Summary of the Position Paper: Classification of Interest-free loans (“IFLs”) for Luxembourg tax purposes

You can download the full document here https://www.l3a.lu/positionpaper

Should interest-free loans be classified as equity or debt?

Decisions by Luxembourg’s Administrative Tribunal in two cases since 2022 that interest-free loans (IFLs) should be classified as equity rather than debt instruments have resulted in legal uncertainty regarding the treatment of IFLs, which are a common feature of many alternative investment structures in the Grand-Duchy.

These developments have prompted the L3A to issue a position paper clarifying the legal and tax implications of IFLs, and analysing the features of financial instruments to be considered when classifying them as either debt or equity.

IFLs are generally classified as debt instruments unless they have specific features that lead them to be treated as equity instruments. However, in a September 2022 ruling concerning an IFL granted by a Luxembourg company to its wholly owned subsidiary in the grand duchy, the Administrative Tribunal held that this particular IFL was an equity instrument, upholding a challenge by the country’s Direct Taxation Authority to its classification as debt.

The decision prompted considerable uncertainty among investors and tax advisers, although in November 2023 the tribunal’s decision was overturned by Luxembourg’s Administrative Court, which ruled that the IFL should be classified as a debt instrument. However, in May 2024 the tribunal delivered a decision in another case in which it again confirmed the reclassification of an IFL as an equity instrument in line with the position of the tax authority.

Therefore, it is necessary to analyse all relevant features of a financing instrument and determine the overall character of the instrument as either debt or equity. 

The criteria to decide whether an instrument should be classified as debt or equity include, for a debt obligation, that the holder is entitled to the return of its investment after a predetermined period; it carries a predetermined fixed return independent of the issuer’s financial performance; and the investor ranks above shareholders in the event of liquidation or bankruptcy.

By contrast, equity fully exposes the investor to the risk of the business, including losses, entitles the holder to receive part of any liquidation surplus, and grants the shareholder rights including voting and supervision.

The right of repayment after a specified period of time is characteristic of a debt obligation, whereas a permanent commitment of funds is an equity feature, although a long-term fixed maturity (30 years and above under German case law) may also indicate that the instrument should be classified as equity. In addition, the ability to convert debt into shares at the borrower’s request, or their right to request early repayment or redemption, may also be indicative of equity.

No single criterion is decisive in assessing classification of a financing instrument as debt or equity; it should be based on the instrument’s overall characteristics, but not all are equally important. While some characteristics provide clear-cut debt or equity indications, other may be less binary, although they can still inform the analysis.

The presence of both equity and debt features can make classification of financing instruments a more delicate exercise, and in such cases the parties may seek to align some of the features with the desired classification for Luxembourg tax purposes.

To determine the classification an IFL requires analysing its terms and conditions. By definition, it does not accrue interest and it is not necessary to define modalities of interest payments – an equity feature. Its maturity should be consistent with the financing horizon; a maturity of 10 years is common, although if it is unclear how long the IFL should be in place, a slightly longer maturity may be advisable to avoid the need for subsequent amendment of the legal documentation.

An IFL generally does not provide the lender with the right to participate in liquidation proceeds or latent capital gains, or in the borrower’s losses, which would indicate an equity instrument. Nor does it generally provide the lender with political or voting rights, also considered equity features.

An IFL is generally unsecured, but it should rank higher than share capital, share premium and other equity contributions. In the event of default upon maturity, IFLs often stipulate that they would become interest-bearing, which may be regarded as a debt feature. By contrast, it is not standard practice for an IFL to include a stapling clause, which would indicate an equity instrument.

An IFL's key equity feature is its interest-free nature, but other factors to be taken into consideration may strongly indicate classification as debt. Ultimately, the classification of IFLs as either debt or equity instruments must be determined on a case-by-case basis. However, for an IFL to be classified as equity for Luxembourg tax purposes, it must have several equity features in addition to the interest-free nature of the loan (which is not a typical situation in practice).

Written by VitalBriefing

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