Private equity investments channelled via Luxembourg investment vehicles (“Luxco”) typically generate tax-exempt income (dividends, capital gains) to the investors and are generally funded by way of debt, for example taking the form of convertible preferred equity certificates (“CPECs”) or alphabet shares. Alphabet shares usually consist of 10 classes of shares, under which all, or at least almost all of the accounting income realised by the Luxco until their redemption goes to class “J”. Following the redemption of class “J”, the same occurs with class “I”, and so forth in reverse alphabetical order. The reason for this strategy is that a redemption of shares is clearly subject to the capital gain rules as applicable to individuals, if a private investor is selling his or her entire stake in Luxco, and provided Luxco swiftly thereafter reduces its share capital by cancellation of the shares thus acquired. Indeed the capital gain in those circumstances is not taxable, because the transaction is deemed a tax liquidation of Luxco. No dividend withholding tax is due at the level of Luxco, if liquidation proceeds get remitted to the investor, since a liquidation gain follows the tax rules of capital gains at the level of the investor. Although said statute would not explicitly also cover the redemption of alphabet shares, it is common practice to consider the capital gain rules to also be available to the redemption of alphabet shares, on the understanding that this would constitute a partial liquidation of Luxco viewed from the investor’s perspective. If so, no dividend withholding tax applies in that case, too, since a partial liquidation is treated from a tax point of view as a full liquidation of Luxco.
However, if a company buys back its own shares, one may hesitate on the tax qualification of the operation. On the one hand, if the buyback is not followed by a cancellation of shares, because the company that bought the shares subsequently sells them to a third party or an existing partner, the transaction will be very close to a sale of the shares from the exiting shareholder to the new shareholder, the sale merely taking place via Luxco. Hence, there exist no good reasons for not applying the capital gains rules. On the other hand, it is also clear that a company, in which 100% of the shares changes hands, will simply have new owners, while a company buying back 100% of its shares no longer has any capital. Therefore, if the company cancels the shares it has repurchased, the operation economically participates in the nature of the share capital reductions. Share capital reductions however attract dividend withholding tax, if the cancellation is funded with distributable reserves, which normally not only is the case in practice, but also a requirement under law for effectuating the share capital reduction. Hence, some practitioners were somewhat uncomfortable with the redemption of alphabet shares, unless all of the shares held by a given shareholder were repurchased and swiftly thereafter redeemed, in which case the transaction qualifies under statute as a partial liquidation of Luxco. This however poses problems where any given investor typically holds prorata shares in the various alphabet classes, so that, if any given class gets redeemed, even entirely, that investor still holds shares in the remaining classes. In that case, one could argue for the partial liquidation regime not to be applicable, and for a dividend withholding tax to become due. That is exactly what the tax authorities did in a case settled by the Higher Administrative Court in its ruling dated November 2nd 2017 (No. 39.193).
The Higher Administrative Court used this first case in order to immediately set the record straight. After a careful and balanced review of the statute provisions, as well as the fundamental principles underpinning the Income Tax Code, the Court concluded that the Luxembourg tax authorities were wrong in restrictively construing the partial liquidation rules. The Court took the view on that occasion that transfers of shares to the company should never be taxable as dividends, regardless of whether the transfer concerned all or part only of the shareholder’s holdings in the company. The Court thus aligned the tax treatment of transfers of shares to the company to the sale of shares to third parties, whether or not the transferor sells all or part of his social rights, whether or not the company reduces its share capital following the buyback. Consequently, no dividend withholding tax should have been levied.
This is a land-mark decision which will put the entire private equity industry at ease with their exit strategies. Two caveats however need to be made. The first is an obvious one, but the Court felt it necessary to state it explicitly in its findings. The (partial) liquidation regime only applies to genuine transactions. Hence, if the repurchase price is overstated, the dividend withholding tax will apply to the portion of the repurchase price which may not be justifiable. The second is an implicit one: the redemption may not be “abusive”.