Tax liability for foreign substantial interest holders

In this blog, we look at the foreign substantial interest scheme. The substantial interest scheme has been laid down in art. 17 paragraph 3 sub b Corporate Income Taxation Act and art. 1 paragraph 7 Dividend Tax Act. This scheme has been further tightened in recent years. Here we will list the most important changes so that you will know what to look out for. Before addressing these, however, let us first briefly discuss the background to the foreign substantial interest scheme.

Background to the foreign substantial interest scheme

A substantial interest exists when a (legal) person owns 5% or more of a company’s shares. Even if a (legal) person holds at least 5% or more of the profit-sharing certificates, options or voting rights of a legal person, there is a substantial interest. Taxation must be paid on the income from such a substantial interest. In the past, taxation of that income could easily be avoided. In order to prevent the avoidance of tax on substantial interest when filing income taxation returns, the foreign substantial interest scheme was introduced into Dutch legislation. On the basis of this scheme, it must be assessed whether the foreign company, in its capacity as shareholder of a Dutch company, is actually avoiding Dutch taxation.

Foundation of the current foreign substantial interest scheme

Using two tests, the “avoidance test” and the “company test”, it is determined whether a foreign company is actually avoiding taxation. The avoidance test examines whether the foreign company holds the substantial interest in the Dutch company with the main objective (or one thereof) of avoiding taxation. If that is the case, the foreign company is designated as a foreign substantial interest holder and is liable to pay tax, unless the company test is satisfied. In the company test, whether the substantial interest can be allocated to the assets of a company is key. If the company test has been satisfied, the substantial interest scheme cannot yet be applied.

Stricter foreign substantial interest scheme

The foreign substantial interest scheme has been changed twice in recent times; in 2016 and 2018. The “Law implementing changes to the Parent-Subsidiary Directive” came into effect on January 1, 2016, whereby the company test was discontinued. However, it appears from the explanatory memorandum that the company test has been integrated into the avoidance test. Previously, taxation could still be avoided on the basis of an artificial construction. This is no longer possible subsequent to the tightening. In addition, as of January 2016, the direct shareholder must now comply with certain substance rules if a ‘switch’ takes place between a company at the top of the structure and a company at the bottom of the structure. Switching occurs if an intermediary, as it were, switches the company at the top with the company at the bottom.  An example of a substance rule is that half of the directors of the company must live in a certain country. If it appears that insufficient substance is present in the switching company, this is an artificial construction. As a result, the foreign substantial interest scheme proceeds, which means that more income tax must be paid.

With effect from January 1, 2018, the legal text of art. 17 paragraph 3 sub b of the Corporate Income Tax Act has been further tightened. This has clarified where there is an artificial construction. The tightened legal text shows that a construction or transaction can consist of several parts or steps and should be regarded as artificial insofar as they have not been designed for valid business reasons that reflect economic reality. The switching function of an intermediary is also regarded as a valid business reason. Furthermore, the legislator has added two substance requirements to the already existing substance requirements. Firstly, the wage cost sum of the company must, depending on the location, amount to a maximum of 100,000 euros and, secondly, that company must have acquired private office space.

Summary
 The foreign substantial interest scheme has been tightened in recent years. The purpose of this is to prevent substantial interest income tax from being avoided in Dutch income taxation. Where a company structure is used, it is important that the substance requirements are taken into account. If it appears that insufficient substance is present, the structure can be classified as artificial. As a result, the foreign substantial interest scheme is applicable, which means that more income tax must be paid.

Should you have any queries regarding this scheme, please do not hesitate to contact us.

More posts by Jimmy Cox