General memorandum on using hybrid loans as alternative for participation exemption

1. Introduction

This article looks at an alternative way for using the Netherlands as a holding jurisdiction. Traditionally, the participation exemption is relied on in order to prevent double taxation of corporate income taxes between parents and subsidiaries; in this article, I shall look at using the Dutch hybrid loan legislation for achieving the same result. It must be noted upfront that this solution will not work for everyone, however, where it does, it will provide a lot more flexibility than the participation exemption itself does.
NB!! When looking at this memorandum, one needs to bear in mind the Dutch thin capitalisation rules which became effective 1 January 2004. See our separate memorandum on the subject.

2. Requirements of a good holding jurisdiction

When looking for a good holding jurisdiction anywhere, there are a number of factors to consider. These include the following:

  1. The capital duty must be as low as possible.
  2. Income and gains from subsidiaries must not be subject to an income or a gains tax at the level of the holding company. This relief should be provided in the form of a tax exemption of income from subsidiaries rather than a tax credit for the income tax paid by the subsidiaries (also referred to as an indirect tax credit): in case of an indirect tax credit, additional tax could be levied at the holding company level in case of low taxed income from subsidiaries. The tax exemption (also referred to as a "participation exemption") should be applicable to dividends received, capital-gains realised and other income received from the subsidiaries. Finally, the threshold for a participation qualifying for a participation exemption should be as low as possible. (Here it is important to bear in mind that relief at the holding company level is not a government favour, it is the governments' enactment of the generally accepted principle that corporate profits should not be taxed twice with corporate income tax. It is also a logical consequence of the fact that the governments of the world have decided that interest payments are deductible and dividend distributions are not.)

    The following are examples of conditions that typically have to be satisfied in order for a participation to qualify for a participation exemption (or for that matter, an indirect tax credit):
    1. a minimum required participation in the subsidiary, e.g. 5% of the voting power or issued shares, or a minimum invested amount of x million Euro's;
    2. a minimum period during which the participation must be held in order for the participation exemption to apply either to income received or to gains realised. This requirement can apply to the overall participation held in a company or can apply on a share by share basis (i.e. each individual share must be held for a minimum of x years/months);
    3. an activities-test, requiring the subsidiary to run an active business enterprise. Here certain activities, such as the leasing of real estate or the performance of insurance or financing activities may not qualify as being active, or may only qualify if additional conditions are satisfied;
    4. a subject-to-tax-test, requiring that the subsidiary must be subject to an income tax. It may also be required that the tax is at least x% of the tax that would have been levied in the holding jurisdiction, if the subsidiary was subject to tax in the holding jurisdiction;
    5. CFC legislation, which usually consists of a combination of an activities-test and a subject-to-tax-test as described here above. The legislation would typically also include de minimis exemptions and black, gray or white lists for certain activities, tax regimes or tax jurisdictions.
  3. Capital losses and costs made in connection with the participations should be deductible.
  4. Dividend withholding tax on the distribution of income received from, and gains realised on, the participations should be nil or as low as possible.
  5. There should be no interest withholding tax.
  6. There should be no net wealth tax on the holding company, or if there is, participations should be exempt from it.
  7. The holding jurisdiction should have an extensive tax treaty network, reducing or eliminating taxation at the source on dividends received from and capital gains realised on participations.

    8. There are also other soft factors that one should bear in mind. These are:

  8. The holding jurisdiction should be politically and financially stable; it should also have a legislative stability, meaning that rules should not be changed continuously, unless it is to relieve perceived instances of overkill. Any legislation introduced to combat deemed abusive structures, should be introduced without retro-active effect and, where reasonable, provide grandfathering rules allowing for reasonable restructuring periods. Much more remains to be said about this topic, but not in this article.
  9. There must be the possibility to gain certainty in advance about the tax consequences of a structure through tax rulings which can be acquired in a reasonable amount of time with a reasonable amount of effort.
  10. Requests for information about the group, the ultimate beneficiaries, the structure and the tax treatment thereof in foreign jurisdictions should be both reasonable and relevant and should not resemble "fishing expeditions" into unknown territory. The same applies for any for any cross border exchanges of information.

All the above factors should have a reasonable predictability for a period of at least 5 years.

3. The Dutch participation exemption

When measuring the current Dutch participation regime against the above list, the following applies:

  1. 0.55 Percent capital duty is due on equity contributions to a Dutch holding company, unless a specific exemption applies, such as the exemptions for share mergers, asset mergers, internal reorganisations or the contribution all the assets and liabilities of an entity to a Dutch company.
  2. The Netherlands has a participation exemption under which dividends, capital gains and other income from (Dutch and foreign) participations are exempt from corporate income tax. The conditions for the participation exemption include the following.
    1. In general, the minimum required participation is 5 percent of the par value of the issued and outstanding shares of the subsidiary. When dealing with foreign subsidiaries outside the EU, a participation of as much as 50 percent may effectively be required in order to demonstrate that the participation is not held as a portfolio investment only. See letter c, hereafter for more details.
    2. In theory there is no minimum required holding period. However, a participation may not be held as inventory. Based on case law and the parliamentary history of this condition, the condition only applies to passive companies of which it is clear that the intention has never been to hold the participation as an investment. Holding shares in a passive company for a short period of time only, could indicate that the shares were held as inventory.
    3. Participations in subsidiaries resident outside the Netherlands only qualify for the participation exemption if the shares are not held as a portfolio investment only. The shares are deemed to be held as a portfolio investment, among others, if the subsidiary is a passive company. An exemption from this condition applies for companies resident in Europe and qualifying for the benefits of the so-called EC Parent/Subsidiary Directive (nr. 90/435/EEC), provided that less than 70 percent of the assets of those European subsidiaries consist of passive branches (as defined by Dutch law) or participations in subsidiaries resident outside the EU which would not have qualified for the Dutch participation exemption. One of the conditions for these subsidiaries to qualify for the benefits of the Parent/Subsidiary Directive is that the Dutch holding must have an interest of at least 25 percent in the subsidiary.
      It is important to note that the portfolio investment test does not only apply to passive companies. It could also apply to investments in an active company if there is no relation between the activities of that company and the activities of the group to which the Dutch holding company belongs. In practice, the portfolio investment condition is the condition usually causing the most uncertainty with regard to the application of the Dutch participation exemption.
    4. Foreign participations must be subject to an income tax. However, the Netherlands does not require a certain minimum of tax to be levied, i.e. a very low income tax is sufficient as well.
    5. When using the traditional narrow definition of CFC legislation (i.e. that it concerns laws leading to the current taxation at the level of the shareholder of undistributed income of the subsidiaries), the Netherlands only has limited CFC legislation. According to this a participation must annually be marked to market, if it represents an interest of at least 25 percent in a company resident outside the Netherlands of which at least 90 percent of the assets consist of investments or passive financing activities.
      However, if CFC legislation is seen in a broader context (i.e. that it concerns a limitation of relief from double taxation for certain controlled foreign subsidiaries), then all the conditions to the participation exemption become relevant. The reason is that it is an all-or-nothing situation: either the participation exemption applies and no extra tax is levied in the Netherlands, or the participation exemption does not apply and the full income from the subsidiary is subject to double taxation. In the latter case no credit is granted for the underlying income tax paid by the subsidiary or its subsidiaries, regardless of the height of that underlying income tax.
  3. Capital losses are generally not deductible under the participation exemption. An exception exists for losses realised upon the liquidation of a subsidiary. In that case the difference between the amended basis of the participation and the liquidation proceeds may be deductible. The amended basis consists, among others, of the historic price paid for the participation, less certain dividend distributions received from that subsidiary in the past. Various conditions apply.

    Costs made in connection with a participation generating Dutch taxable income are deductible, but costs made in connection with other participations not. This rule is about to be changed, pending the outcome of a case (C-168/01 Bosal Holding BV vs Dutch State Secretary of Finance) before the European Court of Justice in which the limitation on the cost deductions for EU participations has been said to be contravening EU law. It is not yet known how the rule will be changed.
  4. Dutch dividend withholding tax is due upon the distribution of profits by the Dutch holding company. The rate under national law is 25 percent of the gross dividends. Under tax treaties this rate is usually reduced to 15 per cent for portfolio shares and 5 percent for participations.
  5. Except for interest payments on certain hybrid loans, as described hereafter, the Netherlands generally does not levy a withholding tax on outgoing interest payments.
  6. The Netherlands does not levy a net wealth tax from companies.
  7. The Netherlands does have an extensive network of tax treaties, generally eliminating or reducing dividend tax at the source to 5 or 10 percent and eliminating capital gains tax at the source on qualifying participations.
  8. The participation exemption regime has proven to be anything but stable during the past number of years. A substantial overhaul of the regime took place in 1990. Further changes were introduced, among others, in 1997, 2001 and 2002. Changes are also expected in 2003 (see paragraph 4 here above).
  9. A new ruling policy has been introduced in the Netherlands as of 1st April 2001. The introduction of this new policy has been painful. Initially, it literally took years to acquire certain rulings. However, rulings have been issued lately and it is hoped that the process will be less painful going forward. Nonetheless, at the time of writing this article, easily obtaining a ruling confirming the application of the participation exemption, is not a Dutch selling point. Part of the "problem" with requesting participation exemption rulings is that taxpayers are required to disclose the whole group structure (even if only a small part of it has anything to do with the Netherlands). On top of that taxpayers have to sign away upfront certain rights of objection against cross border exchanges of information.

4. The Dutch hybrid loan legislation

As of 1 January 2002 there is a new regime in the Netherlands for profit sharing loans. This regime distinguishes between different categories of loans.

4.1 Caveats concerning the use of hybrid loans

See our detailed memorandum for further details.

The conclusion, when looking at these caveats, is to rely on the 10 year maximum for profit sharing loans, rather than the fifty year period for profit dependent loans, where possible.

5. Using hybrid loans as an alternative to the participation exemption

5.1 Proposed structure

Subscribers can see our detailed memorandumfor further details. The following is a summary of the headings of issues dealt with in our detailed memorandum.

5.2 Income and gains from YCo

5.3 Costs and losses from YCo

5.3.1 Participation exemption applicable

5.3.2 Participation exemption not applicable

5.3.3 ABV can not fully redeem the YCo loan

6. Factors to bear in mind

6.1 Dutch CFC legislation

6.2 Ten year lifespan

6.3 Limitation on interest deductions for participations failing the subject-to-tax-text

6.4 Having an economic interest in YCo

6.5 Legal stability

7. Interest received by the hybrid loan creditor

7.1 Substantial shareholders

8. Conclusion

The conclusion when looking at the profit sharing loan legislation as an alternative for or extension of the participation exemption has to be that one can now have in the Netherlands a holding company where no capital duty is due, no dividend withholding tax is due, there are no subject-to-tax-tests, minimum interest tests, minimum holding period tests, activity tests or portfolio exemption tests applicable (the table below shows the comparison). All one has to do is to make sure or that the participation is sold and the loan redeemed within 10 years. But in tax land, 10 years is an eternity.

CriteriumParticipation ExemptionHybrid loans (no participation exemption)
See our detailed memorandum for further details.

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Last reviewed 18 July 2003