HOLLAND will have to allow some Dutch companies additional tax deductions, the European Court of Justice said in September.

The case is important to Dutch companies with subsidiaries elsewhere in Europe. It applies potentially to all open tax years of Dutch companies. The Dutch government is moving to limit the damage.

Bosal Holding, N.V. is a Dutch manufacturer of car fuel exhaust systems. The company has subsidiaries with operations in other member countries in the European Union. It tried to deduct its costs of acquiring and financing these subsidiaries against its tax base in Holland. Holland has a “participation exemption” that exempts Dutch parent companies from having to pay tax in Holland on earnings distributed to them by subsidiaries in other countries. Certain requirements have to be met to qualify for this exemption. The exemption also applies to capital gains from the sale of shares in a qualifying subsidiary. Since the income from the subsidiary is not taxed in Holland, Holland does not allow the parent company’s costs tied to the subsidiary to be deducted. However, Holland denies the parent company a deduction only for costs tied to subsidiaries with no operations in Holland. A parent can deduct costs tied to a subsidiary — foreign or domestic — with operations in Holland.

The European Court of Justice ruled in September that this feature of the Dutch tax system is discriminatory, because costs incurred by Dutch taxpayers in connection with subsidiaries with Dutch activities are deductible while costs incurred for subsidiaries with activities solely in other countries in the European Community are not. This makes the establishment of activities outside The Netherlands relatively unfavorable, which is an infringement of the freedom of establishment, one of the fundamental freedoms provided for in the EC treaty.

“The judgment of the Court of Justice means that costs incurred by Dutch taxpayers in connection with subsidiaries with activities in other EC member states are deductible for Dutch corporate income tax purposes,” according to Waldo Kapoen, a tax partner with Loyens & Loeff in Amsterdam. The decision applies to deductions in all open tax years. The judgment is not clear about whether costs attributable to a subsidiary with activities in a country outside the EC should also be allowed as a deduction. For subsidiaries in countries that form part of the European Economic Area (Lichtenstein, Norway and Iceland), the costs will probably be deductible, Kapoen said.

The Dutch government announced the day after the court ruling that it would propose legislation to deal with the consequences. The Ministry of Finance said in a press release that expenses tied to domestic and foreign participations will be deductible, but that two measures will be introduced to avoid erosion of the Dutch corporate tax base. One measure will limit excess intercompany loan financing by placing a limit on the debt-to-equity ratio that will be allowed. The other measure will limit the ability of Dutch holding companies to use losses in one year to shelter income from a different activity in another year. The new measures are expected to take effect on January 1, 2004.

Keith Martin