Netherlands: Scope Of Netherlands Tax Legislation For Classifying Hybrid Loans Still Unclear

The Netherlands government recently published a tax bill that includes, inter alia, a provision for classifying certain profit sharing loans as equity. If enacted, the bill will become effective 1 January 2002.

The Netherlands government had previously already proposed some legislation for re-characterizing certain loans into equity (in November last year). However, this legislation included a large amount of ‘overkill’ and triggered a furious response from the Netherlands banks. They feared that the new legislation would adversely affect all kinds of financing structures and securitization transactions. As a result of a huge lobbying effort by the banks, the government was forced to repeal the new rules a couple of weeks after they had been proposed.

The modified rules that now have been proposed, are specifically designed "not to interfere with banking products and financing structures that are not tax-driven", according to the Explanatory Notes. However, a recent statement issued by the Netherlands State Secretary of Finance creates much uncertainty as to the scope of the new rules. As a result, securitization transactions and regular financial instruments could still become affected.

Netherlands tax law does currently not include any provision stipulating under what circumstances a loan can be requalified as equity. However, over the years some guidelines have been developed in jurisprudence. According to this case law, the legal form of a financial instrument is decisive when classifying a loan made by a creditor as either debt or equity. This general rule does not apply, however, if the terms of a loan are such that the holder thereof "participates to a certain extent in the issuer’s equity". According to case law by the Netherlands Supreme Court, this situation only occurs if all the following requirements are met:

The Supreme Court has also accepted other exceptions to the general rule: if the parties in fact intended to provide equity capital instead of debt (sham transaction), or if a shareholder extends a loan under such circumstances that it is apparent to the holder that the loan will not be fully repaid (loss financing).

The obvious results of such re-characterization are that payments made by the debtor are not tax deductible, and that they are subject to Netherlands dividend withholding tax.

According to the proposed legislation, a loan can be re-characterized as equity in one of the following situations:

1. (i) The amount of the interest on the loan is fully or partially contingent upon the profits or the profit distributions of the company, and (ii) the period until the maturity date of the loan exceeds 10 years; or
2. (i) Not the amount, but the obligation to pay interest is contingent upon the profits or the profit distributions of the company, (ii) the loan is subordinated, and (iii) either the loan has no fixed maturity date or the period until the maturity date exceeds 50 years.

As a consequence, a senior note with a term of 11 years which carries an interest rate that is partially contingent on the profits of the debtor may become subject to reclassification as equity under the new rules.

The Explanatory Notes to the bill did not elaborate on the precise scope of the new rules. Many questions were therefore left unanswered. For example, how should the term "maturity date" be interpreted? Do the new rules also apply to convertible bonds or deep-discount bonds? Under what circumstances can interest payments be considered to be "contingent upon the profits" of the debtor? What exactly does "subordinated" mean (i.e., subordinated to whom)?

The Netherlands State Secretary of Finance has very recently responded to some of these questions. With respect to the interpretation of the term "subordinated" as used in situation B, he indicates that subordination to one or more ordinary creditors is already sufficient to trigger a requalification (provided, of course, that the other requirements of situation B are met).

More importantly, the State Secretary of Finance has now also provided some guidance on the interpretation of the concept of "profit contingency". According to the State Secretary, interest is also contingent on the profits of the debtor if the interest is linked to the appreciation or depreciation in value of one or more of its assets. He specifically gives the example of a real estate company which is funded with a loan. The interest due on this loan is linked to the value of a particular building of the company, so that no interest is due if the building depreciates in value. The State Secretary is of the opinion that such mechanism will result in "profit contingent interest payments". He justifies his opinion by arguing that any value changes of the building touch the company’s profit- and loss account, so that the interest due on the loan is "indirectly" related to the company’s profits.

This statement by the State Secretary of Finance could drastically expand the scope of the proposed legislation. Under his reasoning, numerous types of financial instruments and transactions could run the risk of being recharacterized into equity. For example, the interest on bonds issued by an SPV in a repackaging transaction could be deemed to be contingent on the proceeds from the underlying assets of the SPV. Also certain derivative instruments could be affected, such as long-term credit linked notes and swaps.

The State Secretary’s remarks are potentially so far-reaching that the question arises whether they have somehow been misconstrued. Perhaps he was focusing on a case in which a company only has one single asset and issues a note whose return is linked to this particular asset. Since the substance over form doctrine is also recognized in Netherlands tax law, it could perhaps be argued that under these circumstances the interest on the note should be deemed to be contingent on the company’s profits. However, the problem is that it cannot be deduced from the State Secretary’s comments whether he really intended to limit his remarks to these types of situations.

What if the State Secretary decides to adhere to his broad interpretation of the concept of profit contingency? It then still remains to be seen whether his views will ultimately hold before a Netherlands tax court, as interpretative statements issued by the Ministry of Finance are not binding upon the courts. First of all, the literal wording of the proposed legislation does not seem to provide sufficient basis for the State Secretary’s viewpoint in the first place. Moreover, it is settled case law in the Netherlands that interest payments which are merely related to a certain asset of the debtor or to a certain item of its gross revenue do not constitute "profit contingent interest payments". A deviation from this long standing jurisprudence can only be justified by a very explicit statutory provision instead of some vague remarks uttered by the State Secretary of Finance.