On 17 April 2025, the Luxembourg Higher Administrative Court (Cour administrative), delivered its long awaited decision on case n° 50.602C pertaining to the qualification of interest free loans under Luxembourg tax law and the existence of a permanent establishment in a treaty jurisdiction.
With its decision, the Higher Administrative Court brings further clarity in the process to be used when assessing the tax qualification of financial instruments as well as the existence of permanent establishments.
Background to the case law
A Luxembourg company (“LuxCo”) held two participations that it allocated to its Malaysian branch after the acquisition given that they could not benefit from a tax exemption and funded these investments through two interest free loans from its indirect shareholder (“IFLs”). LuxCo applied for a tax ruling seeking confirmation that the branch would qualify as a permanent establishment (“PE”) under the Luxembourg-Malaysia double tax treaty (“DTT”) and that as a result the right to tax the assets and income of the branch would be allocated to Malaysia rather than Luxembourg. The Luxembourg tax authorities (“LTA”) denied the request based on the abuse of law.
Despite the refusal, in its 2015 tax returns, LuxCo considered the branch as a PE, allocated the two participations to said PE and sought to treat the assets and related income as tax exempt in Luxembourg in accordance with the DTT. Additionally, the LuxCo treated the IFLs as debt instruments.
The LTA rejected the position taken in the tax return and considered that the branch did not qualify as a PE and was in fact an abusive legal construction. In addition, the LTA requalified the IFLs as equity instruments. As a result, LuxCo was considered as holding two participations not meeting the requirements of the participation exemption and could not deduct the IFLs, considered as equity, from its net wealth tax basis.
The Lower Administrative Tribunal followed the LTA (see our previous newsflash) in these conclusions, leading the taxpayer to file an appeal.
Decision of the Higher Administrative Court
The Higher Administrative Court (the “Court”) confirmed the judgment of the Lower Administrative Tribunal (the “Tribunal”) on both points, denying the debt qualification of the IFLs based on the substance over form principle and the permanent establishment qualification of the branch under the Luxembourg-Malaysia DTT.
1. Qualification of the IFLs for tax purposes
Preliminary to its analysis, the Court put aside the two arguments raised in the case at hand to assess the qualification of a financial instrument and recalled the process required to assess financial instruments:
- The principle set by article 40 of the Luxembourg income tax (“LITL”) that the tax balance sheet follows the commercial balance sheet unless specific tax rules provide otherwise, is relevant only for valuation of assets and liabilities.
- The substance-over-form approach whereby economic ownership primes over legal ownership mentioned in paragraph 11 of the Luxembourg adaptation law (Steueranpassungsgesetz), is merely a specific application of the substance-over-form principle and not its source, said principle being rather intrinsically existing in our tax law. As a result, paragraph 11 is only used to guide the allocation of income and assets to the relevant taxpayer and is not the legal source of the substance-over-form principle.
The Court then engaged in the assessment process by relying on its previous decisions and guidance from the parliamentary work of the LITL. The process relies on the review of the loans’ characteristics and the economic circumstances surrounding the operation, the Court putting heavy emphasis on the fact that the economic circumstances surrounding the operation weigh as heavily in the determination as the loans’ characteristics.
Use of borrowed funds
As the Tribunal considered that the use of borrowed funds helped sustain an equity qualification of the IFL, the taxpayer tried to challenge the conclusions of the Tribunal that the IFLs were fundings long-term assets (i.e., shares in subsidiaries) by putting forward several arguments:
- that despite the fact that the parliamentary comments used the words “long term assets” (immobilisations de longue durée) those are not defined in the LITL;
- that the Tribunal took into consideration the assets ultimately held by the subsidiaries (gas pipelines) and not just the direct holdings of LuxCo; and
- that LuxCo ultimately sold the shares in the subsidiaries after a 6 year investment period and the fact that the shares were funded a 10 years maturity debt.
The Court dismissed these arguments on the grounds that:
- The term long term assets as used under the LITL aims necessarily to long term assets given that they would have been qualified as short-term assets (actifs circulants) if they weren’t and several indicators point to the fact that the investment was necessarily long term, such as the accounting treatment of the shares, the details provided in the notes to the financial statements, the use of the same corporate designation throughout the group and the fact that the underlying investments required approval by local authorities before being disposed (foreign direct investments clearances, etc…).
- The underlying investment by the subsidiary must be considered especially given its complexity in the case at hand. This does however not mean that the direct subsidiary is disregarded.
- The fact that the IFLs’ agreements provided for a 10-year maturity is not relevant as in fact the maturity was extended by granting additional loans throughout the ownership period.
Disproportion between debt and equity
The taxpayer challenged the conclusion of the Tribunal that the taxpayer’s debt-to-equity ratio is disproportionate and considered that the proportionate character should be analysed in light of the administrative practice requiring a 85/15 ratio. The taxpayer attempted to justify the 85/15 debt-to-equity ratio by providing a transfer pricing study reviewing the debt structures of peers in the same industry during fiscal year 2015. In addition, LuxCo claimed that such analysis should be done at the time it acquired the assets rather than at year-end as done by the Tribunal (despite previous case laws providing that the analysis should be done upon transfer of the funds).
The Court considered that:
- On the timing of the review, the taxpayer invested progressively during the year 2015 without providing interim accounts to analyse his position upon each investment and the taxpayer did not demonstrate that his capitalization was different before year end, entailing an absence of prejudice and the appropriateness of referring to the year-end accounts, those being the only ones available.
- Administrative practice requiring a 85/15 ratio for holding companies is not legally binding and thus has to be disregarded when assessing the situation at hand.
- Beyond the typographical error in the taxpayer’s designation, the Court held that the relevant issue is not whether other groups adopted an 85/15 debt-to-equity ratio, but rather which ratio would have been applied had the transaction occurred between unrelated parties. It seems that the Court placed emphasis on debt-to-equity ratio observed among independent entities. Notwithstanding the foregoing, the Court rejected the transfer pricing study finding that the section intended to provide an analysis of the accurate delineation of the covered transaction, including the commercial rationale behind as well as the other options realistically available was incomplete and lacked accurate explanation. Apart from a vague explanation of the business purpose, the study failed to offer a robust justification of the chosen structure or an analysis of viable alternatives.
On the amount of debt to be requalified
The taxpayer argued that the outcome of the requalification should be to restate an arm’s length debt-to-equity ratio.
- As mentioned above, the Court dismissed the transfer pricing study and the legal value of the administrative practice. The judges took the view that in the context of qualifying a financial instrument, the assessment process can only result in one qualification, either disguised capital or debt, for the entirety of the instrument without the possibility to reach a hybrid qualification. In other words, the appropriateness of the indebtedness needs to be factored in during the qualification phase of the financial instrument in order to reach a conclusion whether it is effectively a debt instrument.
Absence of guarantee
The taxpayer argued that in the absence of a limited recourse clause, there is no need for a guarantee and in an intra-group context, especially in presence of a shareholder loan (here an indirect shareholder), such guarantees are less frequent in practice.
- The Court found that despite the absence of a limited recourse clause in the loans agreement, the notes to the LuxCo’s financial statements explaining that the lender will not request repayment if the borrower does not have sufficient funds, resulted in the existence of a de facto limited recourse.
- In an intra-group context, the Court agreed with the statement that intra-group relationships imply a level of trust and control not comparable to relationships with third parties. However, the Court considered that where the lender is the indirect shareholder controlling 100% of the borrower, the possibility of granting guarantee or pledges on the borrower’ shares are not excluded. This criterion thus, amongst others, points to an equity qualification of the IFL.
Assessment process
The taxpayer further argued that the majority of the characteristics pointed to a debt qualification and that the judges thus couldn’t conclude otherwise. The Court again sided with the Tribunal, the judges recalling that the assessment process relies on two parts, a review of the characteristics and a review of the overall operations in which the transaction takes place. Thus, meeting a majority of debt characteristics, especially when it results from the absence of dedicated clauses in the agreement, does not automatically result in a debt qualification, when a review of the overall operation leads to a different result.
2. Non recognition of the foreign branch as a permanent establishment
Lastly, the Court analysed whether the Malaysian branch could qualify as a PE under the DTT, by looking at the wording of the DTT and the OCED commentary to the OCED model convention. The judges analysed (i) the existence of a place of business, i.e. a physical place of business of any kind, in particular, a branch or an office, (ii) the fixed nature of that place of business, i.e. it must be established in a specific place and be characterized by a certain degree of permanence, and (iii) the carrying on of all or part of the business of the undertaking in question through that place of business in the sense that persons carry on the business in the State in which the fixed place of business is situated, in this case in Malaysia and (iv) the absence of any preparatory or auxiliary character of that business.
The taxpayer was not able to provide coherent, non-contradictory and substantial evidence as to the existence and the exact place of the leased offices of the branch, the existence of an activity at the level of the branch, as it had no employee or the carrying out (part) of the business of the LuxCo through it, leading the judges to deny the qualification of PE to the Malaysian branch.
Finally, the Court did not analyse the abuse of law aspects of the appeal as it would not change the above conclusions.
Conclusion
On the qualification of financial instruments for Luxembourg tax purposes, this case further clarifies on the relevant characteristics to be analysed and sets aside arguments often invoked but not relevant in this context such as the principle of attachment of the tax and commercial balance sheet. On the method, the Court recalls that the assessment is not an “arithmetical computation” based on a listing of the characteristics but a balance of characteristics and context.
Incidentally, the Court tackles the subject of the right balance between debt and equity for a holding company. First, it confirms once again that the administrative practice requiring a 85/15 debt-to-equity ratio is not legally binding and thus should be disregarded and secondly provides insight on how the Court analyses a debt capacity analysis and at which stage this debt capacity becomes relevant, i.e. during the qualification of the financial instrument stage.
The major contribution of this “landmark” decision is that the debt-to-equity ratio has now been clearly reframed as being one of the major components assessed during the process of qualification of a financial instrument (within the second limb where one should assess the overall operations the financial instrument is financing) rather than a stand-alone concept applied after the fact.
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