On 23 November 2023, the Luxembourg Higher Administrative Court handed down a decision regarding the tax qualification of an interest free loan (“IFL”) granted by a parent company to a Luxembourg resident company.
In the case at hand, a non-resident parent company granted its subsidiary, a Luxembourg company, (the “Company”) an IFL. The Company had deducted for tax purposes a notional interest determined according to a transfer pricing study. According to the facts of the case, the parent company had booked a corresponding notional interest income for tax purposes. The Luxembourg tax administration (the “LTA”) considered that the IFL should be classified as a hidden capital contribution and denied the deductibility of the notional interest. At first instance, the Lower Tribunal agreed with the LTA that the IFL should be reclassified as a hidden capital contribution and the notional interest deductions should be annulled.
The Higher Administrative Court held that the debt or equity classification of the IFL should be made according to an economic and financial analysis of the instrument. In other words, the Higher Administrative Court stressed the importance of a “substance over form” approach and identifying the economic reality of the transaction according to an overall assessment. The Higher Administrative Court drew on parliamentary commentary and previous case law to set out the following criteria to assess the debt or equity qualification of the instrument:
- Documentation of the loan: the Higher Administrative Court considered that a delay of several months in documenting the IFL was not evidence of a hidden capital contribution. On the contrary, the Court noted that capital contributions are as a matter of principle more formalistic than loan agreements.
- The debt/equity ratio: contrary to the LTA’s submission, the Higher Administrative Court found that the Company did not have a disproportionate debt/equity ratio since its ratio was lower than the 99/1 debt/equity ratio commonly accepted at the time (c.f. Circular LIR 164/2 of 28 January 2011).
- A maturity of 8-10 years was not considered as evidence of an equity contribution as insufficiently long-term. In addition, the Higher Administrative Court noted that in the case at hand, the IFL had in fact been reimbursed prior to its term date.
- The absence of a right to participate in profits and liquidation proceeds, as well as the absence of voting rights attached to the IFL were considered as evidence of a debt instrument, although the IFL had been granted by a sole shareholder.
- The use of the funds borrowed under the IFL was considered relevant, the Court noting that the funds had not been used for long term investments.
- Limited recourse clause was not evidence of an equity instrument since the limited recourse clause did not affect the repayment obligation.
- Subordination of the loan: the fact that the IFL was subordinated to the Company first reimbursing any bank loans was evidence of an equity instrument.
- The absence of interest on the IFL was considered an equity instrument’ indicator.
- The absence of a stappling clause was also considered as evidence of a debt instrument since the lender could freely transfer the loan to a third party.
The Higher Administrative Court stressed that a criteria should not be deemed decisive on a stand-alone basis and an overall assessment is required. The Higher Administrative Court concluded that the IFL in question should be qualified as a debt instrument based on its characteristics and therefore annulled the decisions of the Lower Administrative Tribunal and the LTA.
This decision is a welcome addition to the case law on the qualification of debt or equity of IFLs and other financial instruments.
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