Recent developments regarding Foreign Subsidies Regulation, Pillar Two and redemption of interest rate swaps

I. Foreign Subsidies Regulation

1.         Introduction

As part of its new EU 2020 industrial strategy, the European Commission (EC) has introduced its latest instrument to ensure a level playing field in the internal market: the Foreign Subsidies Regulation (FSR). The EC’s new strategy aims to drive the European Union's competitiveness and its strategic autonomy at a time of moving geopolitical plates and increasing global competition.

The EC released the proposal for the FSR on 5 May 2021. Following the ordinary legislative procedure, the FSR became directly applicable across the European Union (EU) on 12 July 2023.

Although the FSR does not include any direct tax rules, it may impact the tax position of Dutch multinationals that are active in non-EU countries and multinationals from non-EU countries that wish to invest in the EU.

2.         Background

While State aid rules prevent EU Member States from granting subsidies, the EC had no instrument to address distortions caused by subsidies granted by non-EU countries. The FSR provides the EC the power to redress the distortive effects of foreign subsidies.

Foreign subsidy

A foreign subsidy in the context of FSR exists if (i) it confers a financial contribution, (ii) granted directly or indirectly by non-EU countries to undertakings economically active in the EU, (iii) that confers a benefit and (iv) that is limited to one or more undertakings or industries.

The requirement of specificity or selectivity is based on the same mechanism as the State aid rules. In addition, foreign subsidies must have a distortive effect on competition within the EU. A distortion is deemed to exist where a foreign subsidy is liable to improve the competitive position of an undertaking in the internal market and where it negatively affects competition in the internal market. A distortion is determined on the basis of indicators, such as the amount, nature, and purpose of the foreign subsidy. The EC may conduct a ‘balancing test’ to determine the negative effects caused by the foreign subsidy in the EU, while taking into account the positive effects of a subsidy on the relevant subsidised economic activity on the internal market. In this regard, the EC will also consider other broader positive effects of the foreign subsidy in relation to the relevant policy objectives, in particular those of the EU. Subsidies of less than €4 million (over three consecutive years) granted to an undertaking are unlikely to be regarded as distorting competition. It should be noted in this regard that ‘an undertaking’ could also mean a group.

Financial contribution

The scope of a financial contribution under the FSR is defined in a broad and inclusive manner. It does not only include subsidies but has a broad range of forms such as capital injections, grants, loans, loan guarantees, fiscal incentives, setting off of operating losses, compensation for financial burdens imposed by public authorities, debt forgiveness, debt to equity swaps or rescheduling.

The financial providers may be non-EU government authorities or public/private entities whose actions could be imputed to a non-EU government.

3.         Power of investigation by the EC

The FSR provides the EC with three tools: two ex ante notification-based tools and one ex officio power of investigation.

i.             Concentrations

Where the acquired company, one of the merging parties or the joint venture generates an EU turnover of at least €500 million and the transaction involves a foreign financial contribution of more than €50 million in the three years preceding the entry into the agreement, a notification obligation applies.

ii.            Bids in public procurements

The second ex ante notification-based tool concerns bids in public procurements involving a financial contribution by a non-EU country where the estimated contract value is at least €250 million and the bid involves financial contributions in the three years before the notification of at least €4 million per third country.

iii.           Ex officio

In addition to these two ex ante tools, the FSR provides for a general tool where the EC may investigate all other market situations on its own initiative (ex officio) or may request an ad-hoc notification for smaller concentrations and public procurement procedures. In this regard, the EC has a broad power of investigation and may conduct an investigation in each sector or economic activity, or on the use of each subsidy, to identify the distorting effects of foreign subsidies. Based on relevant information, the EC will then assess the degree of distortion. The impact of the FSR will therefore not be limited to mergers and acquisitions and public procurements.

4.            Commitments and remedies

While the review by the EC is pending, the closing cannot be completed and an investigated bidder cannot be awarded the contract until cleared by the EC. If, after an in-depth investigation, the EC takes the position that the foreign subsidy does not distort the internal market, it may issue a ‘no objection’ decision. The EC also issues a no-objection decision if the positive effects of the foreign subsidy outweigh a distortion in the internal market.

If the EC finds that an undertaking received a foreign subsidy that distorts the internal market, the EC may issue a so-called ‘commitment decision’. Such a commitment offered by the undertaking must completely and effectively eliminate the distortion in the internal market, such as repayment of the subsidy plus appropriate interest. If the undertaking concerned does not offer any commitments or the EC does not consider the commitments appropriate and sufficient to fully and effectively remedy the distortion, it adopts a decision prohibiting the concentration or the award of a procurement contract to the undertaking concerned (a ‘prohibition decision’).

In addition, the FSR gives the EC the right to impose fines and periodic penalty payments where a notification contains incorrect or misleading information or where no notification is made. If the undertakings concerned intentionally or negligently provide incorrect or misleading information in a notification, the EC may impose a fine of up to 1% of the total turnover in the preceding financial year. The fine may amount to 10% of turnover if the undertakings concerned intentionally or negligently fail to notify a concentration or the public procurement procedure in accordance with the rules of the FSR.

5.            Timing

Since 12 July 2023, the EC has had the power to investigate financial contributions granted by non-EU countries to undertakings active in the EU. If the EC finds that such financial contributions constitute distortive subsidies, it can impose measures to redress their distortive effects.

The notification obligations under the two ex ante tools will start to apply on 12 October 2023 (nine months after entry into force).

6.            Observations

As stated above, the FSR does not include any tax rules. However, the FSR may impact the tax position of the undertakings that receive any form of financial contribution. The scope of a financial contribution under the FSR is very broad. Even tax exemptions and tax reliefs – which are not considered a ‘subsidy’ – could be considered a financial contribution and fall within the scope of the FSR. Involvement of a financial contribution – which is only one of the elements of the term ‘foreign subsidy’ – suffices to give rise to a notification obligation. The FSR could therefore significantly impact undertakings that benefit from certain tax incentives or even regular tax regimes in non-EU countries. 

Although the FSR does not apply with retroactive effect, it does have a retroactive impact. When a concentration and public procurement procedures are reviewed, financial contributions granted in the three years before notification will be considered to assess whether there is a distortion in the internal market. In the case of ex officio investments, the EC even considers the last five years.

The FSR increases the administrative burden for non-EU undertakings seeking to invest in or otherwise enter the EU single market. In addition, EU undertakings operating in third countries to which foreign subsidies are granted may also fall within the scope of the FSR. Moreover, the FSR leads to increased scrutiny of mergers and acquisitions and public procurement processes.

The EC has stated that it will strictly enforce the obligations arising from the FSR. In order to achieve its objectives as effectively as possible, the EC is providing 145 full-time equivalents. It is therefore very important to assess whether the FSR affects your situation and to consider what further actions may be appropriate.

II. Pillar Two: recent developments

1.         The second set of Administrative Guidance

On 17 July 2023, the OECD/G20 Inclusive Framework (IF) published a second set of Administrative Guidance (following the first set of Administrative Guidance published in February 2023) in relation to Pillar Two. The second set of Administrative Guidance will be incorporated into a revised version of the Commentary on the Pillar Two rules, which is expected to be published later this year. Although the Administrative Guidance has not (or not yet) been incorporated into the Dutch legislative proposal for the Minimum Tax Rate Act 2024 (Wet minimumbelasting 2024), the Dutch legislature has stated that the Netherlands will take the current and future OECD Administrative Guidance into account in interpreting the Pillar Two rules.

This second set of Administrative Guidance includes guidance on (i) currency conversion rules; (ii) tax credits; (iii) the application of the Substance-based Income Exclusion (SBIE); (iv) the Qualifying Domestic Minimum Top-up Tax (QDMTT), and introduces (v) two additional safe harbours.

Introduction of safe harbours

The Administrative Guidance introduces two additional safe harbours: (i) the QDMTT Safe Harbour and (ii) the Transitional UTPR Safe Harbour.

(i) The QDMTT Safe Harbour

The QDMTT aims to ensure that a jurisdiction will be able to collect the top-up tax of low-taxed entities based in that jurisdiction. If the domestic rules of that jurisdiction qualify as a QDMTT, an ultimate parent entity (UPE) located in another jurisdiction is, in principle, obliged to give credit for the top-up tax collected under the QDMTT. The application of this credit mechanism does, however, require at least two separate top-up tax calculations in respect of the same jurisdiction: (i) the QDMTT calculation based on the domestic rules; and (ii) further calculations under Pillar Two. The Administrative Guidance provides for a practical solution by introducing the QDMTT Safe Harbour, based on which, under certain circumstances, the second calculation under Pillar Two no longer needs to be made. As a result, the top-up tax payable in other jurisdictions is deemed to be zero. The QDMTT Safe Harbour should mitigate compliance costs for taxpayers and administrative burdens for tax authorities. However, in order to qualify for the QDMTT Safe Harbour, a jurisdiction’s QDMTT must meet three standards in addition to the existing QDMTT rules and guidance: (i) the QDMTT Accounting Standard; (ii) the Consistency Standard; and (iii) the Administration Standard. 

(ii) The Transitional Undertaxed Profits Rule Safe Harbour (the ‘Transitional UTPR Safe Harbour’)

The UTPR acts as a backstop rule to collect any top-up tax that is not collected under the income inclusion rule or the QDMTT. Based on the Transitional UTPR Safe Harbour, the UTPR top-up tax calculated for the jurisdiction of the UPE of the MNE group is deemed to be zero if the UPE jurisdiction has a corporate income tax that applies at a rate of at least 20%. This Transitional UTPR Safe Harbour provides for a transitional relief in the UPE jurisdiction during the first two years in which the Pillar Two rules come into effect. The Transitional UTPR Safe Harbour applies only to the tax years that run no longer than twelve months beginning on or before 31 December 2025 and ending before 31 December 2026.

Additional guidance on the QDMTT

The first set of Administrative Guidance (dated February 2023) already provided guidance on the design and operation of the QDMTT. The second set of Administrative Guidance includes guidance on the application of the QDMTT in relation to joint ventures, flow-through entities and investment entities. In addition, additional guidance is provided on, among other things, the blending of income and taxes on a jurisdictional basis in respect of the QDMTT.

The application of the SBIE

The second set of Administrative Guidance includes guidance on the application of the SBIE (and therefore the allocation of employees and tangible assets) if those employees or assets are used outside the jurisdiction of the constituent entity that employs the employee or owns the tangible asset.

Tax credits

The Administrative Guidance includes additional guidance on the treatment of tax credits, such as in respect of refundable/non-refundable tax credits, marketable/non-marketable transferable tax credits, and other tax credits. The treatment of tax credits is relevant to the calculation of the effective tax rate (ETR) of a jurisdiction, as tax credits reduce the ETR. The ETR of an MNE group under Pillar Two rules is determined by dividing the amount of covered taxes (e.g. Dutch corporate income taxes) by the amount of net qualifying income as determined under the Pillar Two rules. Tax credits may be treated as qualifying income or as a reduction to covered taxes and will therefore reduce the ETR irrespective of their qualification. If they are treated as a reduction to covered taxes, however, the reduction will in principle be smaller.

Currency conversion rules when performing Pillar Two calculations

Neither the Pillar Two rules nor the OECD commentary provides guidance on how the Pillar Two calculations should be made if – based on the accounting standard used – the amounts required to make such calculation are not in the relevant currency for purposes of the Pillar Two calculations. To ensure that the Pillar Two rules are applied in a consistent matter in the situation in which currency translations are required, the OECD has provided further guidance on how to apply the Pillar Two rules in such situations.

Observations

The second set of Administrative Guidance brings some clarity on certain matters. However, a great number of issues remain unclear. As stated above, the Netherlands will take into account current and future OECD Administrative Guidance in interpreting the Pillar Two rules.

However, the question remains whether other countries will incorporate the latest guidance into their local Pillar Two implementation.

2.         The standardised form of the GloBE Information Return

In addition to the second set of Administrative Guidance, the OECD recently published the standardised top-up tax information return. The Pillar Two rules create a number of procedural obligations on the basis of which it is ensured that the correct amount of top-up tax will be levied. One of these procedural obligations is the obligation to prepare an information return that must contain the information that the tax authorities need to evaluate the correctness of the top-up tax liability of a constituent entity under the Pillar Two rules. The standardised information return provides an overview of the information that should be included in the information return. In short, the standardised information return is divided into a general section, which includes the information regarding the MNE group (or domestic group) as a whole, and a jurisdictional section, which includes the relevant information for every jurisdiction in which the MNE group is operating.

We refer to our previous Tax Alerts of 24 December 2021, 31 October 2022, 21 December 2022, 16 January 2023 and 8 June 2023 for more background on Pillar Two.

III. Tax treatment of the redemption of interest rate swaps

In our Tax Alert of 11 March 2022, we discussed that the Dutch Supreme Court had answered preliminary questions posed by the District Court of Noord-Nederland regarding the tax treatment of the redemption of interest rate swaps. In short, a taxpayer had concluded various interest rate swaps that had become negative because of falling interest rates. As a result of the strain on its liquidity position, the taxpayer terminated the interest rate swaps and replaced the variable interest loans by fixed-interest loans. The taxpayer wanted to deduct the amounts paid on the redemption of the swap (i.e. surrender charges) from its taxable profit at once, in one lump sum. The tax inspector, on the other hand, was of the opinion that the surrender charges should be capitalised and amortised based on the Dutch sound business principles. The Dutch Supreme Court stated that, in principle, such surrender charge can be recognized at once, but this may work out differently if the new (fixed-interest) loan can be considered to replace the variable interest loan in combination with the interest rate swap. In the case at hand, however, the characteristics of the combination of the interest rate swap and the variable interest loan differed from those of the fixed-interest loan, as a result of which the Supreme Court subscribed to the taxpayer’s position and stated that the surrender charges could be recognized at once in the year of surrender.

On 11 July 2023, a knowledge group of the Dutch Tax Administration (DTA) issued a statement on the tax treatment of interest swaps. The case at hand involved a taxpayer that had entered into contracts with Bank X to hedge risks on existing and future variable interest loans from Bank Y and Bank Z. When the interest rate swaps were entered into, they contained mutual break clauses. Under a mutual break clause, both parties have an option right on agreed dates to terminate the interest rate swaps prematurely, against settlement of the market value at that time. It was undisputed that, despite the existence of the mutual break clauses, there was such a correlation between the variable interest loans and the interest rate swaps that the fixed risk on the money loans as at the balance sheet date was highly mitigated. Following Dutch case law, the taxable result on the variable interest loan and the interest rate swap (collectively also referred to as swap combinations) should then be determined jointly as a result of such correlation.

Several years after the contracts were entered into, the mutual break clauses were replaced by mandatory break clauses. As a result of the mandatory break clauses, the maturity of the interest rate swap was shortened. The question was whether the variable loan was still sufficiently correlated to the interest rate swap after this replacement. In its statement, the knowledge group of the DTA stated that there was still sufficient correlation between the variable interest loan and the interest swap, despite the reduction in the maturity of the interest rate swap. This is because a difference in maturities does not affect the assessment of correlation (i.e. what matters is that the variable rate to be received in the future does not change). 

In 2018, the taxpayer proceeded to refinance the swap combination. As part of that refinancing, Bank Y and Bank Z took over the taxpayer’s interest rate swaps and provided new fixed-interest loans with equal notional amounts and maturity dates as the interest rate swaps. The previous money loans were repaid by the taxpayer. To compensate for the assumption of the negative values of the interest rate swaps, the taxpayer paid a higher-than-market interest rate with (risk) mark-ups on the new loans during the term. The question was whether the taxpayer could recognize the negative results arising out of the redemption of the interest swap at once. The knowledge group of the DTA stated (with reference to the answers of the Dutch Supreme Court referred to above) that the fixed interest loan could not be deemed to replace the swap combination. This is because the risk arising from the mandatory break clause that the taxpayer will have to pay disappeared as a result of the unwinding of the swap combination and the conclusion of the new fixed-rate money loan. Consequently, the negative results could be recognized at once. The fact that negative results are discounted in an interest rate does not change this conclusion.

The statement by the knowledge group of the DTA seems to align well with the above-mentioned answers of the Dutch Supreme Court.