In proceedings conducted by KPMG Meijburg & Co the Supreme Court recently ruled that, for the calculation of double taxation relief, a foreign exchange loss on a corporate loan does not have to be deducted from interest income. This results in more room for crediting foreign withholding tax on interest income in the Netherlands.
The case
The case involved a group financing company resident in the Netherlands ("the BV") that, in 2003, granted several USD loans to a group company resident in Brazil. The BV claimed credit of the Brazilian withholding tax on the interest it had received on these loans, based on the tax treaty in place between Brazil and the Netherlands, against the corporate income tax on the interest received owed in the Netherlands. In euros, however, the BV had suffered substantial foreign exchange losses on the principal of the USD loans. In the inspector's view, these foreign exchange losses should be regarded as interest costs to be set off against the Brazilian interest received, pursuant to the Decree on the Avoidance of Double Taxation ("Decree"), to which the tax treaty refers with regard to this subject. This would lead to a reduction of the amount the BV would be able to credit. The BV did not agree with this view and appealed the decision; the District Court found in its favor. The District Court's decision was upheld by the Court of Appeals, upon which the Deputy Minister of Finance filed an appeal to the Supreme Court.
The relevant rules
Based on the tax treaty concluded between Brazil and the Netherlands in 1990 Brazil is entitled, in respect of interest paid to a creditor resident in the Netherlands, to levy a tax of 15% on the gross amount paid in interest. The creditor, in turn, is entitled to credit this tax against the corporate income tax due in the Netherlands ("first limit"). If, however, the amount in Dutch corporate income tax attributed to this interest is lower than the amount in withholding tax, the tax credit is limited to this lower amount ("second limit"). For the calculation of the amount in Dutch corporate income tax to be allocated, the treaty refers to the Decree. The Decree states that the credit of foreign levies on interest is limited to that part of the amount in Dutch taxes on global income that is equal to the ratio of foreign interest ("numerator") and global income ("denominator"). In this tax relief fraction, the numerator is on a net basis, due to which the interest-related costs must be deducted from the amount in foreign interest. The core question of the procedure was, whether the foreign exchange losses must be regarded as costs as referred to above, which would result in a smaller numerator and, therefore, a larger tax credit.
The Supreme Court Judgment
The Supreme Court confirmed the decisions of both the Amsterdam Court of Appeals and the Haarlem District Court in this case. In its ruling, the Court of Appeals found that the interest included in the profit is equal to the income element on which Brazil is entitled to levy a tax pursuant to the tax treaty with the Netherlands. This does not include currency exchange differences regarding the principal on which that interest was received. In addition, the treaty refers to interest paid, which also results in the currency exchange differences not having to be taken into account. Also, in terms of costs, there is no connection between a foreign exchange loss on the principal and the interest received. In this context, 'costs' must be taken to mean only the current expenditures paid for out of the interest income, such as management costs and interest on debt financing. The Supreme Court fully concurs with the Court of Appeals' findings.
Commentary KPMG Meijburg & Co
A further element the inspector and the Deputy Minister brought forward in the procedure was, that interest on loans in foreign denominations always contains a foreign currency exchange component; consequently, this could entail a connection between a foreign exchange loss suffered on the principal and the interest received, although the inspector was unable to quantify this component. The Court of Appeals considered this argument by way of hypothesis and rejected it, whereas the Supreme Court ignored it on the ground that it was not relevant to the Court of Appeals' decision.
We therefore assume that the situation is clear at last: foreign currency exchange results on the principal are not relevant to the calculation of the numerator in the tax relief fraction. The second limit will not be reduced by foreign exchange losses on the principal, nor will the second limit be increased by foreign exchange gains. This is not only the case under the tax treaty with Brazil, but also under tax treaties the Netherlands concluded with other countries and which refer to the Decree for the calculation of the tax relief, and possibly also in situations where the interest originates in a developing country and the Decree applies. In 1992, the Supreme Court ruled that costs made for covering foreign currency exchange risks result in a lower second limit, although in that case the costs involved were costs actually incurred in connection with foreign interest income.