the interaction with the anti-abuse provisions may prove to call for detailed legislation.
An implementation of BEPS Action 2 in the Dutch participation exemption would add more complexities to an already complex part of Dutch corporation tax law. Such actual implementation would prove even more difficult, considering that similar rules are being required by recent changes in the EU Parent-Subsidiary Directive.
The EU Parent-Subsidiary Directive (the Directive) was introduced in 1990. Although it has been changed on many occasions since, its tenor has remained the same. It obliges member states to either apply an exemption or credit for dividends received by a parent entity in one member state from shareholdings of 10 per cent or more in another member state. The Directive also prohibits any dividend withholding tax in such relationship. The Directive’s aim is to ensure that corporate profits are (only) taxed once – aiming to counter both double taxation as well as double non-taxation.
On 8 July 2014 an amendment to the Directive was introduced, which targets cross-border hybrid loans and aims to neutralise double non-taxation. Member states must implement the amendment in their domestic legislation by 31 December 2015 at the latest. The adopted text provides for a mandatory limitation of the exemption of payments received through hybrid financing arrangements. Pursuant to this limitation, the member state where the parent company is established shall tax profits distributed by a subsidiary in another member state, to the extent such profits are deductible by the subsidiary. The member state where the parent company is established shall refrain from taxing such distributed profits to the extent such profits are not deductible by the subsidiary. Implementation of the anti-hybrid amendment in Dutch corporation tax law would mean that the Dutch participation exemption can no longer adhere to the principle of disregarding the foreign tax treatment. Thus, this too would require changes to some fundamental precepts of the Dutch system.
Furthermore, on 27 January 2015 the Directive was amended to include a general anti-abuse rule (GAAR). It states that the benefits of the Directive shall not be granted with respect to arrangements with the main purpose or one of the main purposes to obtain a tax advantage that defeats the object and purpose of the Directive. The member states must implement the changes in their domestic legislation by 31 December 2015 at the latest. It is expected that the Dutch law proposal for this implementation will be issued on 15 September 2015. The “abuse” targeted by the EU with this introduced GAAR is primarily the evasion of dividend withholding tax, not corporation tax. However, not every member state levies a dividend withholding tax. The UK, Cyprus or Hungary, for instance, do not. As the GAAR cannot have the intention to force member states to introduce dividend withholding tax, implementing the new GAAR will then either be irrelevant for these member states, or alternatively may require changes to domestic participation exemption regimes. The European Commission has previously stated during the ECOFIN that the GAAR amendment is not intended to intervene in domestic systems with respect to the participation exemption. Nonetheless, the text of the amendment is not limited to withholding taxes, but extends to “the benefits granted by this Directive”. That clearly is not limited to dividend withholding tax, but extends to all benefits of the Directive, including the (corporation tax) exemption of article 4(1)(a) of the Directive. The scope of the GAAR and any impact thereof on the Dutch (and other countries’) participation exemption regime is therefore unclear. However, on the basis of the text of the amendment, domestic participation exemption regimes could be affected.
On the other hand similarly the question can be raised whether changes are required or whether the GAAR is irrelevant, considering the Dutch system as such. The benefits granted by the Dutch participation exemption are to a large extent not based on the Directive. As stated, the Netherlands has known some form of a domestic participation exemption since 1894. Since 1914, benefits from foreign participations could fall under the participation exemption as well. The introduction of the Directive in 1990 therefore granted Dutch shareholders little to no additional rights with respect to the Dutch participation exemption, which was already fully developed by then. Therefore, it is not clear whether changes to the Directive, such as “not granting the benefits of this Directive”, could or would have any actual effect on the Dutch participation exemption.
The Netherlands, with its small domestic market and open borders, has long held dear to the principle of CIN. International developments may force the Netherlands into a more CEN approach with respect to its participation exemption regime, requiring substantial changes to a settled and complex system. It is therefore the question whether and how the Netherlands will respond, and whether it will do so eagerly. Nonetheless, the globalising world economy and increasing mobilisation of production factors, and particularly the fast-paced developments in OECD and EU context under public and political pressure, may perhaps present the Netherlands with no other choice.