On 8 May 2024, the Luxembourg Lower Administrative Tribunal (the “Tribunal”) (n° 47267) ruled on the tax qualification of interest-free loans (“IFLs”) granted by a parent company to a Luxembourg subsidiary (the “Company”) as well as the non-existence of a Malaysian permanent establishment (the “Branch”).
In the case at hand, a Luxembourg company (the “Company”) was granted two IFLs used to finance the acquisition of participations in two companies (the “Subsidiaries”). The Company requested an advance tax ruling on the allocation of the participations to the Branch. The Luxembourg tax administration (the “LTA”) rejected the request on the grounds that the transaction was not compliant with legal provisions. The structure was nonetheless implemented and during the tax assessment procedure, the LTA reclassified the IFLs as hidden capital contributions, denied the recognition of the Branch and identified the existence of an abuse of law under §6 of the Luxembourg tax adaptation law (Steueranpassungsgesetz – “StAnpG”), which the Tribunal ultimately followed.
Reclassification of the IFLs as hidden capital contributions
As usual, the Tribunal held that the classification of the IFLs should be determined based on the characteristics of the instruments and the circumstances surrounding their conclusion. The Tribunal emphasized the importance of identifying the economic reality of the transaction through an overall assessment. The Tribunal relied on parliamentary commentary to the tax law and previous case law, including a recent decision by the Luxembourg Higher Administrative Court of 23 November 2023 (no. 48125C) (for more information on this decision, please refer to our previous Newsletter) to set out the criteria to assess the debt or equity qualification of the IFLs.
First, the Tribunal analysed the criteria which tend towards a reclassification of the IFLs as equity:
- Absence of an interest rate: While it is emphasized that this indicator alone is insufficient to justify such a reclassification, it is nonetheless an equity-like feature. The lender’s ability to potentially impose an interest rate foreseen in the IFLs was considered as not creating a compensation and as inconsistent with market conditions, thus insufficient to reverse the equity-like aspect on that point. Likewise, an interest rate of 1% in case of default of the borrower does not remedy the absence of an interest rate.
- Disproportion between share capital and loaned funds: A debt/equity ratio of 0.1/99.9 was considered as indicating an undercapitalization, placing the risk of loss entirely on the lender and thus, contributed to the equity-like features of the IFLs.
Although these elements were not raised by the LTA, the Tribunal highlighted two additional indicators suggesting the instruments should be classified as equity:
- Absence of guarantee/collateral: granting half a billion USD loan without guarantees was deemed inconsistent with market conditions.
- Allocation of the proceeds to long-term investments: The proceeds of the IFLs were used essentially to finance long-term investment thus contributing to the equity-like features of the IFLs.
The Tribunal acknowledged that two indicators suggested a debt classification:
- Maturity of 10 years.
- Absence of a stapling clause.
However, the Tribunal concluded that these two indicators were insufficient to sustain a debt classification overall. Even though the agreements do not include participating interest features, liquidation proceeds participation, conversion options, repayment in shares options or voting rights, the overall circumstances were considered. The Tribunal emphasized that it is not a matter of merely summing up the indicators, as the legislator did not intend to give more weight to certain criteria. The Tribunal concluded that the indicators collectively establish that the IFLs should be considered, for tax purposes, as hidden capital contributions as an independent third party under market conditions would not have provided such an amount with virtually no equity, without any guarantee and remuneration. The Tribunal considered that the Company could only benefit from such conditions due to the relationship with the lender (i.e., belonging to the same Group).
The taxpayer also argued that based on the 15/85 debt-to-equity ratio required by the administrative practice for holding companies, only 15% of the IFL should be requalified as equity. The Tribunal rejected such argumentation on the grounds that the taxpayer did not demonstrate the existence of such practice and even in such case, a partial requalification would require that 85% of the debt bears interest and effectively qualify as debt. Therefore, the Tribunal supported the full reclassification of the IFLs as equity.
Acknowledgment of abuse of law in the context of the Malaysian permanent establishment
The non-recognition of the Branch
The Tribunal ruled that the non-recognition of the Branch is justified since in practice the sole document supporting the existence of the Branch was a “Service Level Agreement” - whose actual implementation remained unproven - and a board resolution. These documents, without concrete evidence of actual operations, indicated in the eyes of the Tribunal only preparatory activities and did not allow the conclusion that a “branch” existed under the Luxembourg-Malaysia double tax treaty.
The Tribunal stated that the Company’s activity should be performed in Malaysia through a fixed place of business, even if the Branch conducts only holding activities. The Tribunal underscored the effective business activity and tangible substance in the “branch” as essential criteria. Finally, and perhaps surprisingly, the Tribunal added that the recognition of a “branch” by Malaysian authorities does not constitute binding legal evidence for the LTA or the Tribunal.
Abuse of law
Next to the non-recognition of the Branch, which does not ipso facto characterize the existence of an abuse of law in the meaning of the §6 StAnpG, the Tribunal continued its analysis and relied on the usual cumulative elements to assess the existence of abuse of law:
- Use of private law forms or institutions: the operation involved the acquisition of participations, set-up of the Branch, and allocation of the participations to the Branch.
- Tax savings resulting from the bypassing or reduction of the tax burden: the Company acknowledged that the allocation of the participations to the Branch was based on the inability to benefit from the participation exemption regime. The Tribunal considered that the arrangement aimed to reduce, for the years concerned, the net wealth tax burden.
- Use of inappropriate means: the Tribunal considered that the normal means would have been to be fully subject to net wealth tax when unable to benefit from the provisions of §60 of the Luxembourg evaluation law (Bewertungsgesetz – “BewG”) that foresees a net wealth tax exemption for qualifying participations, rather than attributing those participations to the Branch to effectively exclude them from being subject to net wealth tax.
- Absence of any valid extra-fiscal related reasons that might justify the means chosen: based on consistent case law, the burden of proof is not on the LTA to demonstrate a lack of economic reason behind the operation but on the Company. As the Branch was disregarded, no economic reason could be evidenced.
Given that the conditions were fulfilled, the Tribunal concluded that the arrangement constituted a “wholly artificial arrangement” aimed at obtaining a tax advantage for net wealth tax purposes and acknowledged the existence of abuse of law.
The Tribunal’s decision is pending confirmation as an appeal has been lodged in front of the Higher Administrative Court.
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