The Netherlands takes a rather formal approach with respect to the tax characterization of a financial instrument, as the form of the instrument is generally decisive for its character for Dutch tax purposes. A substance-over-form exception applies, however, for a debt instrument that (i) has no term or a term in excess of 50 years, (ii) carries a profit contingent interest, and (iii) is subordinated. The Dutch Revenue Service argued that a substance-over-form exception should be made as well with respect to certain debt-like equity instruments, but this argument has been dismissed by the Supreme Court in a February 7, 2014 ruling. The case related to redeemable preferred shares issued by an Australian company to a Dutch company that sought to apply the participation exemption with respect to its income from the shares. The shares had the following characteristics: (i) an entitlement to cumulative and fixed dividends, (ii) seniority over other share classes, (iii) redemption after 10 years, and (iv) limited voting rights. Furthermore, the Australian issuer was entitled to deduct the dividends for Australian tax purposes.

With its decision, the Supreme Court settles a long debate in favor of the taxpayer by rejecting that equity can be recharacterized into debt for purposes of the participation exemption, even if a deduction is available for the issuer. Taxpayers that seek to benefit from this ruling need to be cautious, however, in view of the recent proposals to amend the EU Parent-Subsidiary Directive and the OECD work on hybrid mismatch arrangements, which both seek to deny the participation exemption in case the issuer is entitled to a deduction.

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