Dutch Supreme Court answers preliminary questions on redemption of interest rate swaps

The case

The housing association in question had concluded various interest rate swaps that had become substantially negative as a result of falling interest rates. The resulting obligations to provide security (so-called 'margin calls') placed such a strain on its liquidity position that the housing association would potentially not meet the mandatory stress test. In order to circumvent the margin calls, the housing association terminated the interest rate swaps. At the same time, the loans with a variable interest rate - for which the interest swaps were initially concluded - were replaced by fixed-interest loans.

As background, an interest rate swap is a contract with (usually) a bank, whereby the variable interest rate of a loan is 'exchanged' for a fixed interest rate (the swap rate). In this way the risk of fluctuations in the market interest rate can be hedged. The debtor then pays the agreed fixed swap rate to the bank concerned, instead of the variable interest rate on the loan the debtor entered into. In return, the debtor receives from that bank the amount of the variable interest he has to pay to its creditor. In the case at hand, the housing association had hedged the interest rate risk of variable rate loans with such interest rate swaps. As part of an interest rate swap contract, there was an obligation to deposit cash with the bank as security in the event of a drop in interest rates (the margin call). Because the market interest rate fell sharply in the years 2013 and 2014, this obligation would have a significant impact on the liquidities (immediately available cash) of the housing association. It therefore redeemed the interest rate swaps in 2014 and refinanced the underlying variable rate loans into fixed rate loans. As a result, after the redemption and refinancing, it paid a lower fixed interest rate than the fixed swap rate before.

The housing association wanted to deduct the amounts paid on redemption (surrender charges) from its taxable profit at once in one lump sum. In an interlocutory judgment, the District Court of Noord-Nederland referred the matter to the Supreme Court for a preliminary ruling.

The Supreme Court ruling

In dispute is the tax treatment of the redemption payments. Based on good business practice, costs should as far as possible be charged to the period in which the related revenues are recognized ('matching principle'). The housing association wanted to deduct the redemption sums at once from its profits. This because, the interest rate swaps and the variable interest loans have been terminated resulting in a loss actually realised, so there is no need to apply the matching principle. . The Tax inspector, on the other hand, was of the opinion that the surrender charges should be capitalized and amortized. In his opinion, the redemption must be assessed in conjunction with the refinancing.

In its advice to the Supreme Court, the  Advocate-General  concluded  that the combination of a variable rate loan and an interest rate swap actually functions as a fixed rate loan. According to him, the redemption of the interest rate swaps and the refinancing can be compared to the refinancing of a fixed-rate loan. The part of the surrender sums of the swaps attributable to the interest rate difference should, in his opinion, be capitalized and amortized during the period in which the variable interest rate loans would still have been outstanding. According to the Advocate-General, the remaining part of the surrender charges, which relates to the termination of the liquidity risk, may be deducted directly from the profit.

However, the Supreme Court does not follow the same line. The Supreme Court puts first and foremost that sound business practice does not oppose recognizing a loss in the year of surrender if the variable-rate loan connected to the interest rate swap (the swap combination) is also terminated. In that case there is a definite loss. The motive of the surrender is irrelevant for this purpose.

In more detail, according to the Supreme Court, the rules based on good business practice are as follows:

1. Fixed rate loans, falling market interest rates: A declining market interest rate generally affects the fair value of the liability of a fixed rate loan. The fair market value of the obligation increases. Taking the matching principle into consideration,  it is however not permitted to set the value of the loan on the liability side of the balance sheet for tax purposes at this higher fair value and deduct the related expense from the year in which the interest rate decrease occurs. Deductions are made for the annually agreed and payable interest expenses in the years to which they relate (and of course subject to any statutory interest deduction restrictions).
2. Premium interest adjustment for fixed-rate loan: If against a payment of a premium a lower fixed interest rate is agreed for the remaining term of a loan (interest adjustment), the amount paid may not be deduced from the profit at once. This amount must be capitalized and charged to profit through amortization over the remaining term of the loan.
3. Early repayment of fixed-rate loan, resulting in a new substitute loan: If a premium (penalty interest) is payable on an early repayment and a new loan is subsequently taken out, the penalty interest may not be deducted from the taxable profit at once in a lump sum. In this case, the payment must be capitalized and amortized, and this during either the remaining term of the original loan, or - if this is shorter - the term of the substitute loan.

Whether it is a substitute loan must be assessed according to the circumstances. In short, this would require comparing the characteristics of the two loans. Also the extent to which the replacement loan finances the same or similar asset as the original loan may be relevant.

The same rules apply in situations where a variable rate loan has been agreed in combination with an interest rate swap. For example, in the event of an interest rate decrease with an interest rate swap, an (additional) payment obligation arises. In its ruling of November 8, 2019, the Supreme Court determined that if the interest rate swap is related to a variable rate loan, the additional payment obligation on the interest rate swap may not be taken as a stand-alone tax loss.

If an interest rate swap is surrendered and the related variable rate loan is also terminated, the surrender price of the interest rate swap may be deducted from the profit in a lump sum in the year of surrender. This may  work out differently if a new loan is entered into to replace the n variable rate loan in combination with the  interest rate swap. In that case, there may under circumstances be a need to  capitalize and amortize the surrender charge.

However, if there is a substantial difference between the loan and swap combination and the new loan entered into , there is no question of replacement for the purposes of these rules. In that case, the redemption sums may again be deducted from the taxable profit in a lump sum. The Supreme Court has ruled that there is a substantial difference, for example, if in the original situation an interest rate swap could entail obligations to make security payments ('margin calls'), and this is no longer the case in the new situation.

In the case of the housing association, the characteristics of the combination of interest rate swap and variable rate loan differ from those of a fixed rate loan in particular by the possibility of margin calls. In this case, it cannot be said that the substitute fixed rate loans essentially continue the original combination of variable rate loans and interest rate swaps. When surrendering the interest rate swaps in this case, therefore, good business practice allows the surrender price to be deducted from the taxable profit in the year in which the surrender takes place. The housing association does not have to capitalize and amortize the loss incurred by the redemption of interest rate swaps.

This ruling of the Supreme Court may be considered to end a long discussion, which also came up during our tax seminar in November of last year (click here to see the slides (in Dutch)).