Rami Karimeri
After some rather lengthy deliberation, the European Court of Justice, in its recent decision C-585/22 X BV, has clarified its approach to when a financing transaction can be considered artificial, leading to the non-deductibility of interest expenses. The significance of the new case relates to what the Court had stated earlier in case C-484/19 Lexel:
“It must be held that the exception may include within its scope transactions which are carried out at arm’s length and which, consequently, are not purely artificial or fictitious arrangements created with a view to escaping the tax normally due on the profits generated by activities carried out on national territory (para. 56)”.
This, in rather plain terms – as also the advocate general in the new case noted – seems to say that loans provided at arm’s length terms, by definition, cannot be considered artificial and therefore cannot constitute tax avoidance. However, the advocate general was also of the view that the Court ought to refine this view, which it did, albeit by clarifying it had not held the above view to begin with. Let us first look at the details of the fresh case.
The case X BV concerned a fairly simple scenario where a Dutch group company had acquired shares from an external party. It financed this acquisition with a loan from a Belgian group company. The Belgian group company, in turn, acquired the lent funds as an equity contribution from its Belgian parent, which is also the parent of the Dutch company. The Belgian lender was subject to a special tax regime. In such circumstances, the Dutch rules only permitted the deduction of interest, provided business reasons for the loan were predominant.
The EU Court was forced to revisit Lexel, as the Dutch referring court explicitly asked (paraphrasing here) whether the Court indeed was of the strong view that loans issued at arm’s length terms could not be considered artificial. The referring court also asked whether it would make a difference if the financing was spent on acquiring shares in another group company rather than in an external transaction – basically whether it matters if the share transaction is an internal reorganization or an acquisition from a third party. This seems like an interesting angle from a Finnish point of view, as that was basically the dividing line established in cases decided by the Finnish Supreme Administrative Court in 2021, right after Lexel had come out (KHO 2021:178, KHO 2021:179). The SAC applied the domestic general anti-avoidance rules to an internal reorganization on the basis that the share transfers had an artificial nature, and consequently, the related loan expenses should not be deductible. On the other hand, the SAC accepted the deductibility of interest on the acquisition loan where the shares were acquired from a third party.
The EU Court’s reply in the recent case can perhaps be summarized in three points:
- When, in Lexel, the Court said that loans reflecting arm’s length terms cannot be artificial, it did not mean this at all. Instead, it meant that loans issued at arm’s length can also be artificial (para. 84), to be judged based on the “economic sense of the loan at issue and the related legal transactions” (para. 75). This is obviously problematic, and it seems at least a bit surprising that the Court did not borrow terminology and ideas more closely, for example, from transfer pricing guidelines, where similar considerations have been mulled over quite thoroughly. The Court’s way of thinking still veers in that direction, as it called for “verifying the economic validity…by ensuring that such transactions could have been concluded between the companies party to the contract in the absence of a special relationship” (para. 75).
- If a loan is found to be artificial, it is possible to deny the deduction of all interest (para. 88). This reply was given, at least in part, to also clarify previous statements made by the EU Court, where it had held that adjustment should only be made to the arm’s length level of interest. This makes sense to me, at least on an abstract level. The thinking here is that we cannot adjust the terms, as the whole loan is qualitatively tainted – we are no longer talking about 50 shades of grey, but only pitch black.
- When the artificiality of the financing is assessed, it does not matter as such if the loan relates to an external acquisition or an intra-group reorganization.
This last point, in my view, is the most interesting, especially in the Finnish context. Recall that the case in front of the EU Court concerned an external acquisition. In the judgment, the Court therefore “officially” only touched on that circumstance and noted that EU law does not stand in the way of denying the deduction of interest “where that debt is considered to constitute a wholly artificial arrangement or is part of such an arrangement” (para. 93). The pressing question is what the Court means by the debt being part of “an arrangement”. Does it refer solely to how the financing was organized or also to how the money was spent?
Based on the judgment expressly, as well as some other justifications recounted by the Court (for example, paras. 54, 60 & 61), it seems to me that the Court was only deciding its view on the financing. After all, the financing was used for an external share deal. At least in normal circumstances, it would be rather difficult to claim that obtaining shares from third parties is artificial, nor was that the case here.
Indeed, the Dutch rules were particularly geared to deny the deduction of interest where funds existing within the group were, through some artifice, turned into loans where the interest income is subject to low taxation, but the deduction has full effect in the Netherlands. It was the financing, which was at issue, rather than the nature of the share deal.
This is where the decision departs from the justifications provided by the Finnish SAC in its decisions of 2021. It specifically linked the artificiality to the share deal rather than the financing. In the case where the deduction was denied (the intra-group transaction), the SAC stated roughly the following: “When assessing the share disposals as a whole, their purpose had been to obtain a tax benefit in the form of interest deductions. The share disposals had consequently not been in line with the actual nature or purpose of the matter, and they were artificial in nature.”
Perhaps precisely because the artificiality was linked to the share deals rather than the financing, the SAC had to draw at least a fuzzy border between external deals and intra-group organizations. After all, as noted above, it seems difficult to view external deals as artificial. The legal debate in the external acquisition case was diverted to whether the use of an SPV as the acquisition vehicle was artificial or not. However, even in that case, the acquisition loan provided to the SPV was from a related party, which in fact brings that case closer to the fresh case considered by the EU Court. However, the Finnish rules are different, as they do not link the deductibility of interest to share deals in particular, like the Dutch rules do. Perhaps therefore, the SAC did not seem concerned with the nature of the financing, or at least did not touch on this explicitly.
So, what can we make of this from a Finnish perspective? It seems quite clear that we cannot claim that loans which are at arm’s length cannot by definition be artificial based on what the EU Court stated in Lexel alone. Rather, in light of the decision in X BV, we should also stop to verify that the financing transaction(s) could have been concluded between third parties – that they have economic validity.
Yet, because such a test is arguably already included in the application of the arm’s length principle, it seems that the import of the decision resides merely in the recognition that jurisdictions are permitted to look at financing arrangements as a whole within the group. This is instead of focusing solely on the terms agreed between the immediate parties to the loan agreement. If such intra-group arrangements are devoid of economic reality, and lead to tax benefits contrary to the purpose of the rules, EU law will not stand in the way of protecting the domestic tax base.
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