Court case at hand

The case concerns an individual living in Germany but working in the Netherlands. The individual participated in a management investment plan, by holding an interest in the ordinary share capital of a Dutch company. These ordinary shares (as subordinated instruments to the preferred share capital) qualified as a lucrative interest.

In 2018, the individual received a dividend and thereafter realised a capital gain when disposing of the shares. In relation to the dividend, 15% Dutch dividend withholding tax had been withheld. This court case deals with the impact of the German – Netherlands tax treaty (Treaty) on the Netherlands’ ability to tax the income. But first, we will address the Dutch domestic treatment.

Domestic taxation of lucrative interest income

Certain types of management investment plans (including sweet equity and carried interest) may qualify as lucrative interest. A lucrative interest is considered to be granted with the intention to also form a remuneration for services rendered by the individual (e.g. employment or management services). To qualify as a lucrative interest, the interest should generally offer the potential for a disproportionately high return compared to other investors, for example by using subordinated and/or leveraged instruments, e.g., ordinary shares subordinated to preferred shares.

As a principal rule, proceeds derived from a lucrative interest are taxed in Box 1 (progressive rates up to 49.5%). However, under certain conditions, it is possible to elect for taxation in Box 2 (31% rate, with a reduced rate of 24.5% for the first EUR 68,843 in income). To apply the more favourable Box 2 treatment, three cumulative conditions must be met:

  • the lucrative interest is held through an intermediate holding company (indirectly held - see relevance below);
  • the taxpayer holds a substantial interest (in short, 5% or more) in the intermediate company; and
  • at least 95% of the net proceeds are distributed by the intermediate company to the individual within the same calendar year (so that these proceeds can be taxed in Box 2).

Lucrative interests under tax treaties

A decree from 2021 on Lucrative Interests in International Situations (Decree) sets out the Dutch State Secretary’s policy with regard to the treaty classification of lucrative interest income. The Decree distinguishes three scenarios:

  1. Directly held lucrative interest: employment income or as directors’ fees.
  2. Indirectly held lucrative interest, without Box 2 election: same as category 1.
  3. Indirectly held lucrative interest, with Box 2 election: dividend or capital gains income.

If the income is treated as employment income, the work state would typically claim broad taxing rights (in the case at hand, the Netherlands). However, if the income is taxed as a dividend or capital gain, it is typically the resident state (Germany) that has unlimited taxing rights, with restricted taxing rights on dividends allocated to the source state (the Netherlands).

Since the implementation of the lucrative interest rules, the above distinction between a directly and indirectly held lucrative interest has been subject to debate. By taking the position that a dividend or capital gain should be taxed as employment income, the Netherlands may unilaterally extend its taxing rights. Logically, in the reverse situation (a Dutch resident working abroad), such treatment may lead to non-taxation in the Netherlands, and potentially also in the work state which may allocate taxing rights to the Netherlands.

Findings of the Court

In the case at hand, the taxpayer took the position that taxing rights over the dividend should under the Treaty be allocated to Germany, with the Netherlands only being allowed to levy a 15% dividend withholding tax. The capital gain realised on the disposal of the shares should be taxable only in Germany.

The Dutch tax authorities disagreed. They argued that the income should be taxed as employment income, as the nature of the income follows from the lucrative interest having been granted as a remuneration for employment. Such treatment would allocate taxing rights over ~75% of all income to the Netherlands (based on time spent).

In first instance, the District Court of Zeeland-West Brabant followed a largely grammatical approach. It held that this concerned income from shares and that the income should be taxed as such under the Treaty. The District Court considered it relevant in this respect that also under Dutch domestic law, income from a lucrative interest is not taxed as a remuneration for employment.

The Court of Appeal confirmed the District Court’s decision, while also referring to the Commentary to the OECD Model Tax Convention. This commentary references the distinction between a gain made upon the exercise of an employee stock option (typically, employment income), and any further income derived from the shares after acquisition (a dividend or a capital gain realised as shareholder).

The Court of Appeal then applied a similar logic. The Court confirms that the grant of a lucrative interest below the fair market value may constitute a remuneration for employment (and can be taxed accordingly at that time), but it holds that any subsequent dividends and capital gains are realised in the individual’s capacity as investor and must therefore be classified as such for tax treaty purposes.

As a result of this decision, the Netherlands is limited to levying a 15% (withholding) tax on the dividend, while fully relinquishing the right to tax the capital gain, which is taxable only in Germany.

Conclusion

With this ruling, the Court of Appeal has taken a clear position on the classification of lucrative interest income derived from shares, explicitly departing from the position as set out in the Decree. This decision is particularly relevant for lucrative interest holders that do not live and work in the same country. These developments should be monitored as it is now up to the Dutch tax authorities to bring the case in front of the Dutch Supreme Court.

Other developments

The ruling discussed above forms part of a broader trend in which the Dutch tax authorities scrutinise the qualification of lucrative interest income in cross-border situations. In another recent Court case, a taxpayer had invoked the partial non-resident taxpayer regime (under the Dutch expatriate regime, the so-called ‘30% ruling’) in relation to income derived from an indirectly held lucrative interest. As a result, the income was not subject to tax in Box 2. The tax authorities argued that by doing so, the income shifts back to Box 1.

In deviation from what the Amsterdam Court of Appeal found last year, the Court of Appeal of 's-Hertogenbosch took the view that the income should still be considered ‘realised’ for Box 2 purposes, regardless of application of the partial non-resident taxpayer regime. Thus, the income would not shift back to Box 1. Although this Court case specifically relates to a taxpayer benefitting from the 30% ruling, the logic behind the decision also has relevance for ‘regular’ taxpayers that hold lucrative interests through a foreign entity.

In relation to the above case, the Dutch tax authorities have already lodged an appeal with the Dutch Supreme Court.

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