In a judgment dated 27 July 2022, the Luxembourg Higher Administrative Court (Cour administrative) (the “Court”) handed down a decision concerning hidden dividend distributions.
Facts of the case
In the case at hand, an individual (the “Director”) was the shareholder of a foreign company (“Company Y”), which in turn was the shareholder of a Luxembourg company (“Company X”).
The Director made a number of advances to Company X, which were subsequently reimbursed by Company X to the Director. In addition, Company X applied 8% interest to these advances. These cash advances were mostly recorded in the financial accounts as advances/loans granted by the Director to Company X even though the wording of the cash movement was not always accurate.
According to the Direct Tax Administration (Administration des contributions directes) (“DTA”), the advances were to be considered as hidden capital contributions so that any reimbursement of these advances should be treated as hidden dividend distributions in favour of the Director and thus should be subject to 15% withholding tax. In addition, the DTA considered the 8% interest to be “excessive” on the ground that such interest rate was not in line with the market conditions and reduced it to 3%. The difference was also characterised as a dividend distribution subject to 15% withholding tax. In the first instance, the Luxembourg Lower Administrative Court (Tribunal administratif) rejected the DTA’s approach and ruled that the payment made to the Director constituted a reimbursement of advances made to Company X and did not qualify as a hidden distribution.
Findings of the Court
Firstly, the Court recalled that in application of Luxembourg tax law a hidden dividend distribution can only be recognised (i) when a shareholder, group member, or interested third party receives an advantage that should be analysed as an expenditure of income without adequate consideration, and (ii) that the shareholder, group member or interested party would not have been able to obtain in the absence of the shareholder link.
Secondly, the Court held that a person who is the ultimate economic beneficiary of a corporate structure, holding indirect rights in the company deemed making a hidden dividend distribution can meet the definition of “interested third party” for the purposes of establishing such hidden dividend distribution. The Court underlined that this criterion is not sufficient as such and the DTA must establish that the company has suffered a financial imbalance in order to exclude transactions that comply with the arm’s length principle. Further, the Court held that the burden of proof lies on the DTA to establish that a hidden dividend distribution has occurred and, to do so, it should outline a body of evidence that makes this distribution probable.
In the present case, the Court highlighted that the DTA must prove that (i) Company X has suffered a decrease or forgone an increase in its net assets and (ii) payments were made to a shareholder, member of the corporate group, or interested third party. The Court concluded that the DTA had not demonstrated that Company X had provided a financial advantage without consideration to the Director to its detriment.
Finally, with regard to the interest rate, the Court held that an interest rate is normally determined according to the financial strength of the borrower, the maturity of the loan, eventual guarantees, and rates applied on financial markets. Since the DTA had not provided any substantial analysis to demonstrate that a 3% rate was more appropriate than 8%, the Court rejected the DTA’s argument. In sum, the Court found that the DTA had not met its burden of proof in establishing a hidden dividend distribution had occurred and confirmed the first instance judgment.