Non-arm’s length suretyship

It is as important for shareholders to observe arm’s length terms and conditions when standing surety for their company as it is when lending their company money. The criterion for deciding whether or not arm’s length standards have been adhered to is whether the shareholder in question when entering into the suretyship arrangement was exclusively acting as a shareholder, as this would stop any losses arising of the suretyship being charged against the company’s result from sundry operations. Whether or not “shareholder motivation” played a part when the suretyship arrangement was entered into depends on whether or not a random third party would have agreed to stand surety, in the same scenario and on application of the same terms and conditions, for a non-profit sharing fee. It is the Tax and Customs Administration with which the burden of proof regarding non-arm’s length arrangements rests.

A company’s acquisition of the entire share capital of a fellow private limited-liability company was financed using a bank loan, which the acquiring company secured by presenting the lending bank with liens on its stocks, machinery and equipment and claims on group companies and with an undertaking on the part of its director-cum-controlling shareholder to stand surety not only for the various group companies’ debts, but also for the debts of the object of the acquisition. A few years later the acquiring company went under. Having invoked the suretyship arrangement with the shareholder, the bank was paid 50,000 euros by the director-cum-controlling shareholder in exchange for it granting him final discharge from liability. The director-cum-controlling shareholder in his income tax return docked said 50,000 euros from his “Box 1” income, which reduction the Tax and Customs Administration disallowed by reason of the suretyship arrangement having been non-arm’s length: it had, after all, been an infinite surety arrangement the shareholder and the bank had entered into involving an indefinite level of indebtedness (given that the set-up of the surety arrangement had been such as to cater as well for debts incurred at the post-borrowing stage). The dispute was brought before the District Court, where it was established that the infinity of the arrangement was incompatible with the 50,000 euro payment qualifying as a surety fee, given that the terms and conditions the shareholder had gone along with would have discouraged any third party from doing the same. The suretyship arrangement had thus fallen short of arm’s length standards so that the loss was non-deductible. The District Court’s decision to the relevant effect was upheld by the Arnhem-Leeuwarden Court of Appeal to which the case was subsequently referred.

Dutch version: Onzakelijke borgstelling