A transaction even if formally structured as a loan may receive a different tax treatment if its characteristics align more closely with equity. A recent court decision highlights the importance for asset managers to thoroughly evaluating the substance of financial transactions, in their specific context and regardless of their formal structure, to ensure consistent tax treatment.
On 23 November 2023, the Luxembourg Administrative Court overruled a decision rendered by the Administrative Tribunal on 23 September 2022.
In this case, a Luxembourg company (the 'Company') had received an interest-free loan ('IFL') from its shareholder, which was itself financed by a profit-participating loan. Although the IFL did not involve interest payments, the Company deducted notional interest for tax purposes, in line with its transfer pricing documentation.
The tax authorities challenged this deduction, arguing that whether a financial instrument is classified as debt or equity should be assessed by application of the 'substance over form' principle. On this basis, they considered that the IFL should be treated as equity since a capital increase would normally be the preferred financing method for genuine business reasons and since the decision to structure it as a loan appeared to be mainly motivated by tax advantages. The Tribunal sided with the tax authorities, ruling that the IFL bore more characteristics of equity than debt.
The Court's approach in assessing the nature of the loan focused on the economic characteristics of the transaction and examined how the loan integrates into the Company's overall operations.
Some factors such as the maturity date, the use of the borrowed funds, the existence of shareholders rights such as voting or profit participation, the presence of guarantees, and the level of subordination are notably deemed important by the Court for the qualification of the instrument as debt or equity and must be assessed in a global analysis within the context and market practices in which the transaction occurs. Beyond the characteristics of the instrument, the actual behavior of the parties involved remains also important and cannot be only assumed.
According to the Court:
- Maturity Date: a duration of 8-10 years is not particularly long and does not imply the lender's intention to invest
- Debt-to-Equity Ratio: the regulations existing at the time of the transaction allowed for a minimal equity requirement, thus the significant loan amount compared to equity does not by itself suggest disguised equity
- Profit Participation or shareholder rights: the lack of entitlement to income along with the absence of shareholder rights such as voting, does not indicate equity
- Subordination: the loan was subordinated to a bank debt of the company but subordination of intragroup loans to bank debt is a common practice and required by financial institutions
- Limited recourse clause: although it transfers investment risk to the borrower, limited recourse clauses are commonly used and do not eliminate the mandatory repayment obligation
- Actual Repayment: The IFL repayment by the Company, that occurred before the maturity date, further demonstrated the loan's nature as a debt
The Court concluded that most of the relevant characteristics of the IFL supported its classification as a debt instrument, thus affirming the Company's ability to deduct the notional interest.
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