1. Facts of the case law
In the case at hand, a Luxembourg company (“Borrower”) received in 2016 an interest free loan from its corporate shareholder (“Lender”). Lender received a profit participating loan (“PPL”) from its Cayman Islands shareholder.
Among other features, the interest free loan had a retroactive effect of around 7 months (but still during the same financial year) to have the same effective date than the PPL granted by the Cayman Islands shareholder. The interest free loan carried a term of 8/10 years, a limited recourse clause, the possibility (but not the obligation) for the Lender to demand the issuance of shares of the Borrower for a portion or the entirety of the interest free loan.
Adhering to the general arm’s length principle of art. 56 of the Luxembourg tax law, Borrower proceeded with a transfer pricing adjustment by which it reported and deducted a notional (arm’s length) interest on its indebtedness under the interest free loan.
2. Court reasoning
The Luxembourg tax authorities took a different position and considered that the interest free loan should be treated as an equity injection by Lender into Borrower and, by virtue thereof, denied the imputed (arm’s length) notional interest expense reported by the Borrower. The Tribunal confirmed this approach and stated that this mode of financing was "made solely for tax purposes". Consequently, the Tribunal also confirmed the non-deduction of a notional interest on such interest free loan.
The Tribunal followed the substance over form principle, i.e. by reference to the economic reality of a transaction, to determine the tax nature of the funds contributed to the Borrower. It qualified the interest free loan as equity by identifying several features that are more in line with equity than debt. Those features are notably:
- the maturity dates (i.e., 8 and 10 years),
- a limited recourse clause,
- the absence of any interest, and
- the possibility for Lender to demand the issuance of shares of Borrower for a portion or the entirety of the interest free loan.
3. Conclusion of the case law
Based on the features included in the interest free loan agreement, the Tribunal concluded that the intention of Lender was mainly to make funds available to Borrower rather than to act as a real lender and decided to requalify the interest free loan into equity on the grounds of the "normal way of financing dictated by serious economic and legal considerations" that should have been followed by the taxpayer.
The consequences of such decision are not only linked to the denial of the imputed interest but also that the interest free loan would be not deductible for net wealth tax purposes.
The taxpayer has submitted an appeal against the decision of the Tribunal so the final word is with the Administrative Court.
4. Previous decisions of the judges
The Court has already previously been asked to deal with interest free loans in a case where a Luxembourg company granted participating loans to subsidiaries located abroad. Those loans have been wrongly taken into account for the computation of the unitary value of the Luxembourg company and the Luxembourg company argued that the loans were in fact to be considered as additional capital contributions. In 26 July 2017, the Court ruled that loans granted to Luxembourg companies were to be characterized as "disguised capital contributions". At this occasion, the Court referred to the economic and financial analysis of the operation for tax purposes itself described in the parliamentary work of the Luxembourg income tax law. According to the Court, the elements to be taken into account for the requalification of a loan into equity are the interest rate, the conditions of repayment, the allocation of the funding to long term asset, the lack of guarantees, the excessive debt to equity ratio and the circumstances in which the loan is granted.
Other judgements from the Tribunal dated 13 December 2018 (n°40704 and 40705) added other features such as the voting rights for the benefit of the lender, its participation in the profits and risks of the company, its right to a possible liquidation proceeds, a high degree of subordination of the instrument in relation to other securities, a long-term maturity, the option to convert the instrument into capital by unilateral decision of the company, the reimbursement in shares of the company and the presence of a “stapling” clause, corresponding to a provision preventing the transfer of the instrument independently of that of the shares of the borrowing company.
Based on the above, we would recommend taxpayers to perform a review of their existing interest free loans to see if and how their terms may have to be amended in view of those case laws.
For any questions, please contact your trusted advisor at Tiberghien Luxembourg or contact any of the authors of this publication.
Michiel Boeren – Partner (email@example.com)
Gauthier Mary – Senior Associate (firstname.lastname@example.org)
Madeline Morel – Associate (email@example.com)