Dutch Supreme Court: property rights also require a leveraged effect of more than 1 in 10 to qualify as lucrative interest

Background

Based on Dutch tax law, a special tax regime for lucrative interests applies to the direct or indirect holding of qualifying lucrative instruments, such as shares (depositary receipts for shares are put on a par with shares), receivables and property rights that meet certain objective criteria, if such instruments are intended as remuneration for activities performed. As a general rule, in case of leaver provisions, the instruments are considered to relate to activities performed.

 The characteristic of a lucrative instrument is that it offers the holder the opportunity to earn a return with  a limited investment that is disproportionate to the capital invested and/or the risks to be run (the leveraged effect). With respect to shares, a lucrative interest may be present if a company has different classes of shares and a relevant class of shares:

• is subordinated to other classes of shares and the total issued share capital of that subordinated class of shares is less than 10% of the total issued share capital of the company (10% criterion). The “total issued share capital” refers to the total amount of nominal value of the issued shares (share premium and informal capital are not taken into account); or
• has a preference of at least 15% per year.

In addition, a lucrative interest is also present in the case of property rights that are “economically similar or comparable” to the aforementioned subordinated classes of shares that constitute a lucrative interest (leveraged shares). This is a ‘catch-all’ category and prevents easily avoiding a lucrative interest by creating shares that do not meet the abovementioned 10% criterion, but economically have the same function as those shares. For example, by financing a company with shareholder loans (instead of preference of preference shares), or by issuing a low amount of preference share capital on which a large amount of share premium is contributed, a similar leveraged effect is created as in respect of leveraged shares.

 However, it is not explicitly mentioned in the law what kind of “leveraged effect” is required for the property rights to be considered “economically similar or comparable” to leveraged shares. Based on statements made during the parliamentary proceedings, the Dutch tax authorities in practice take the position that it should be tested if capital invested in the property rights is less than 10% of the total capital invested. In this respect “capital invested” refers to share premium, informal capital and shareholder loans.

Pursuant to the lucrative interest regime, any income and capital gains from a direct lucrative interest are taxed as ordinary income against progressive Dutch personal income tax rates up 49.50% (2023). Any losses from a direct lucrative interest are deductible. If the lucrative interest is structured indirectly via a substantial shareholding (i.e. an interest of at least 5% of  the shares (or a class of the shares) in an entity holding the lucrative interest), a choice may be made to have income and capital gains taxed under the substantial shareholding regime at a flat rate of 26.9% (2023), provided certain conditions are met.

Relevant facts

In the case at hand, the taxpayer was employed as CFO within a group of companies. The group ran into financial difficulties in 2013. On the restructuring and refinancing of the group, various bank loans and subordinated loans of the holding company of the group (Topco) were converted into cumulative preference shares. In addition, a financial institution granted a bank loan to a subsidiary of Topco and its shareholders guaranteed the fulfilment of that loan. As part of the restructuring, the Topco also issued ordinary shares and set up a management participation plan (MPP). In April 2014, the taxpayer acquired depositary receipts for ordinary shares (depositary receipts) in Topco for EUR 630,000. In December 2014, the value of the depositary receipts dropped to EUR 1 and in April 2015 the taxpayer sold the depositary receipts for EUR 1. In his 2014 Dutch personal income tax return, the taxpayer wrote down the value of the depositary receipts to EUR 1 and deducted the EUR 629,999 loss as negative income from lucrative interest. The Dutch tax inspector denied that deduction.

Court proceedings

The Gelderland Lower Court (the Court) ruled that the depositary receipts of the taxpayer did not constitute a lucrative interest. In the Court’s opinion, the depositary receipts are not a separate class of shares. This is because - apart from the special rights laid down in the depositary receipt holders agreement - no  special rights in terms of profit-sharing, decision-making or entitled were granted to the depositary receipts. As the total issued share capital on the ordinary shares is more than 10% of the total issued share capital of Topco, the depositary receipts (which are put on a par with the underlying shares) do not qualify as lucrative interest. In addition, the Court also found that the depositary receipts are not economically similar or comparable to leveraged shares, because the total capital invested in the depositary receipts is more than 10% of the total capital invested in Topco.

Before the Arnhem-Leeuwarden Court of Appeal (the Court of Appeal) it was only in dispute if the depositary receipts are economically similar or comparable to leveraged shares. More specifically, it was in dispute whether an amended 10% criterion (taking into account share premium and informal capital) is relevant to determine whether the depositary receipts were economically similar or comparable to leveraged shares. The Court of Appeal found that it does not explicitly follow from the legislative history that this should be determined based on an amended 10% criterion, but rather based on a material criterion. For that purpose. .the Court of Appeal found that it should be determined, based on an all facts and circumstances, (i)  whether there is a leverage mechanism, for example - but not only - as a result of extreme financing and/or non-arm’s length interest - or (cumulative preferential) dividend rates, (ii) as a result of which the shares may generate potential returns disproportionate to the capital invested (i.e. may share more than proportionately in the return on a total investment) and/or the risk actually run on the investment and (iii) there is otherwise a situation in which shares can generate returns disproportionate to the capital invested and/or the risk actually run on the investment it is relevant that those depositary receipt could have enabled the taxpayer (as intended) to earn a return that was disproportionate to the capital invested and the risk to be run with that investment (material criterion). Based on the relevant facts, the Court of Appeals ruled that the depositary receipts constitute a lucrative interest.

Dutch Supreme Court

The Dutch Supreme Court found that the legislative history shows that the 10% criterion aims to limit the presence of a lucrative interest to situations where a leveraged effect of more than 1 in 10 is created. Based on legislative history, such leveraged effect is present if certain shares represent a very limited part of the company's equity and more than proportionally share in the surplus profit, i.e. the profits that remain after the interest obligations have been paid and regular dividends have been distributed.

Unlike the Court of Appeal, the Supreme Court found that is not sufficient that the relevant property rights offer the taxpayer the opportunity to earn a return with a limited investment that was disproportionate to the capital invested and the risk to be run. According to the Dutch Supreme Court, it follows from a grammatical interpretation and legislative history that property rights are economically similar or comparable to leveraged shares if those rights, taken in conjunction, provide a leveraged effect of more than 1 on 10 or a similar effect. The Dutch Supreme Court therefore found that the economic comparability of property rights with leveraged shares should relate to the leveraged effect as expressed in the 10% criterion. In this respect the Dutch Supreme Court noted that in the case of an analogous application of the 10% criterion to property rights, besides the nominal value of the issued shares, also share premium, informal capital and loans that actually function as equity are taken into account.

Final remark

With this ruling, the Dutch Supreme Court removes the uncertainty that arose in practice following the decision of the Court of Appeal that a material test should be applied to determine whether property rights are economically similar or comparable to leveraged shares. The Dutch Supreme Court now provides clarity that property rights are economically similar or comparable to leveraged shares if they provide a leveraged effect of more than 1 on 10: in other words, whether the capital invested in the property rights is less than 10% of the total capital invested, whereby share premium, informal capital and subordinated loans that actually function as equity (profit-participating loans) should be taken into account.

The Dutch Supreme Court has referred the case back to another court of appeal to determine whether the depositary receipts provide a leveraged effect of more than 1 on 10. If the capital invested in the depositary receipts was less than 10% of the total capital invested in Topco, the depositary receipts would qualify as lucrative interest and the taxpayer could deduct the EUR 629,999 loss in his Dutch personal income tax return. If otherwise, the tax inspector rightly refused the deduction of that loss.