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Abuse of Law & Tax Losses: Luxembourg Case Law

A recent case law on anti-abuse is currently in the focus of attention of Luxembourg tax practitioners. Luxembourg tax law does not define the abuse of law and, until now, the rare case law in this respect was not providing for such definition.

A recent decision of the Luxembourg Administrative Court sets, for the first time, the criteria of the abuse of law and makes a very broad application of the concept. Taxand Luxembourg details the careful management of existing and new structures that will have to be performed in the light of these new criteria.

A group acquired from private investors a construction company (LuxCo 2), via a Luxembourg holding company (LuxCo 1). LuxCo 1 received some debt financing from the group and lent on part of the monies to LuxCo 2. In 1995, the initial private investors decided to buy back their investment. LuxCo 2 was at that time incurring considerable losses. The group sold the shares and receivable on LuxCo 1 for the counterpart of two Swiss Francs: one Franc as a consideration for the shares and one Franc as a consideration for the receivable. Shortly after this transaction, LuxCo 1 booked a full depreciation on its receivable in LuxCo 2.The courts (Cour administrative "CA" 7 February 2013, 31230C confirming Tribunal administratif "TA", 12 July 2012, 28815) alleged that the structure was abusive: LuxCo 2 was keeping on its balance sheet a liability deprived of economic reality for the sole purpose of enjoying the carry forward of tax losses. As a result, the liability had to be disregarded for tax purposes and the taxpayer had to be denied the right to carry forward its losses.

In the case at hand, the tax authorities, the TA and the CA each concluded that the structure was abusive, but on different grounds. The tax authorities and the TA found an abuse but failed in using the proper arguments. The CA reframed the legal disputes, defined the criteria of an abuse of law, and analysed step by step if the conditions were met in the case at hand. An operation is to be characterised as an abuse of law if four conditions are met:

A use of forms or of institutions offered by private law

  1. A reduction in the tax burden
  2. An inappropriate "path"
  3. The absence of valid non-tax reasons justifying the path chosen

In its judgement, the CA occasionally combines 3) and 4) but for the purpose of this article we have kept them separate.

As to the first condition, the CA considered that the purchase agreement and the application of accounting rules qualify as a use of forms offered by private law.

As to the second condition, the CA considered that keeping the liability on its balance sheet enabled LuxCo 2 to maintain the carried forward losses so as to offset them against future profits. According to the CA, this qualifies as a reduction in the tax burden.

The CA mainly elaborated on the third condition: the CA concluded that an inappropriate path was chosen, but on different arguments than those of the tax authorities and of the TA.

The tax authorities initially suspected the abuse focusing on the negligible consideration paid for the acquisition of the receivable on LuxCo 1. They considered that the purchase was actually hiding an indirect debt waiver from the private investors to LuxCo 2 via LuxCo 1. The CA rejected these: a transaction should not be considered as per se suspicious because of a low consideration. The CA even considered that purchasing for a negligible price was the proper attitude of a diligent acquirer, willing to avoid that a third party debtor would recover its claims and jeopardise the future of the acquired companies.

It is also worth noting that in the first instance (TA), the dispute was on transfer pricing matters. The TA qualified the operation as abusive, considering that the transaction wasn't concluded at arm's length. Doing so, the TA erred in law. Luxembourg tax law provides for specific transfer pricing provisions and for a specific anti-abuse provision. An operation should not be considered as abusive solely because of a violation in transfer pricing requirements.

In the CA, the representative of the government argued as follows. The private investors initially sold their investment and repurchased it a few years later with a huge loss, and for a negligible consideration. The transaction was, according to him, not in line with usual business practices (that are profit-driven), and as such was suspicious by nature. Among other arguments, he also noted that other group companies waived their respective receivables over LuxCo 2. LuxCo 1 booked a full depreciation on the receivable from LuxCo 2. LuxCo 1 was therefore considering the receivable as doubtful. In such context, according to the representative of the government, it did not make sense to keep the liability on LuxCo 2's balance sheet. These facts might have influenced the decision of the CA but the CA issued its decision on different grounds.

The CA noted the following facts at LuxCo 1's level: the receivable on LuxCo 2 was booked with a full depreciation. Its own liability was booked at nominal value. At LuxCo 2's level, the liability was still on the balance sheet at nominal value. A company is, in principle, required to book a liability, without having regard to depreciations booked by its creditors. However, none of the creditors (the private investors, LuxCo 1) ever asked for a repayment, even when LuxCo 2 subsequently realised profits, 4, 5, 6 and 7 years later. Further, LuxCo 2 never charged interest on the loan to LuxCo 1. The combination of each of these factual elements revealed that the private investors actually did not intend to recover their monies under the loan financing. Any other diligent creditor would have written off its receivable. An inappropriate path was therefore chosen according to the CA.

As to the fourth condition, the taxpayer argued the existence of non-tax reasons: a creditor is free to grant a debt waiver or not, and the managers of LuxCo 1 might have to assume personal liability if they had waived the debt. These arguments were dismissed by the CA, considering that the final creditors (ie the private investors) controlled the structure. As a result, according to the CA, the sole explanation for not waiving the debt was a fiscal one. The private investors wanted to avoid exceptional profits at the level of LuxCo 2 that would have been generated by a write off. The CA concluded that there was an abuse of law within the meaning of paragraph 6 of the Tax Adaptation Law.

Your Taxand contact for further queries is:
Keith O'Donnell
T. +352 26 940 257


Taxand's Take

We have split our comments into two parts; first the general principles set down by the CA, and second the application of those conditions to the facts.

1) The definition of the four conditions seems sensible and broadly in line with international principles. Two comments can be made nonetheless.

The third condition, ie inappropriate path, will need clarification as it risks creating a circular logic. There is also a clarification needed as to the burden of proof for this condition.

The fourth condition, ie absence of valid non-tax reasons echoes similar judgements internationally. However, it seems to require that the non-tax reasons justify the path chosen as opposed to the scheme not being wholly artificial which seems like a higher burden of proof on the taxpayer than in Cadbury Schweppes for example. It will be interesting to see whether this condition would stand up to EU scrutiny, in a cross-border EU context.

2) As to the application of these conditions to the facts of the case, it seems to us very hard to arrive at the conclusion of the CA. There was a clear non-tax transaction which the CA accepted (thankfully overturning a bizarre finding of the lower TA). The CA, however, seemed to conclude that what would in normal commercial circumstances be a perfectly standard choice of treatment, ie maintaining an intercompany receivable rather than waiving it, had insufficient valid non-tax reasons. In our experience, it is exactly the opposite: the waiver is the more complex and less natural transaction which usually requires more justification commercially prior to proceeding.

The CA, therefore, seems to postulate that a taxpayer is required to carry out an operation (loan waiver), which is legally and commercially questionable, in order to eliminate a tax advantage (loss carry forward) which has been legitimately and commercially obtained. To our knowledge such a finding is quite unpredictable internationally. Thus, as a preliminary conclusion, we could say that having established a sensible set of general conditions, the CA's finding on the facts is likely to create uncertainty for taxpayers going forward. It will be important to review existing and planned structures to ensure that this dimension is adequately managed.

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Taxand's Take Author

Keith O'Donnell
Taxand Board member & Taxand global real estate tax service line leader