On July 21, 2011, the European Court of Justice in Luxembourg (“ECJ”) rendered its judgment in the Scheuten Solar Technology case. In dispute was whether the effective non-deductibility of interest on an intra-group loan was in breach of the Interest and Royalties Directive.
Facts
The Scheuten Solar Technology case (case no. C-397/09) involved the adding back of interest based on German legislation. For the purposes of corporate income tax (Körperschaftsteuer), the interest paid by the German subsidiary to the Dutch parent company was deductible. However, for the purposes of business tax (Gewerbesteuer) half of the deducted interest was added back to the tax base, effectively resulting in a deduction limitation. The Bundesfinanzhof (“BFH”), the highest German tax court, requested the ECJ for a preliminary ruling. One of the questions asked of the ECJ was, briefly put, whether the Interest and Royalties Directive precludes the application of a German interest deduction limitation. In essence, what is being asked is whether the Interest and Royalties Directive requires the deduction of interest in the source State.
The Interest and Royalties Directive is intended to prevent the double taxation of interest and royalties in certain affiliated relationships. Article 1(1) of the Directive states that, under certain conditions, payments of interest and royalties arising in a Member State are exempt from all taxation in the source State, regardless of whether this taxation is levied as withholding tax or imposed via an assessment. Scheuten Solar argued that this also means that restrictions on interest deductions are prohibited, because not allowing a deduction increases the taxable profit, which in turn results in an increase in the tax liability.
ECJ Decision
The ECJ agreed with the Advocate General that the deduction limitation falls outside the scope of the Interest and Royalties Directive; one of the reasons being that the tax in question is not triggered by the interest payment, but through a correction to the total annual profit. The Dutch parent company received the total amount of interest paid without German tax being levied on this amount. The Directive also does not contain rules for determining the debtor’s profit, including as regards deduction limitations. The ECJ believes that the Interest and Royalties Directive is only intended to prevent juridical double taxation. In other words: to prevent the same creditor of the interest or royalty being taxed twice on the same income for example, via a withholding tax in the source state and then again via a profit tax in the state of residence. The ECJ concluded that the position taken by Scheuten Solar - profit determination at the level of the debtor - was not covered by the Directive.
Consequences for the Netherlands
The Dutch Corporate Income Tax Act 1969 (“CITA”) and German legislation both contain various interest deduction limitations. The CITA includes Section 10d on thin capitalization, and Section 10a that is directed against ‘cash roundabouts’, i.e. where the dividend distributed or equity paid into a company is immediately loaned back to the dividend distributing or equity contributing company. It is also expected that as of January 1, 2012, a specific deduction limitation will take effect for interest paid by acquisition holding companies. Because the ECJ has advised interpreting the Interest and Royalties Directive in such a way that it does not prevent the German interest deduction limitation, it is unlikely that the Court of Appeals would conclude differently should the ECJ be asked to rule on the Dutch deduction limitation. However, this does not mean that the interest deduction limitation or certain elements included therein could not be contrary to other European rules, such as the freedom of establishment or the free movement of capital, or with provisions included in tax treaties that the Netherlands has concluded with other countries.