The Tribunal ruled that the repurchase of shares is in principle to be qualified as leading to capital gains, and not as a distribution. However, to the extent the repurchase price exceeds the fair market value of the repurchased shares, the excess qualifies as a hidden dividend distribution that is subject to withholding tax. The Tribunal does not rule out the notion of tax abuse in respect of share class redemptions in certain situations but did not need to consider it in the case at hand.
The case is relevant for many Luxembourg companies that have issued so-called alphabet shares with the aim of offering to investors the flexibility to repatriate profits by redeeming a class of shares. In such a case, it is reasoned that no withholding tax is due: either based on so-called partial liquidation treatment, or on the basis of capital gain treatment following the 2017 Luxembourg Administrative Court judgment in case 39193C on a repurchase of shares in a different setting (the 2017 Judgment).
Background
In the case at hand, a Luxembourg limited liability company had organised its share capital in 10 different classes of shares (named A to J) next to a class of ordinary shares, all held by the same shareholder. The lettered classes each made up about 5% of the nominal share capital. In a subsequent year, the company repurchased class J shares at a price significantly above its proportional nominal value, even though its articles of association did generally not attach different shareholder rights to the various classes: they just specified that any repurchase of an entire class of shares needed to happen in reverse alphabetical order (from J to A), at a redemption price amounting to (up to) virtually all of the distributable reserves.
The company considered the repurchase (and cancellation) of class J as a partial liquidation not subject to withholding tax, as liquidation proceeds are not subject to such tax. In a subsidiary reasoning, the company also invoked the 2017 Judgment for capital gains treatment, also without withholding tax.
The tax authorities challenged this treatment on the grounds of abuse of law and upheld their levying of 15% withholding tax on the excess of the repurchase price over the nominal value of the repurchased shares.
Outcome
The Tribunal concluded that:
- The disposal of shares by the shareholder is in principle not a profit distribution but triggers a capital gain not subject to withholding tax;
- However, if the repurchase price exceeds the fair market value of the repurchased shares (i.e., what a third party would have paid for these shares) and that excess is motivated by the shareholder relationship, the surplus of the repurchase price constitutes a hidden distribution of profits, subject to withholding tax;
- Absent differences between the various classes of shares, the large asymmetry between the actual repurchase price and the proportional share in the net assets of the company of the repurchased shares led the tribunal to find that the company failed to establish that the repurchase price was not above the fair market value of the repurchased shares;
- Absent elements made available to the tribunal to determine the fair market value of the repurchased shares, the case is referred back to the tax authorities for such determination;
- Because of its above conclusion, the Tribunal has deemed it unnecessary to address whether in the case at hand there was abuse of law.
On the first point, the Tribunal observes that by selling shares, the shareholder renounces the rights linked to these shares. Economically, the value of the shares is constituted by the initial investment in the share capital and the participation in the reserves. Notwithstanding that mixed basis for the value of a share, the law provides that the entire gain upon the sale of shares to a third party is to be taxed as a capital gain. The same applies, the Tribunal holds, for corporate transactions between the company and its shareholder such as, among others, liquidations, mergers and demergers, and when a participation is repurchased or withdrawn and there is a corresponding reduction of the share capital. The Tribunal concluded therefore that the repurchase of the class J shares, followed by a share capital reduction, is to be taxed as a capital gain.
In line with the 2017 Judgment, the Tribunal included the caveat that a hidden distribution of profits may still arise in case the redemption price exceeds the fair market value of the redeemed shares, and such excess has no valid economic reasons but is solely explained by the shareholder relationship. The Tribunal then recalled a few elements in the case at hand that seem more relevant in the context of an abuse of law analysis rather than a transfer pricing analysis, such as the facts that (i) there was only one shareholder, (ii) all classes were created at the same time and (iii) the share classes did not have separate economic rights (other than allocating distributable reserves upon the redemption of a share class). The latter feature in particular is a difference with other fact patterns more often seen on the market.
On that basis, the Tribunal concludes that the repurchase price of the shares should be treated as a hidden distribution of profits, but only insofar it exceeds the fair market value of the shares. The Tribunal referred the case back to the tax authorities for the determination of the fair market value of the shares and considered it was no longer necessary to address abuse of law.
Impact
Both the State and the taxpayer have 40 days from the notification of the judgment to appeal to the final instance, which is the administrative court.
Subject to appeal, if any, the Tribunal’s judgment gives welcome clarity to the principal tax treatment of a repurchase of (a class of) shares, followed by their cancellation. Many Luxembourg companies have issued so-called alphabet shares with the aim of offering investors the flexibility to redeem a class of shares as additional means of repatriation. The Tribunal confirms the redemption price should, as a matter of principle, not be assimilated to a regular profit distribution, subject to reflecting the fair market value of the redeemed shares.
Open questions remain, however, notably (i) on how the fair market value of such a class needs to be determined and (ii) in which situations, if any, there might be a finding of abuse of law. Companies and their investors considering a repurchase of a class of shares should thoroughly consider these questions before proceeding.
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