Key Luxembourg tax decision: debt vs. equity classification and permanent establishment recognition

Background of the case

On 13 October 2014, a Luxembourg company (the "Company") acquired stakes in various companies, financed through (interest-free) shareholder loans provided by another entity in the same group (the "IFLs"). Anticipating to allocate these participations to a Malaysian branch (the "Branch"), the Company filed a tax ruling request with the Luxembourg tax authorities (the "LTA"). The request sought confirmation of (i) the recognition of the Branch as a permanent establishment and (ii) the eligibility of the participations for the participation exemption regime.

While the structure had been implemented in the meantime, the LTA rejected the ruling. Subsequently, the LTA adjusted the Company's 2015 tax return and 2016 net wealth tax, (i) rejecting the recognition of the Branch, (ii) recognising the existence of an abuse of law under §6 of the Steueranpassungsgesetz (“StanpG”), and (iii) requalifying the IFLs as hidden equity contributions.

Whilst on 8 May 2024 the Luxembourg Administrative Tribunal (the "Tribunal") confirmed the position of the LTA¹, the case was then brought before the Luxembourg Administrative Court (the "Court") which also had to rule on the qualification of the IFLs for Luxembourg tax purposes as well as the existence of the Branch.

Findings by the Court

1.   On the requalification of the IFLs

At the outset, the Court dismissed the argument raised by the Company that the tax qualification of an instrument follow the principle of basing the tax balance sheet on the commercial balance sheet. According to the Court, this theory, as provided for under Article 40 paragraph (1) LITL, does not concern the classification of a financial instrument but rather the valuation of assets and liabilities for the purposes of the tax balance sheet.

In line with the Tribunal, the Court referred to the parliamentary works²and to consistent case law concerning the general assessment of the characteristics of an instrument with a view to its classification for tax purposes³. On this basis, the Court reviewed the characteristics of the IFLs, focusing on three of them which, according to the Company, were allegedly misassessed:

Use of Funds

• The Court upheld the Tribunal judges' conclusion that the IFLs financed long-term fixed assets. In light of Article 21 LITL, the Court differentiates between assets held in the short and medium term and fixed assets, which must be understood as being inherently long term. The Court based its reasoning on a number of factual elements, i.e.:
• The classification of the assets as ‘non-current assets’ in the Company’s accounts;
• The acquisition of the shareholdings being subject to government approval, highlighting the complexity, scale, and long-term nature of the investment. The Court noted, interestingly, that a short-term character could have been plausible had the shareholdings been in listed companies, thereby supporting a degree of liquidity – however, this was not the case here;
• The shareholdings were the only assets held by the Company;
• The Company exercised significant influence over its subsidiaries, despite holding only approximately 15% of the shareholding, due to its representation on the subsidiaries' boards;
• The similarity between the names of the Company and its subsidiaries, supporting the intention to form a group. The Court pointed out that, from a commercial perspective, using similar names in a short-term strategy would make little sense due to the risk of later misleading potential clients through possible confusion between the various entities, thereby creating self-inflicted competitive issues;
• Finally, the 10-year maturity does not counterbalance the classification as equity, as, over several consecutive years, the group’s strategy has been to refinance the Company by granting new loans with a maturity of at least 10 years each time. Such a practice effectively amounts to granting a loan for a period exceeding 10 years.

Disproportion Between Equity and Loan Amounts:

• The Court also shares the findings of the Tribunal emphasising that a significant disproportion between the loan amount and the level of equity must be assessed in light of the debt-to-equity ratio requirements at the time the funds are made available⁴. That said, even though the IFLs were granted at different times over the course of the year, the Tribunal correctly based on the debt-to-equity ratio as at 31 December 2015 since no interim financial statements were provided and the Company failed to demonstrate that the ratio would have been different at the time of the disbursement of the second IFL.
• As for the transfer pricing documentation submitted by the Company, the Court rejects it on the grounds that it does not pertain to the Company, does not demonstrate what debt ratio would have been applied had the funding taken place between unrelated parties, and appears inaccurate and incomplete.

Absence of Guarantees: 

• The Court agrees with the Tribunal that the absence of a limited recourse clause does not justify the lack of guarantees in the IFLs. Moreover, the Court noted that the Company’s accounts mention that the lender would not demand repayment in cases where the borrower (i.e. the Company) lacks the necessary funds—which ultimately results in an implicit limited recourse clause.
• Although, in an intragroup context, it is conceivable that the guarantees in place might be less extensive than those in an arm’s-length transaction, guarantees could still have been established—for example, through a pledge over the Company’s shares (as the lender wasn’t the direct shareholder of the Company).

To those contested features, were added other equity-like features analysed by the Tribunal, such as in particular:

Absence of interest :

•  One of the IFLs did not provide for any interest at all, and while the second allowed the possibility to impose one, the Tribunal concluded this did not reflect the behaviour of an independent third-party lender, as the loans lacked financial compensation. The application of a default interest rate of 1% was considered as insufficient as it characterised this as compensatory, and not as remuneration typical of a loan between third parties.

Although other factors supported the classification as a debt instrument (e.g., 10-year maturity, absence of a stapling clause, absence of participatory interest, absence of participation in liquidation surplus, inability to convert the principal into capital, absence of an option to repay the principal through the issuance of shares, and lack of voting or informational rights), the Court confirmed that these elements had been considered and further emphasised that the debt/equity analysis is not simply a matter of aggregating criteria but rather involves a comprehensive economic assessment of the overall situation.

Finally, regarding the Company's argument that the reclassification of the IFLs as equity should have been limited to only 15%, based on the 85/15 debt-to-equity ratio practice, the Court made it clear that such a practice has no legally binding value. The documentation provided by the Company to support this ratio did not convince the Court, as it lacked a detailed analysis justifying the structure that had been implemented. In any case, this line of argument is irrelevant for the Court, which specifies that the question concerns the nature of the IFLs, which logically cannot be hybrid in character: they must be classified entirely as either debt or equity.

2.     Non-recognition of the Malaysian permanent establishment

The Court then considered the non-recognition of the Branch, following the same approach as the Tribunal, i.e. that the Company's argument regarding the existence of a branch in Malaysia must be examined in light of the conditions set out in paragraphs 1, 2(b) or (c), and 4(e) of the double tax treaty concluded between Luxembourg and Malaysia.

Similarly to the Tribunal, the Court briefly confirmed the non-recognition of the Branch within the meaning of the aforementioned provisions, on the grounds that the Company failed to:

• clearly identify the address of the Branch (and therefore did not fulfil the requirement of permanence);
• prove that services were actually rendered by the Branch, including two services provided for under the "Service Level Agreement";
• provide any documents prepared by the manager of the Branch, who was furthermore not listed among the individuals participating in the Company’s general board meeting reporting on the Branch's activities, despite that meeting taking place after its appointment.

With regard to the weight to be given to the confirmation provided by the Malaysian authorities, the Court once again agreed with the Tribunal, noting that this confirmation lacked detail and did not establish that the Branch existed as of 1 January 2016.

On this basis, the Court rejected the Company's arguments concerning the existence of a fixed place of business in the form of a branch in Malaysia.

In doing so, the Court deemed it unnecessary to examine the characterisation of abuse of law under §6 of the StanpG, as the Branch was not recognised for tax purposes. Accordingly, there is no need to address the issue of abuse of law to justify the contested tax treatment.

Conclusion

On the classification of an instrument for Luxembourg tax purposes, the Court draws its conclusions based on its consistent case law and provides some interesting clarifications on how judges approach the analysis of such instruments. Once again, the general context of the structure and the transaction play a decisive role in the analysis, which is conducted not on an arithmetic basis but through a holistic approach – certain features, however, carrying greater weight, such as the financing ratio or the use of funds.

Particularly noteworthy is the Court’s confirmation on the non-binding nature of the administrative practice of the 85/15 debt-to-equity ratio. This emphasises the importance of ensuring an arm’s-length financing ratio, which should be supported by a transfer pricing analysis.

Finally, the reasoning of both the Tribunal and the Court on the analysis of a permanent establishment, as well as the weight afforded to the confirmation by a foreign jurisdiction, has been particularly interesting to follow.

^{[1] See decision n°47267 of the Luxembourg Administrative Tribunal of 8 May 2024.}

^{[2] Parliamentary document to the LIR n°571/4}

^{[3] See for example: Decision n°38357C of the Luxembourg Administrative Court of 26 July 2017 and n°40704 of the Luxembourg Administrative Tribunal of 13 December 2018}

^{[4] Decision n°48125C of the Luxembourg Administrative Court of 23 November 2023.}