Luxembourg Administrative Court Requalifies Interest-Free Shareholder Loans as Equity for Tax Purposes

Background of the Case

The case involved a Luxembourg holding company that acquired participations, which were subsequently allocated to its Malaysian branch in an effort to secure treaty-based tax relief, as they did not qualify for the Luxembourg participation exemption when held directly. These participations were funded via two IFLs received from the indirect shareholder. The company had previously submitted a ruling request to the Luxembourg tax authorities (LTA) seeking recognition of the Malaysian branch as a permanent establishment (PE) entitled to tax treaty protection, which was rejected on grounds of tax abuse. Despite this, the taxpayer proceeded to treat the branch as a PE in its 2015 tax returns, allocated the participations accordingly, and claimed an exemption for the related assets and income under the treaty. The taxpayer also treated the IFLs as deductible debt instruments.

The company’s tax position was rejected by the Luxembourg tax authorities (LTA), who reclassified the IFLs as equity contributions. As a result, the taxpayer was denied both the treaty-based tax exemption and the ability to deduct the IFLs from its net wealth tax base. The Administrative Tribunal confirmed this view, prompting the company’s appeal to the Court.

Qualification of IFLs for Luxembourg Tax Purposes

The Court upheld the requalification of the IFLs as hidden capital contribution rather than debt, based on substance-over-form principle. The Court reaffirmed that the classification of a financial instrument for tax purposes must follow the substance-over-form principle, meaning that its economic reality takes precedence over its legal form. Accordingly, determining whether an instrument qualifies as debt or equity for Luxembourg tax purposes requires a comprehensive assessment of all relevant features - not merely the contractual terms - within the broader context of the transaction. The analysis must consider the economic circumstances surrounding the arrangement as a whole, rather than isolating individual characteristics of the loan agreement.

In assessing whether the IFLs should be treated as equity rather than debt, the Court considered several key factors:

• Substance Over Form Prevails: The qualification of a financial instrument for tax purposes in Luxembourg is determined by its economic reality assessed under § 11 of the Adaptation Law (StAnpG), not its legal form or accounting treatment. The Court confirmed that article 40 of the Luxembourg income tax law (LIR), which links tax and commercial balance sheets, applies only to valuation, not to debt/equity classification.
  
  
• 85/15 Debt-to-Equity Ratio Deemed Non-Binding: The Court dismissed the taxpayer’s reliance on the 85/15 administrative practice for holding companies, affirming that such guidance is not legally binding. The relevant test is the arm's length principle (as per Art. 56/56bis LIR): whether an independent third party would have granted a loan on comparable terms. Moreover, a proper transfer pricing (TP) study is required to substantiate such arrangements, and the company’s TP study was dismissed for lacking substantive analysis in support of the debt classification under the arm’s length principle.
  
  
• No Partial Requalification: Full Debt or Equity Treatment: The Court made it clear that partial reclassification is not permitted. Specifically, it rejected the argument that only the portion of the IFL exceeding an arm’s length debt level should be requalified into equity, emphasizing that the core issue is the nature of the IFL and that such IFL must be classified in full as either debt or as equity.
  
  
• Key Equity Features: The Court identified several key features that pointed decisively toward an equity classification in the present case:
  
  
  • The interest-free nature of the IFLs was inconsistent with typical debt remuneration, as no independent lender would provide funding without compensation.
    
    
  • The use of the proceeds of the IFL to acquire and fund long-term, equity-like assets (i.e. participations in subsidiaries).
    
    
  • The substantial undercapitalization of the borrower (a 99.998 /0.002 debt-to-equity ratio was noted by the Administrative Tribunal), indicating the lender bore virtually all economic risk.
    
    
  • The absence of guarantees that could have been provided by the borrower to secure the loan — even in an intra-group setting, combined with de facto limited recourse (evidenced by notes suggesting repayment was conditional on available funds), deviating from typical creditor protections. Even without explicit limited recourse clauses, the financial statements implied de facto limitations on repayment obligations, further supporting an equity characterization.
    
    
  • The irrelevance of the stated maturity (10 years), as the IFL had been extended through subsequent refinancing, undermining the notion of a fixed repayment obligation.

Practical Implications for Taxpayers:

This ruling reaffirms that the qualification of financial instruments under Luxembourg tax law depends on its economic reality and not on its legal form, its accounting entries or on past administrative (tax) practice. The Court’s approach confirms the continued application of the substance-over-form principle and reinforces the arm’s length principle as a central tool in analyzing intra-group financing.

Following the Court’s decision, taxpayers should expect heightened scrutiny from the Luxembourg tax authorities on intra-group financing arrangements, particularly those involving interest-free loans. The Court’s decision emphasises that past informal administrative practice like the 85/15 debt-to-equity ratio offer no legal protection and cannot be considered a substitute for a case-by-case analysis of what should constitute an arm’s length transaction (which then includes debt-equity analysis, interest rate setting, security etc.). To mitigate the risk of a reclassification of (interest-free) loans into equity (which could give rise to adverse Luxembourg tax consequences upon repayment of such loans or may result in an increased net wealth tax liability), Luxembourg corporate taxpayers must ensure comprehensive TP documentation in line with OECD standards.

The Court’s decision may have a direct impact on your financing arrangements. If you would like to discuss your specific circumstances or explore the options available to you, please contact the authors of this publication or your usual advisor at Tiberghien.