The Luxembourg Tax Authorities Challenge Interest-Free Loans: Is It a Call for Action?

Introduction

On September 23, 2022, the Luxembourg Administrative Tribunal confirmed, with decision 44902, the Luxembourg tax authorities’ position on financing in the form of an interest-free loan (IFL) that is granted to a Luxembourg company by its sole shareholder: such financing is to be treated as a hidden capital contribution (equity). This treatment entails, inter alia, the non-deductibility of notional interest expenses on the IFL as well as the non-deductibility of the IFL for the purposes of net wealth tax.

The Facts of the Case

On April 29, 2016, the Cayman sole shareholder (“Cayco”) of a Luxembourg company (“Luxco 2”) provided funds via a profit-participating loan (PPL) to its Luxembourg subsidiary, which in turn, on the same date, granted an IFL to its fully owned Luxembourg subsidiary (“Luxco”). Luxco then invested in debt instruments. (See the accompanying figure.)



The IFL legal agreement was not executed until December 19, 2016, some months after the funds were provided to Luxco, with retroactive effect from April 29, 2016.

The two Luxembourg companies entered into a fiscal unity as of January 1, 2017. Typically, as part of a fiscal unity, the income at the Luxco level is offset with a deduction on the PPL at the Luxco 2 level. In the absence of fiscal unity, the income at the Luxco level would have been fully taxable without a deduction on the PPL save for a notional deduction on the IFL. For the 2016 tax year, Luxco deducted an amount of notional interest expense on the IFL in its tax return. Notional interest income at the level of Luxco 2 (though not relevant to the case) would be taxable, but offset with an expense on the PPL. The Luxembourg tax authorities, in the assessment of Luxco for 2016, denied the company’s notional interest deduction on the IFL.

The Luxembourg Administrative Tribunal focused on analyzing the terms of the IFL, in particular the “limited recourse clause” and a “conversion option.” According to the tribunal, the interaction of certain clauses in the IFL agreement actually removed any obligation on the borrower to repay the funds, leading the tribunal to conclude that the intention of the lender (who was, at the same time, the sole shareholder) was to provide its subsidiary with equity rather than to act as a lender.

The fact that the IFL provided for the possibility, at the option of the lender who was also the sole shareholder, of the contribution of part or all of the IFL in exchange for shares at a predetermined ratio was held by the tribunal to be a further indication of a hidden capital contribution.

Other features that, according to the tribunal, should generally be considered in a debt-versus-equity analysis were the lack of an interest rate, the absence of protection against a repayment default, the allocation of the funding to long-term assets, the lack of guarantees, and the excessive debt-to-equity ratio, along with the general circumstances in which the financing was granted.

The Substance-over-Form Approach and the Qualification of IFLs

The tribunal decided to recharacterize the financing as equity on the basis of the “substance over form” principle, which looks at an arrangement’s economic rationale rather than its legal aspects alone. In other words, the Luxembourg tax authorities will not be bound by the legal construct of a transaction. Rather, they will consider the economic reality of a transaction in order to apply the tax treatment appropriate for that reality.

From a tax point of view, an arrangement that is a debt in appearance can carry the characteristics of equity. On the basis of the “substance over form” approach and the principle, from article 40 of the Luxembourg Income Tax Law, that the tax balance sheet follows the commercial balance sheet (principe de l’accrochement du bilan fiscal au bilan comptable), an IFL will also be considered to be a debt instrument for Luxembourg tax purposes on a case-by-case basis to the extent that the instrument has debt characteristics.

In summary, according to the tribunal, the real content of an economic transaction is relevant for the application of the tax law, and it must be identified. Thus, where the intention behind the transaction (given the terms of the instrument and related circumstances) is that of a shareholder investing in its subsidiary rather than that of a lender (who expects a return and repayment of the funds), the loan is to be recharacterized as hidden capital.

The Tax Consequences of Recharacterizing an IFL as Equity

On the evidence of the case at hand, the tax consequences of recharacterizing an IFL as hidden capital are the following:

  • Any dividend distribution from Luxco to Luxco 2 would result in the disallowance of the yield accrued on the PPL issued by Luxco 2, because the PPL will be considered to be financing the participation in Luxco (which includes the IFL as equity), not a receivable. This result is arrived at through the application of the tax rules according to which expenses in relation to exempt income, such as dividends, may not be deducted—a way to avoid, indirectly, double non-taxation.
  • There is no deduction of notional interest for income tax purposes.
  • The IFL is non-deductible for net wealth tax purposes.

 

Conclusion

The specific facts of the case may have played a role in the Luxembourg tax authorities’ decision to challenge the loan, but the tribunal’s statements are not applicable only to the specific circumstances and facts of the case, the activity of the entity involved in the case, or the absence of a fiscal unity.

The tribunal’s decision confirms the need for companies (1) to consider whether a shareholder that is also a creditor of the company behaves like a creditor when granting a loan, and (2) to take the economic features of this behaviour into account. This principle applies outside the context of IFLs; companies must give it careful consideration when financing their corporate structures through either debt or equity, because such financing is normally motivated by strategic business decisions that trigger different tax consequences.

The tribunal’s decision may still be appealed. Nonetheless, taxpayers should review the terms and conditions of their Luxembourg IFLs to ensure that these loans are not at risk of being characterized as equity.

Alex Pouchard and Paula Przybielska
EY Luxembourg


International Tax Highlights

Volume 1, Number 3, November 2022

©2022, Canadian Tax Foundation and IFA Canada

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