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More clarity on the fiscal consequences of a loan provided not at arm’s length

More clarity on the fiscal consequences of a loan provided not at arm’s length

The Supreme Court created somewhat more clarity at the end of last year with regard to the consequences of providing a not at arm’s length loan within a group (Supreme Court, 25 November 2011, LJN: BN3442).

If a company needs financial resources, another group company may be able to provide these. For example, a parent company can furnish these resources as equity. If equity is furnished, the subsidiary will pay out dividend in exchange for that. Pursuant to the participation exemption, this dividend will usually be untaxed. If the subsidiary’s shareholder equity decreases as a result of losses, the parent may not deduct these losses (decline in the value of the participating interest) from the profit.

If the parent company or another company within the group provides a loan to the company that needs financing, the company that receives the loan (the debtor) may deduct the interest it pays and the interest is taxed at the company which provided the loan (the creditor). On the other hand, if the company taking the loan cannot repay it, the company furnishing the loan can deduct the loss it has consequently suffered from its profit.

The fiscal starting points mentioned above apply if the loan provided within the group is extended “at arm’s length”, but not if the loan is one that is not at arm’s length.

When is there is a situation of a loan that is not at arm’s length?
In principle the tax authorities follow the intention of the parties. If the parties opted for a loan arranged under civil law (and not for a formal or informal capital contribution), then this serves as the basis for the tax authorities as well. This is only not the case if:

– there is a sham transaction;

– there is actually a case of an equity interest;

– it was clear at the start of the loan that the creditor would not be able to repay the loan, or repay it in full (see, among others, the Supreme Court, 24 May 2002, LJN: AE3171).

The Supreme Court also states that if a loan within a group is not at arm’s length, only an interest rate that would be considered at arm’s length can be taken into account for tax purposes. This must be set at an interest rate that the debtor would have to pay if it were to borrow money from a third party under otherwise identical conditions, with suretyship from a group company.

The Supreme Court furthermore stipulates that the moment at which the loan was entered into is the reference point for assessing whether the loan is or is not at arm’s length, whereby the loan as a whole must be taken into consideration. The Supreme Court does not rule out, however, that as a result of actions by the creditor which are not at arm’s length, an arm’s length loan within a group may cease to be at arm’s length during the term of that loan.

The Supreme Court is clear about the default risk. In the event of a loan that is not at arm’s length, this risk lies in the capital domain and is therefore not deductible. The same applies for the risk that the interest on a loan that is not at arm’s length is ultimately not paid by the creditor.

In its judgement of 13 January of this year (Supreme Court, 13 January 2012, LJN: BP8068) the Supreme Court found that the facts that no formal security was furnished, no repayment scheme was agreed on and the interest was added to the loan did not stand in the way of the finding that there was not a case of a not at arm’s length loan. Circumstances at the moment the loan was entered into could justify this, despite the facts mentioned above. For instance: could the debtor have provided adequate security and/or did it have sufficient repayment capacity and/or did it have good prospects of a healthy continued existence. Caution is always advised when furnishing loans within a group therefore.

Karen Verkerk

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