Luxembourg Court Rules on the Tax Treatment of MRPS

In the context of two decisions rendered on March 31, 2022 (Administrative Court cases nos. 46131C and 46132C), the highest Luxembourg tax court has concluded that the mandatorily redeemable preference shares (MRPS) issued by a Luxembourg company to its sole shareholder qualify as equity, given the characteristics of the instrument, the circumstances of its issuance, and the forms used. The court upheld the judgment of the tribunal of first instance, which was issued in May 2021. Although the case is very fact-specific and the decision per se does not mean that MRPS are always equity, the court made some interesting statements that deserve more detailed examination.

The Court’s Findings and Arguments

Although the court acknowledged that the MRPS had certain debt features (for example, 10-year maturity, no voting rights except for the cases foreseen by the Luxembourg commercial law, and cumulative and preferred fixed dividends), it nevertheless rejected their classification as debt instruments.

The taxpayer based its position—that MRPS constitute debt for tax purposes—on the principle of substance over form. The court’s view, on the other hand, was that MRPS involve no obvious mismatch between the legal form adopted (share capital increase) and the underlying economic reality (a provision of funds by a single shareholder to its subsidiary). The court highlighted the fact that the distribution of a preferred dividend depends on the existence of a net profit after payment of the company’s creditors, which thus places the MRPS holder on a different footing—namely, that of a creditor granting a loan. Moreover, the court emphasized that the taxpayer was seeking to treat the MRPS as debt from a tax point of view only, having treated them as equity, not debt, in its financial statements, even though the Luxembourg accounting provisions offer the possibility of applying the principle of substance over form. The court also seemed to suggest the possibility for a concordant accounting and tax treatment of the instrument at the level of both the Luxembourg company and the sole shareholder, which, however, was not the case in the situation at hand.

Also, because of German prudential rules applicable to the shareholder, the financing through a loan was not possible. The court concluded that the equity financing appeared to be coherent and reflected the economic substance of the transaction, and it considered that the taxpayer had failed to prove that the intended requalification of the MRPS as a debt instrument was based on considerations other than tax.

The tax treatment of the MRPS in the case at issue was not covered by an advance tax agreement (tax ruling) from the Luxembourg tax administration.

Impact on Canadian Investors

Luxembourg MRPS financing structures are well known to, and have been extensively used by, Canadian parent entities: these instruments were treated as debt in Luxembourg for GAAP and tax purposes, which gave rise to deductible interest, but were treated as equity both in Canada (for tax purposes) and in Luxembourg (for legal purposes)—a classic example of a hybrid financial instrument mismatch with a deduction/non-inclusion outcome. These arrangements were no longer appealing after the introduction in Luxembourg of the EU anti-hybrid rules with third countries, effective as of 2020—rules that essentially deny the deduction on such instruments if the payment is not included at the level of the payee.

Nevertheless, the repercussions of the decision may be significant for taxpayers that used MRPS in arrangements that were not blessed by a binding tax ruling, especially given that Luxembourg tax rulings granted before January 1, 2015 lost their binding effect after the end of the 2019 tax year.

It is worth mentioning that the Luxembourg statute-of-limitations period is generally 5 years, but it can be extended to 10 years in the event of additional taxation resulting from incomplete or inaccurate declarations, with or without fraudulent intention. According to previous decisions of the Luxembourg courts, a transaction that is recharacterized as a hidden dividend distribution would be considered to constitute an inaccurate declaration, and thus the requalification of payments made on MRPS as dividends is expected to fall within the scope of the 10-year limitation period—including, potentially, situations where the Luxembourg company has already been liquidated. The Canada-Luxembourg tax treaty is of no relevance in the present context because no double taxation needs to be addressed.


This case highlights Luxembourg’s substance-over-form approach, which is also applied in many other countries. The courts often use this concept to prevent potential abuse in cases where the legal form adopted by the taxpayer in a transaction does not reflect the transaction’s economic substance, and the main purpose of the transaction was to obtain tax benefits. In such a case, the tax administration may disregard the legal form in favour of the underlying economic reality, and the facts and circumstances of each specific case are of utmost importance for the final assessment. It appears, however, that the substance-over-form approach differs slightly when the instrument under review is legally debt as opposed to equity. Although an overall assessment of the economic features of a debt instrument seems to be enough for that instrument to be possibly recharacterized as equity for Luxembourg tax purposes, this economic analysis might have to be supplemented with a demonstration that the recharacterization results in concordant treatment of the instrument, for book purposes, by the issuer and the holder.

Finally, whether to classify a financial instrument as debt or equity currently appears to be a frequent topic in the Luxembourg courts, and it is certainly an area that is increasingly scrutinized by the Luxembourg tax administration (which has resulted in tax litigation), especially in light of the international developments regarding hybrid financial instruments. Taxpayers should be aware of the possibility of retroactive implications arising from such challenges.

Alex Pouchard and Paloma Nunez
Ernst & Young LLP, Chicago

International Tax Highlights

Volume 1, Number 2, August  2022

©2022, Canadian Tax Foundation and IFA Canada

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