Important Tax Update: Luxembourg Court Decision on Interest Free Loans and Debt to Equity Ratio – A Global Impact

Why Does this Matter to Your International Deals?

International transactions, such as private equity deals, mergers and acquisitions, and financing arrangements, frequently leverage Luxembourg entities as holding companies or joint ventures. It is common for such companies to be funded through a mix of intra-group debt and equity, with instruments, such as Interest-Free Loans ("IFLs") that are frequently used.

The Decision – Key Points

In this recent decision, the Luxembourg Administrative Court notably confirmed that:

• IFLs: IFLs granted by (indirect) shareholders to a Luxembourg company may be reclassified as hidden equity contributions for tax purposes depending on their terms and conditions and the economic reality. The accounting treatment does not determine the tax treatment; and
• Debt-to-Equity Ratio: The debt-to-equity ratio of a Luxembourg company must be assessed on a case-by-case basis and be documented appropriately from a transfer pricing perspective. Reliance on previous administrative practice or comparisons to other companies is not sufficient.

How Does this Decision Impact the Structures?

This decision reiterates the importance of structuring and keeping structures up to date in light of legislative and market practice developments, and confirms that potential adverse tax consequences for Luxembourg companies may arise in the following ways:

• IFLs: Reclassification of IFLs as equity by the Luxembourg tax authority results in: (i) the loss of tax deductibility for net wealth tax purposes, potentially increasing the Luxembourg company net wealth tax liability; and (ii) in case of exit with related repayment of principal, such payment could be treated as dividend and, in principle, subject to 15% withholding tax; and
• Debt-to-Equity Ratio: Tax Authorities are increasing the frequency and scrutiny of transfer pricing audits, with a particular focus on the debt-to-equity ratio. Insufficient documentation to support the Luxembourg company's debt-to-equity ratio, or reliance on outdated practices, or mirroring industry averages exposes the company to potential challenges from the Luxembourg tax authority.

What Should Be Done?

We strongly recommend the following actions:

• Review Existing and Future IFLs: Conduct a case-by-case analysis of all existing and planned IFLs with a focus on the terms and conditions of the loans and the overall economic context. Ensure these terms reflect a genuine loan arrangement, with economic substance, rather than a disguised equity contribution. For example, pre-funding loans should genuinely resemble pre-funding agreements, not perpetual loans. Finally, alternative structuring could be considered when helpful, e.g. capitalisation of part of the IFLs or conversion into interest bearing loans; and
• Document Debt-to-Equity Ratios: Meticulously document the debt-to-equity ratios of Luxembourg companies, demonstrating adherence to the "arm's length principle" (i.e. what independent third parties would agree upon). Relying on previous administrative practice or mirroring industry averages is insufficient.

We would be pleased to discuss with you the potential implications of this case law on both your existing and future structures. Our team is available to assist you in evaluating and addressing any tax risks associated with intra-group debt implemented within your structures, assessing the appropriate debt to equity ratio of the Luxembourg companies, and developing strategies to mitigate potential adverse tax consequences, all while ensuring tax compliance.

Hana Mattar (White & Case, Trainee, Luxembourg) contributed to the development of this publication.

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