Uncertain Times For Investors In The Netherlands

Entity Classification

The legislative proposals concern entity classification rules and were originally intended to take effect on 1 January 2022. The effective date has now been postponed but the proposals are likely to take effect in the foreseeable future.

The proposals are intended to update the rules for determining when an entity is tax transparent or not. If an entity is tax transparent, then its profits and losses are taxable directly in the hands of the participant. If it is not transparent, it is treated as a company and taxed itself.

Currently, the Netherlands has unusual rules for determining whether a limited partnership (in Dutch commanditaire vennootschap) is treated as tax transparent or not. It is considered transparent if a partner can only be substituted or join the partnership if all the existing partners, both managing and limited partners, give their consent. This is also used to determine the character of foreign partnerships. Since a provision requiring such consent is uncommon in limited partnerships outside the Netherlands, it means that a foreign limited partnership will almost always be treated as a corporate entity, even if there are certain restrictions on the transfer of a partnership interest, because it either does not require unanimity or the restriction takes some other form.

Even though there is only one type of limited partnership for commercial law purposes, for tax purposes there are effectively two types of limited partnership: the so-called closed limited partnership, which is completely tax transparent and the open limited partnership, which is treated as a company. Even then, the matter is somewhat more complex because on the basis of case law a general partner’s interest in the partnership is still considered to be transparent and only the limited partner’s interest in the partnership is treated as shares in a company. Profit distributions to limited partners in an open limited partnership are treated as dividends and are therefore also subject to dividend tax.

As a result, two entities with the same legal form can be treated differently for tax purposes, depending on whether they include the unanimous consent rule and by changing the partnership agreement, they can switch from one to the other easily.

Under the new proposals, all limited partnerships would automatically become transparent for tax purposes.

This can have significant effects for existing entities, since on the date the new legislation takes effect a partnership which is treated as non-transparent will be deemed to have effectively distributed all of its assets to its partners at market value. This would have significant tax consequences since in addition to corporate income tax on a realisation of the various assets, including unrealised gains, there could be dividend tax on a deemed dividend to the shareholders. The standard rate of Dutch dividend tax is 15 per cent.

Thereafter, the partners would be deemed to own the assets in the partnership directly. This could also in some cases have a significant tax effect including the question as to which tax treaty may be applicable on payments to and from the partnership.

Several arrangements for mitigating the effects of this change are proposed:

• A rollover arrangement where the assets are transferred to a legal entity which is also subject to corporate income tax. This would not apply where the partners are individuals, although they could set up a separate company to enable this to occur.

• The partners could, if they are individuals, transfer their interest in the limited partnership to a company in the European Economic Area (EEA) in exchange for shares. This can be decided separately by each partner.

• If the tax is actually payable, then the tax can be spread over ten years without interest.

The rules would also apply to a mutual investment fund (fonds voor gemene rekening) which has similar rules for determining whether or not it is tax transparent, so that in general such a fund would also cease to be treated as a corporate entity. Such funds are often used for investment purposes by Dutch residents.

There is an exception if the fund is traded on a regulated stock exchange or if the holding is subject to a repurchase obligation which is habitually exercised: then it will still be treated as a corporate entity.

Foreign entities could also be affected by the new proposals. If an entity is not comparable to a Dutch legal entity, the tax treatment in the country of incorporation of the foreign entity would normally be followed. However, if such a foreign entity is resident in the Netherlands, it would always be treated as a legal entity. Entities which are comparable to Dutch entities would be treated in the same way as the Dutch equivalent. The question as to whether an entity is comparable is likely to result in frequent discussion with the authorities.

Taxation Of Unearned Income

The case law concerns the Dutch taxation of investment income for individuals, so-called Box 3.

The Netherlands has an unusual way of taxing unearned income. Holdings of securities, real estate and most other passive assets are taxed in a separate category of income called Box 3 on the basis of a notional return on the value of the net assets (assets less liabilities) on 1 January of the year concerned. This is taxed at a fixed rate, currently 31 per cent. The tax, which is effectively a form of wealth tax but treated as an income tax, is intended to cover regular income such as interest, dividends and rents but also capital gains on a sale of the assets. The actual income itself is not taxed. The benefit of this system is that it is stable so that the taxpayer knows roughly what he or she must pay and the government knows roughly what income it can expect.

However, while the system is simple and indeed was quite popular in its early years when returns were higher, there have been a number of legal challenges in recent years when interest rates dropped significantly. As a result, the calculation of the tax has become more complex. Originally all assets were deemed to yield a fixed return of 4 per cent and this was considered to be a reasonable return for a relatively risk-free investment.

In recent years, to try to take account of the fact that bank savings accounts generally yielded much less than investments, the deemed return was amended and an arrangement was introduced with a notional mix of bank accounts with a low return and other investments with a higher return, whereby individuals with a lower level of assets were considered to have mostly bank accounts and those with more net assets were deemed to be skewed towards other investments and thus the higher return. Individuals with net assets in excess of EUR 1,000,000 were considered to have no bank savings accounts. This resulted in different levels of effective tax ranging from around 0.56 per cent to 1.71 per cent. This effective tax applies regardless of the actual income realised.

A recent Supreme Court case in December 2021[i] considered whether this contravened the right to peaceful enjoyment of one’s property provided for in the Protocol to the European Convention on Human Rights and whether it contravened the prohibition on discrimination in article 14 of that treaty. In the case in point a couple had assets of approximately EUR 1,000,000, consisting of 80 per cent of bank accounts bearing a low rate of interest. The statutory notional mix treated 21 per cent of the assets as savings accounts and the rest as (riskier) investments yielding a higher return. This notional arrangement meant that the taxpayers had to pay tax on a higher return than they had received. Furthermore, it meant that if a person did not make risky investments along the lines of the notional mix, he/she would be taxed effectively at a higher rate.

The court held that the human rights issues weighed heavier than the simplicity for the legislator so that in certain cases one cannot follow the notional return rule but rather that tax should be levied on the actual return made.

This case was part of a so-called mass objection, as a large number of taxpayers had the same argument. One of the as yet unanswered questions is whether, in view of the fact that this arrangement is a contravention of a human rights treaty, everybody, and not just those who participated in the mass objection, might be entitled to benefit.

Whether the case will only apply to those who have significant bank savings or whether it can be extended to cover all types of investments covered in Box 3 is still an open question.

The government is still reviewing how to deal with this case and, as a result, no final assessments are being issued by the tax office to individuals who have tax payable on Box 3 assets until it has determined how to proceed.

The legislation is in any event subject to a change, probably of the entire system, but this is unlikely to be effected in the next three years because the IT systems of the tax authorities cannot deal with it. More likely a temporary solution will be offered in some form. In any event, this court case has added to the lack of certainty but certainly appears to assist people who have bank savings.

Footnotes:

[i] (HR 24 December 2021, ECLI:NL:2021:1963)  

John Graham
John is Partner of Graham Smith & Partners International Tax Counsel, specialising in international taxation, including family owned companies and the (international) families behind them, trusts in civil law jurisdictions, international structures and expatriates. He has written for various publications on international and Dutch taxation, and is the former editor of the International Handbook of Corporate and Personal Tax (Chapman & Hall). He also taught International Tax and European Tax Policy at the School of International Studies, AVANS University of Applied Science.