LUXEMBOURG Law and Practice Contributed by: Oliver R. Hoor and Fanny Addouda, ATOZ Tax Advisers
applied the concept of disguised capital when clas - sifying the loans for Luxembourg tax purposes. How - ever, both the tribunal and the court appear to have confused the classification of financial instruments with the application of the concepts of hidden capital contributions and disguised capital. Notably, under the disguised capital concept, financing instruments can only be reclassified as equity if they are first clas - sified as debt for Luxembourg tax purposes. While the courts relied on some commentaries from 1955, the financial world is much more sophisticated today than in the past, and the Luxembourg legislator did not address the long-standing administrative practice of debt funding for holding activities. Therefore, one could argue that the legislator has implicitly shifted towards a stricter interpretation of the concept of dis - guised capital. While the Luxembourg courts held that the financing instruments can only be reclassified in their entirety, according to the interpretation of the concept of dis - guised capital by the German Reich Tax Court and the German Federal Tax Court (which developed this concept), only the excessive part of the financ - ing instrument should be reclassified (rather than the entire instrument). In this case, a debt capacity analy - sis could be conducted to support the level of debt funding. For interest-free debt instruments in which no interest is charged, the analysis is expected to result in a very high debt capacity percentage that exceeds the 85:15 debt-to-equity ratio that applies to holding activities based on administrative practice. Administrative Court, Case No 48125C, 23 November 2023 and Administrative Tribunal No 44902, 23 September 2022 – IFL On 23 November 2023, the Luxembourg Administra - tive Court held a decision in a case concerning an IFL that was granted by a Luxembourg company to its wholly owned Luxembourg subsidiary. The case involved a company resident in the Cayman Islands (CayCo) that invested via a Luxembourg invest - ment platform into (distressed) debt owed by third parties. CayCo financed its Luxembourg subsidiary (LuxParentCo) by a mixture of equity and a profit- participating loan (PPL). LuxParentCo used the funds received to finance its Luxembourg subsidiary (Lux - Subsidiary; the taxpayer) by a mixture of equity and
(mainly) an IFL. LuxSubsidiary (the borrower) invest - ed the funds received from LuxParentCo (the lender) mainly into distressed debt instruments. In its corporate tax return, in accordance with Article 56 of the LITL, LuxSubsidiary performed a downward adjustment in relation to the IFL in order to account for deemed interest expenses that would have been due at arm’s length. LuxParentCo recognised deemed interest income in its corporate tax return (correspond - ing to the amount of the deemed interest expenses reflected in the corporate tax return of LuxSubsidi - ary). The upward adjustment was also performed in accordance with Article 56 of the LITL. Both the LTA and the Administrative Tribunal denied the downward adjustment on the grounds that the IFL was to be considered as an equity instrument. The equity qualification by the tax authorities and the Tribunal was mainly based on the fact that the IFL included a limited-recourse clause providing for no or limited risk in case of default. One additional element was that the loan was only formalised several months after the cash had been made available. Thus, accord - ing to the Administrative Tribunal, the intention of the parties was to make a hidden capital contribution. The Administrative Court overturned the judgment of the Tribunal and recalled that the classification of a financing instrument follows the economic approach (so-called wirtschaftliche Betrachtungsweise ). This approach involves, for tax purposes, the economic reality prevailing over the legal form (also referred to as the “substance over form” principle). The Admin - istrative Court performed an overall analysis of the transaction and an analysis of all relevant features of the IFL. Since most of the relevant features of the IFL were debt features, the Administrative Court classified the loan as a debt instrument. As the subject matter of the case was the classification of the IFL as debt or equity, and the Administrative Court is limited by the grounds on which it has been involved, it could not itself review the downward (and upward) adjust - ment in principle (ie, notional interest) and the arm’s length nature of the notional interest rate declared by the borrower. However, the Administrative Court stated that it was wrong to recharacterise the IFL as equity and to refuse to admit the amount put forward
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