Tax Controversy: Trends And Developments In Luxembourg - Withholding Tax

Introduction

Domestic tax controversy, encompassing both (i) objections against assessments or hierarchical appeals against other individual decisions and (ii) subsequent appeals before the courts, continues to increase in volume. In 2022, for the first time, the administrative tribunal (first instance court competent for litigation on direct taxes) and the administrative court (appeal court) issued more than 200 judgments dealing with tax matters.

An analysis of the topics addressed shows both the prevalence of certain subjects and the extension of tax controversy to new areas. This increased volume, variety and complexity of tax controversy also implies longer procedures, which itself presents additional challenges.

Starting with an assessment of Luxembourg tax litigation statistics in Q1 2023, this article will then examine the core issues and conclude with commentary on certain developments in litigation strategies and procedures.

Overview of Volume of Litigation

In Q1 2023, the administrative tribunal issued nearly 50 judgments in tax matters. In appeal, the administrative court issued seven decisions.

It is striking that close to 25% of the cases in first instance were found to be inadmissible. This can be partly attributed to appeals on exchange of information brought by targeted taxpayers, which by now are consistently found inadmissible based on certain judgments of the Court of Justice of the European Union (CJEU). The CJEU requires member states to allow the holder of information to appeal an injunction to provide information, which the tax authorities then pass on to the tax authority of the requesting member state. However, it is not mandatory to grant such a right of appeal to the targeted taxpayer. Several cases were still pending while awaiting a ruling from the CJEU, and these are now being dismissed. This logically increases the inadmissibility rate.

However, it is important to note that there are other reasons why cases may be found inadmissible, such as failure to meet the appeal deadline or failure by the taxpayer to be properly represented in court. Such errors can have costly consequences, as the taxpayer loses its right to challenge the tax due. It is therefore important to seek proper advice before challenging a tax assessment or other decision of the tax authorities.

The ratio of cases won by the tax authorities is also striking: 55% of Q1 2023 cases. Combined with the inadmissible cases, this means the taxpayer only wins (at least in part) 20% of cases. While this statistic may appear to reinforce the administrative tribunal's perceived inclination towards siding with the tax authorities, another factor plays a role: taxpayers too often file appeals in cases that are likely to be unsuccessful. Excluding inadmissible cases, more than half of the cases seemed destined for defeat, based on the available facts and the tribunal's analysis.

Besides contributing to the tribunal's backlog and ensuing delays, this situation raises questions about the diligence of some taxpayers who, in some cases, fail to provide satisfactory evidence for their claims or try reversing the consequences of prior negligence.

The Key Topics in Luxembourg Tax Controversy

The following topics have dominated Luxembourg tax case law in recent months:

exchange of information;
guarantee call assessments (bulletins d'appel en garantie) against current or former legal representatives of companies failing to pay their taxes;
hidden distribution of profits and the special tax regime for the taxation of income from intellectual property (IP regime); and
a recent important judgment on the tax treatment of the repurchase and cancellation of a class of shares.

Withholding tax on proceeds from a repurchase and cancellation of a class of shares

As an alternative to dividends, taxpayers – notably in private equity structures – often resort to the repurchase and cancellation of a class of shares, which has traditionally been assimilated to a so-called "partial liquidation". Contrary to dividends, there is no withholding tax on liquidation proceeds. While that treatment is usually accepted by the tax authorities provided certain features are satisfied, such as implementing different economic rights for the various classes and implementing the classes from the outset (or promptly after incorporation), at least two cases in recent years led to a challenge.

In one of these cases, the tribunal issued in January 2023 a judgment finding that the repurchase of a class of shares should in principle trigger a capital gain for the shareholder and, as a result, the proceed should not be subject to withholding tax. However, this conclusion is subject to (i) the repurchase price being at arm's length and (ii) the transaction not being abusive.

The arm's length requirement is not surprising but is nonetheless likely to raise interesting questions on the valuation of the shares being repurchased. Taxpayers should pay attention to the drafting of the profit allocation provisions in the articles of association. In the case addressed by the tribunal, there were no different economic rights except in case of repurchase of an entire class of shares, meaning it can be questioned whether a third party would really purchase the shares (approximately 5% of the total share capital) at the maximum redemption price.

Because the tribunal seems to anticipate that part, if not most, of the redemption price should be reclassified as hidden dividend due to being in excess of the fair market value, the question of abuse was not addressed. A further case is pending and may provide additional guidance. The tribunal's approach at least suggests that repurchasing a share class rather than distributing a dividend is not necessarily abusive and can be justified.

Exchange of information

The volume of cases on exchange of information is not surprising given the regular use of both the EU directive on administrative cooperation in tax matters and the bilateral tax treaties by other jurisdictions, mostly EU member states.

When admissible, the cases revolve around the notion of the "foreseeable relevance" of the requested information. When the Luxembourg tax authorities receive a request to exchange information, they first need to verify (i) whether the information is foreseeably relevant in view of the tax purposes indicated by the requesting state and (ii) whether they already have the information. In practice, while the tax authorities pay lip service to that check, they appear to readily issue injunctions to the (potential) information holder to provide the information. It is this injunction that is then challenged in court, as the request from the foreign tax authority can only be challenged in the other state.

In many cases, the information holder fails to adequately justify the absence of foreseeable relevance. This is partly because Luxembourg courts are reluctant to address procedural or substantive foreign tax law issues. One recent appeal was successful: the tax authorities had wrongly considered that the recipient of the injunction could be considered the holder of the requested information.

Several taxpayers have tried arguing that, based on the wording of CJEU judgments, they would still have the possibility to challenge the injunction in their specific circumstances. The tribunal has so far consistently dismissed these appeals as inadmissible, raising questions about whether it employs an overly restrictive interpretation of CJEU case law. The current status quo is unsatisfactory in several respects, as it:

denies a right to appeal to the person most affected by the decision, effectively delegating that right to a person that does not have an obvious interest in appealing; and
discriminates between taxpayers depending on whether they exercise control over the holder of information (in which case they can de facto indirectly appeal through the holder of information) or do not control it.

Guarantee call assessments

The Luxembourg tax authorities are allowed to issue these bulletins d'appel en garantie to present or former legal representatives of a company who have committed a fault in the exercise of their functions by not ensuring that the company pays its due taxes. The termination of the mandate of a manager or director does not prevent the tax authorities from seeking payment from such person under a guarantee call assessment. Also, a manager may be held liable for failures to pay taxes that became due before the beginning of the manager's mandate. In such circumstances, the reproach is that the manager failed to remedy the issue once they had the power to do so.

Most of the appeals are predictably unsuccessful. This is partly due to the fact that the judgments in these cases often use similar wording. In many cases, the legal representative claims that they have not committed a fault, as the failure to pay the tax was due to external circumstances, such as the poor financial health of the company or the failure of other legal representatives to act. However, these arguments are usually rejected.

Where the failure to pay concerns wage withholding tax, it is often not possible to invoke the poor financial health of the company because the wage withholding tax is not a debt of the company per se but an amount to be paid on behalf of the employees. The argument furthermore loses credibility when net wages are paid to the employees, and it is solely the withholding tax that is not paid.

Finally, claiming that the tax authorities should rather go after other (ex-) representatives is also not a valid argument, as the procedure explicitly allows the tax authorities to issue guarantee call assessments to any of the representatives, provided that their choice respects the generic principles of appropriateness (Zweckmäßigkeit) and fairness (Billigkeit).

Hidden distributions

This type of case is linked to transfer pricing considerations and sometimes to claims of irregular accounting. These cases address situations where a company has given benefits to a shareholder or a related party which it would not have granted without the beneficiary having such status.

The types of undue benefits can be quite varied, eg:

expenses borne by the company on behalf of the shareholder(s) and the family thereof;
waiver of claims against the shareholder(s) or against other group companies controlled by the same shareholder; or
use of the company car by the shareholder(s) for private purposes.

A majority of these cases is lost by the taxpayer because they fail to rebut the body of evidence submitted by the tax authorities. The failure can arise from a lack of regular accounting and supporting accounting documentation, a failure to justify the commercial rationale of a transaction, or a lack of a proper transfer pricing study.

Application of the IP regime

The former Luxembourg IP regime, like other regimes in other EU member states, was quite generous: it exempted 80% of the net income from a wide range of IP assets and did not entail particular requirements regarding IP development taking place in Luxembourg. As a result, many groups (also domestic Luxembourg groups) resorted to this regime to reduce their tax base.

While a revamped and more restrictive regime has been introduced in line with changes made in the EU following the Organisation of Economic Cooperation and Development's BEPS Action 5 report on harmful tax regimes, litigation is still ongoing in relation to the old regime, which was phased out between 2016 and 2020.

This is a subject where taxpayers are particularly successful in appeal, even in first instance before the tribunal. This is because the tax authorities are said to be unfavourable to the regime and are therefore quick to challenge its application – be it in relation to the timing of the IP asset acquisition, the economic ownership of the IP, the classification of the income as a royalty, or the amount of royalties involved. Due to this tendency to challenge, the tax authorities' arguments occasionally go against the obvious, which explains the higher success rate of taxpayers in these cases.

Topics for the coming months

Upcoming cases include subjects such as:

The debt/equity qualification of financial instruments. The tax authorities seem to take inconsistent stances and the administrative court is expected to further reassert (and possibly refine) the qualification criteria laid down in existing case law. This topic is of key importance for the Luxembourg investment management industry.
Transfer pricing, including unilateral downward adjustments (eg, the imputation of interest on loans bearing no or very low interest, regardless of whether there is a corresponding inclusion of such imputed interest in the foreign tax base of the related lending company). The tax authorities have so far often limited their challenges to generic allegations of non-compliance with the arm's length principle without going in depth into transfer pricing studies and without proposing alternative pricing of intra-group transactions. One may expect the tax authorities to look further into the methodology choices of taxpayers, although they will probably continue not submitting alternative transfer pricing studies.
Foreign permanent establishment recognition. Luxembourg in principle exempts income allocable to a foreign permanent establishment of a Luxembourg tax resident company, where that permanent establishment is situated in a treaty country. The criteria for exempting the income from such a permanent establishment have become more stringent, and the tax authorities are now challenging certain exemptions claimed which do not meet all formal conditions.

Some Strategic Considerations and Trends

To pay or not to pay?

In Luxembourg, an objection and a subsequent appeal before the administrative jurisdictions is not suspensive. As a result, a question often asked is whether the tax must really be paid while an assessment is being litigated. The legal obligation to pay the tax due remains fully in force, unless the taxpayer has obtained from the tax office a payment suspension or payment deferral, both of which are unlikely.

When appealing before the tribunal, the taxpayer can also in parallel request a stay order from the president of the tribunal. For this, the taxpayer must show that their arguments have a reasonable chance of success and that enforcing the payment obligation would cause them severe and irreparable harm.

The president of the tribunal is strict in evaluating these criteria. However, in January 2023 a stay order was successfully granted to a taxpayer who had not demonstrated severe and irreparable harm. The position of the tax authorities was so unreasonable that the president found that the tax authorities could not hide behind formal requirements to maintain the enforceability of a decision that seemed so obviously questionable. It remains to be seen whether this landmark stay order can be invoked in other, less clear circumstances.

If a taxpayer has not obtained a suspension of the payment obligation, late payment interest will accrue at a rate of 0.6% per month. This cost needs to be balanced against (i) the significantly increasing cost of borrowing in case the taxpayer does not avail of sufficient cash and (ii) the risk of the tax authorities seeking to enforce the payment obligation by seizing (in principle Luxembourg-situated) assets.

Waiting for a director's decision

The mandatory first step to challenge a corporate tax assessment is filing an objection with the director of the tax authorities. When a decision which rejects the objection is issued, the taxpayer has three months to appeal such decision before the administrative tribunal. If no decision is issued within six months of filing the objection, the taxpayer is free to directly appeal the assessments before the tribunal without a time limit, as long as no decision has been adopted.

Due to the growing backlog at the director's level, more and more taxpayers choose to directly appeal after six to eight months without waiting for a director's decision. This approach saves time, particularly as the tribunal procedure itself has become more protracted:it is now common for taxpayers to wait 15 to 18 months for the oral hearing after the written phase (which takes five months from the filing of the appeal), followed by an additional three to nine months (or sometimes even longer) for a judgment.

There can be one downside of not waiting for the director's decision: if at any time the director does adopt a decision ruling on the objection, the appeal before the administrative tribunal becomes moot and, if the decision goes against the taxpayer, a whole new procedure needs to be started.

On the other hand, it seems filing an appeal can also spur the director to take a decision in favour of the taxpayer in cases which are likely to be lost by the tax authorities. In this situation, the tribunal procedure can be withdrawn further to the receipt of the decision and, normally, of revised tax assessments.

Taking out insurance

More litigation means more risks and also a new market for insurers and taxpayers wishing to reduce their exposure to potentially large tax bills. One can expect that brokers and insurers will look with increasing interest at Luxembourg, in view of the increasing volume and complexity of tax controversy cases.

Proposed changes to the procedure

A recent bill of law proposes several important changes which still need to be debated by parliament. These include:

introducing a 12-month limitation period to appeal before the tribunal if the director has not responded to the objection within the 6-month minimum period;
aligning the rules for appealing a decision (other than a tax assessment) in absence of response to a hierarchical appeal on the rules for appealing an assessment in absence of response to an objection – this would be a welcome change;
making the filing of objections subject to stricter formal requirements; and
limiting the taxpayers' rights to challenge ex officio assessments; ie, assessments which estimate the tax base of a taxpayer who has failed to file a tax return or to provide sufficiently reliable information to the tax authorities.

In summary, Luxembourg is no longer an outlier with few tax controversy cases. The numerous legislative changes in recent years and further changes due to be implemented (eg, Pillar Two rules) have heightened legal uncertainty, leading to an increase in litigation while the frequency of tax rulings has concurrently decreased.

In parallel to domestic tax litigation, some EU cases have been argued by Luxembourg resident taxpayers and/or Luxembourg itself, including cases on state aid and tax rulings and a case on the conformity of the publicity of information on the register of ultimate beneficial owners with the right to privacy protected by the Charter of Fundamental Rights of the EU. Consequently, tax controversy in Luxembourg extends beyond the borders of the Grand Duchy and can also have an impact across the EU.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Luxembourg: Tax Controversy: Trends And Developments In Luxembourg