Luxembourg administrative tribunal issues landmark judgment on share class redemption
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On 27 January 2023, the Luxembourg Administrative Tribunal (Tribunal) gave its long-awaited judgment (n°42432) on the tax treatment of a redemption (and cancellation) of a class of shares by clarifying that such redemption should in principle qualify as a capital gain and thus be free of Luxembourg withholding tax (WHT).
We would like to share with you our insights thereof.
- Background
In the case at hand, a Luxembourg limited liability company (LuxCo) redeemed one of its 10 different classes of so-called ‘alphabet shares’ (Alphabet Shares) at a price significantly above its proportionate nominal value from its sole shareholder. Each class of Alphabet Shares represented 5% of LuxCo’s nominal share capital and had only been incorporated one year prior to the redemption subject to the litigation at hand. LuxCo’s articles of association did not attach any different economic rights to the various Alphabet Share classes but merely specified that any repurchase of an entire class of Alphabet Shares should be made in a reverse alphabetical order.
LuxCo considered the repurchase of the class of shares as a partial liquidation and therefore not subject to WHT.The Luxembourg tax authorities (LTA) challenged this treatment on the basis of several specific aspects of the case and requalified the transaction as a hidden dividend distribution which is subject to 15% WHT.
- The Tribunal’s judgment
In its judgment, the Tribunal confirmed that a redemption followed by a cancellation of shares qualifies, in principle, as a capital gain instead of a dividend distribution and should thus not be subject to WHT. This conclusion is subject to the shares’ redemption price corresponding to its fair market value (FMV) and being justified based on valid economic reasons and not solely the shareholder relationship.
As a consequence, to the extent that the redemption price exceeds the share’s FMV and is not based on serious economic reasons, the LTA may requalify the redemption and cancellation of shares as a hidden dividend distribution subject to 15% WHT. However, the LTA may solely impose the 15% WHT on the amount exceeding the FMV of the redeemed shares, and not the entire redemption price.
In the case at hand, the Tribunal concluded due to the lack of necessary evidence to compute the redeemed shares’ FMV, the absence of different economic rights allocated to the Alphabet Shares, as well as the fact that the redeemed shares only represent 5% of LuxCo’s share capital, that the redemption price did not correspond to the shares’ real value. In that respect, it referred the valuation of the shares’ FMV back to the LTA.
In light of the above, the Tribunal did not deem it necessary to assess the existence of an abuse of law.
Furthermore, the Tribunal, despite the following factual elements in the case at hand, did not consider that it was necessary to analyse the potential existence of an abuse of law:
- LuxCo was owned by one sole shareholder;
- All different classes of Alphabet Shares were created without distinct economic rights;
- All different classes of Alphabet Shares were established after LuxCo’s incorporation and only one year before the redemption of a class of Alphabet Shares.
- Conclusion
While the Tribunal’s judgment is not final yet and may still be subject to an appeal, it is a positive message to taxpayers and advisors by providing clarity on the tax treatment of the redemption of shares followed by a reduction of share capital. Indeed, the Tribunal confirmed that a redemption followed by a cancellation of shares qualifies, in principle, as a capital gain not subject to WHT in Luxembourg.
In its reasoning, the Tribunal seems to focus on whether the shares’ redemption price corresponds to its FMV and whether a sufficient amount of shares are being redeemed in light of the redemption price paid (i.e. the share capital represented by the redeemed shares should somewhat be proportionate to the redemption price).
We would therefore recommend to Luxembourg taxpayers who have or are thinking of implementing Alphabet Shares in their share capital, to prepare appropriate documentation and valuations in advance of implementing any future share redemption transactions in case of a challenge by the LTA. In addition, the article of associations should be carefully drafted upon implementation of Alphabet Shares in order to ensure that different economic rights exist between each class of shares.
It is unfortunate that the Tribunal did not address the concept of abuse of law, as this remains highly relevant for share redemptions and will be important to follow closely in the future.
We trust you find this publication useful and welcome the opportunity to answer any questions or comments you may have. We will keep you updated on any additional tax measures.