Understanding the Tax Treatment for Redeeming Alphabet Share Classes

The Administrative Tribunal confirms the tax treatment of the redemption of “alphabet” classes of shares

On 27 January 2023, the Administrative Tribunal issued a ruling dealing inter alia with the tax treatment applicable to the redemption of alphabet classes of shares (case 42432), the Decision.

The Decision explicitly confirms that the redemption of a class of shares followed by its cancellation qualifies as a gain from the disposal of a participation. It does not qualify as a distribution of profits (in principle subject to withholding tax (WHT), to the extent the redemption price of such class of shares does not exceed its fair market value. The Decision aligns the treatment applicable to redemption of share classes, whether or not the redemption is followed by a cancellation.

Background

A Luxembourg limited liability company (LuxCo) has a share capital divided into a class of ordinary shares and 10 alphabet classes (from A to J). All classes of shares have same economic features and are held by the same shareholder located in the Cayman Islands (CaymanCo). The classes of shares were created after the incorporation of LuxCo.

In 2014, share class J was redeemed and immediately cancelled. Hence, LuxCo’s share capital was reduced for an amount corresponding to the nominal value of such class J shares (i.e. representing solely 5% of the share capital of LuxCo). However, and as described by the Administrative Tribunal, the redemption price of class J shares corresponded almost to the entirety of LuxCo’s net asset value at the date of the redemption, despite the absence of distributable reserves.

The redemption of class J shares was treated as a partial liquidation as per article 101 of the Luxembourg Income Tax Law (LITL), not subject to Luxembourg WHT.

The Luxembourg tax authorities challenged the partial liquidation qualification due to the absence of economic distinct rights for the different classes of shares. Hence they applied a 15% WHT, arguing that such transaction would have to be regarded as a distribution of profits, thus as a dividend.

An appeal was then lodged against the tax assessments issued to LuxCo (case 42432 at hand) and a request introduced for the suspension of execution of said tax assessments (case 42434).

In the related decision of the Administrative Tribunal dated 22 March 2019, LuxCo argued that both the doctrine and the case-law agreed on the qualification of redemption-cancellation of share classes transactions as purchases of securities and not dividend distributions, notably on the grounds of the decision of the Administrative Court of 23 November 2017 (39193C).

The president of the Administrative Tribunal contested firmly the statement made by LuxCo that the treatment of redemption-cancellation of share classes was set in stone by the courts on the basis that the facts of the 2017 decision were significantly different from those at stake (i.e. distinct shareholders holding separate classes of shares in that case), so that a deeper analysis by the Administrative Court would be necessary.

Content

The Decision confirms that transactions made between a shareholder and its shareholding that would affect the substance of its participation (such as the repurchase of such a participation), followed by a subsequent and corresponding share capital reduction qualify as proceeds derived from the disposal of a participation under the meaning of article 101 paragraph 1 LITL, and not as distributions of profits.

However, it does not prevent the application of article 164.3 LITL provisions (i.e. the recognition of a hidden distribution of profits) in the event the redemption price exceeds the fair value of the participation, if such excess is not be justified by economic viable reasons but would solely result from the shareholder relationship. This limitation is in line the outcome of the court decisions rendered in 2017 and 2019.

In the case at hand, the Administrative Tribunal specifies that the redemption of class J shares is to be considered as a gain from the disposal of a participation since it has been followed by a share capital reduction corresponding to the nominal value of said shares at LuxCo level. However, the redemption price of the class J shares is to be seen as a hidden distribution of profits for the portion of said price exceeding the fair value of the Class J shares.

The Administrative Tribunal seems to consider that LuxCo did not bring sufficient tax evidence to justify the magnitude of the price effectively paid. It decided therefore to refer the case to the tax office which will have to determine the excessive portion of said redemption price of class J shares.

Key takeaways

The Decision is constructive as it confirms and makes explicit that the redemption of a class of shares can be considered in principle as a gain from the disposal of a participation, and not as a dividend distribution.

The reference made to the fair market value, now specifically applicable towards alphabet share classes, is coherent as the matter concerns transactions occurring between related parties. However, the absence of guidance on the determination of the fair value of these share classes is regretful.

While we acknowledge that it is not in the Administrative Tribunals’ prerogatives to provide for valuation methodologies, we can also regret the lack of comments regarding the one proposed by the taxpayer in its arguments. For reference, the taxpayer proposed that the fair value would correspond to an aggregate amount composed by the nominal value, the share premium, potential capital reserves and eventually latent capital gains on assets held by the company. Such a methodology could in our view be relevant, noting also that the Decision reiterates that (as it was already the case also in the 2017 and the 2019 decisions), from an economic point of view, the value of a participation in an opaque company is in principle composed by the initial investment in the share capital and the portion held in the accumulated reserves (i.e. the accumulated and undistributed wealth produced by the company).

We could also regret that the Administrative Tribunal did not rule on the qualification of the redemption of a class of shares as an abuse of law. Such a qualification was part of the arguments developed by the Luxembourg tax authorities in front of the Administrative Tribunal, invoking notably the absence of distinct economic rights between the classes as evidence of the absence of economic viable reasons justifying the redemption of one or another class, especially in presence of a sole shareholder.

In a nutshell, the Decision is welcome as it provides with new elements that could serve as additional guidance and reference to secure the tax treatment applied to taxpayers using this type of instruments. That being said, it still leaves some parts of shades that may be addressed in front of the Administrative Court if the State and/or the taxpayer would appeal the judgment within the 40 days following the notification of the Decision.