Introduction
Luxembourg, a small but economically vibrant country in the heart of Europe, is known for its favorable business environment and robust financial sector. For businesses operating in Luxembourg, understanding the rules and regulations governing taxation is crucial.
Taxation Rules for Luxembourg Capital Companies
Luxembourg’s taxation rules for capital companies (Sàrl or limited liability company, société anonyme or public limited company), including corporations and similar entities, largely mirror those that apply to individual businesses and partnerships. However, there are certain specificities unique to capital companies that necessitate a closer look.
Recognition of Transactions with Shareholders
In the case of individual businesses, Luxembourg tax law defines various types of transactions that a business owner can undertake with their own enterprise. These transactions include drawing a salary, making private withdrawals, or transferring real estate to the business, which results in a supplementary contribution.
Capital companies, on the other hand, possess a distinct legal and tax identity, treating shareholders as separate entities with which they can engage in contracts, much like they would with third parties. Consequently, salaries paid by the company to its shareholders for their work within the company are considered regular salaries, and the sale of real estate from a shareholder to the company remains a bona fide sale.
Distinguishing between Income-Generating Expenses and Income-Utilizing Expenses
Similar to individual businesses and partnerships, capital companies must differentiate between expenses incurred to generate profits (deductible expenses) and expenses constituting the use of income (non-deductible expenses).
This distinction also applies to charges and revenues related to transactions with shareholders, which must be exclusively linked to the company’s activities to influence the company’s profits positively or negatively.
Two scenarios arise when a company’s accounting profit is either artificially diminished or inflated due to transactions with shareholders:
Hidden Distributions of Profits
When a shareholder directly or indirectly receives benefits from the company that they would not have received if they were not a shareholder, the company experiences either a loss of potential earnings or a decrease in its net worth. In such cases, the actual transaction is replaced with what would have occurred had the shareholder been a third party. The company is then deemed to have distributed an undisclosed dividend equal to the abnormal advantage granted to the shareholder.
Hidden Capital Contributions
If one of the shareholders enables the company to realize a profit that it would not have otherwise obtained in transactions with third parties (e.g., waiving a debt, transferring an asset at a price below the market value), the accounting profit must be reduced by the abnormally acquired advantage. This advantage is treated as an additional capital contribution to the company.
Operating Revenues
Under certain conditions, significant capital gains from holdings can be tax-exempt in Luxembourg. This regime, known as the “parent-subsidiary” regime (also used under SOPARFI regime: “Société de Participation Financière“, the Luxembourg holding company), aims to eliminate economic double taxation of dividends, which would occur both at the subsidiary and parent company levels.
Similarly, capital gains realized from the sale of corporate shares, which are generally taxable, can be exempted under specific conditions.
Taxation of Dividends
The tax treatment of dividends in Luxembourg is variable and can be categorized into three main scenarios:
Full Exemption of Dividends
Dividends received by a company can be fully exempted if the following conditions are met:
- The parent company must be a resident capital company or a Luxembourg-based permanent establishment of a resident capital company in a convention country.
- The subsidiary company must be an eligible participation, which means it is either a fully taxable resident capital company, a European Union company covered by the parent-subsidiary directive, or a capital company established in a treaty or non-treaty third-country jurisdiction, subject to taxation comparable to that in Luxembourg (considered comparable if the effective tax rate is at least 10.5%, as per administrative practice, half of the corporate income tax rate).
- The shareholding must represent at least 10% of the subsidiary’s share capital. However, this 10% threshold is not required if the acquisition cost of the participation is at least 1.2 million euros.
- The exemption is granted as long as the parent company holds or commits to hold the participation continuously for a period of 12 months, and the percentage remains intact during that period.
- The income generated from the shareholdings must consist of dividends or similar products (liquidation proceeds).
Partial Exemption of 50% of Gross Dividends
When the conditions for full exemption are not met, either due to a lack of the required percentage of shareholding or the failure to meet the 12-month holding requirement, dividends can benefit from a partial exemption equal to 50% of the gross dividend amount. This exemption is contingent on all other conditions for full exemption being met. Therefore, the dividends must originate from an eligible participation.
Full Taxation of Dividends
Dividends that do not qualify for full or partial exemption are subject to full taxation. An example of this scenario is dividends paid by non-eligible holdings such as companies established in tax havens.
Capital Gains Taxation
To benefit from exemption, certain conditions must be met:
- Both the parent company and the subsidiary must meet the same conditions as those for receiving fully tax-exempt dividends, with the exception that the parent company must hold at least 10% of the subsidiary’s share capital or have acquired the subsidiary for a minimum acquisition cost of 6 million euros.
- The exemption is granted on the condition that the parent company holds or commits to hold a significant participation for a period of at least 12 months. In cases where the company disposes of its participation in stages, compliance with the holding period requirement for a 10% share or 6 million euros is sufficient.
Exceptionally Taxable Capital Gains
In certain instances, capital gains that would otherwise meet all the conditions for exemption may still be subject to taxation. One such situation arises when there were excessive charges incurred before the sale, which reduced the tax base in the past or led to loss carryovers for the company. In such cases, the legislator will subject the capital gain to tax up to the amount of the excess charges incurred in the past.
Consolidated Profit Regime: Tax Integration
Tax integration or consolidation is a fiscal regime where a subsidiary of a parent company is treated as a mere permanent establishment, allowing for the offsetting of profits and losses between the two entities, even though they are separate taxpayers.
The conditions for this regime are as follows:
- The consolidating company must be a resident capital company or a Luxembourg-based permanent establishment of a non-resident capital company subject to a tax regime comparable to the Luxembourg system.
- All companies to be consolidated must be fully taxable resident capital companies (the indirect ownership of fully taxable resident capital companies through transparent entities preserves eligibility for tax integration). International tax consolidation is not possible.
- The consolidating company must hold at least 95% of the subsidiary’s share capital. This threshold can be lowered to 75%, subject to the positive opinion of the Minister of Finance. The participation must also be recognized as particularly conducive to the country’s economic development.
- Companies to be consolidated must apply to the tax authorities. Approval is granted for a minimum period of 5 years, and consolidation effects only apply from the date of approval.
Operating Expenses
Deductibility of Executive Compensation
Remuneration paid to directors for their day-to-day management duties constitutes deductible salaries, even if the director is also a shareholder of the company. Other payments made to directors, referred to as “tantièmes,” are not deductible from the company’s taxable base.
Deductibility of Financial Charges
Interest Payments
Interest payments made by capital companies for loans they have taken out are generally deductible from their taxable base. Deductibility is automatic, regardless of the lender’s status (interest paid to a lending bank is deductible, as are interest payments on shareholder current accounts), or their fiscal status (deduction applies whether interest is paid to a fully taxable or non-taxable person).
However, a shareholder may be tempted to finance the company by providing loans with interest instead of capital injections. This allows the shareholder to receive remuneration in the form of deductible interest for the company, rather than non-deductible dividends. If the shareholder, through the loan extended, receives benefits that they would not have typically obtained if they were not shareholders, the interest payments may be reclassified as hidden dividend distributions.
The tax authorities will scrutinize excessively high interest rates, reclassifying any interest rate that exceeds what a third party would have demanded in the same situation as a hidden dividend. Similarly, excessive indebtedness of capital companies may be subject to scrutiny (the consequences of undercapitalization involve reclassifying borrowed funds as equity and designating interest paid on the excess amount of the loan as hidden dividends).
As a general rule, a debt-to-equity ratio of 15 to 85 (15: equity, 85: debt) is acceptable when a company borrows from its shareholders to acquire a participation. No specific debt-to-equity ratio needs to be adhered to if the loan is provided by a third party, typically a bank.
Charges Related to Exempted Dividends
Expenses related to exempted income are not deductible. This rule implies that interest payments on loans taken to finance the acquisition of a participation are not deductible if the dividends received from that participation are partially or fully exempted.
However, an exception is made for interest exceeding the amount of dividends received (excessive charges). In such cases, the excess portion of the interest remains deductible from the taxable base.
- Fully Exempted Dividends: General rules apply.
- Partially Exempted Dividends: It should be noted that the received income is 50% taxable. Therefore, charges are non-deductible only to the extent of 50%.
- Fully Taxable Dividends: Charges related to these dividends are fully deductible.
In conclusion, understanding the tax rules and regulations governing Luxembourg capital companies is essential for effective financial management and compliance. The specificities related to transactions with shareholders, taxation of dividends, capital gains, and deductions of expenses are key areas where careful consideration is required. By adhering to these rules, companies can optimize their tax positions while remaining in compliance with Luxembourg’s tax laws.
To register your Luxembourg company (Sàrl/limited liability company or SA/public limited company or else), or your Luxembourg holding company, please contact your Damalion expert.
