On 27 January 2023, the Luxembourg low-tier administrative court (Tribunal Administratif) issued an interesting ruling on many levels, and greater emphasis should be put on the tax treatment of alphabet shares.

A reminder of the basic facts would be necessary here: a Luxembourg private limited company (hereafter, the Company) proceeded in 2014 to a share buy-back and further cancellation (within 4 weeks) of the entire shares of a given class of shares. It is worth noting that:

  • the entire shares of the Company were held by a single shareholder, an entity based in the Cayman Islands;
  • the implementation of the alphabet shares mechanism occurred post-incorporation of the Company (in 2013);
  • each class of alphabet shares carried the same legal features, but redemption was to be made in reverse alphabetical order as per the Company’s articles;
  • the share capital of the Company was composed of 12,500 ordinary shares and 10 classes of alphabet shares, each class being composed of 1,425 shares having a nominal value of EUR 1. Therefore, each class represented slightly more than 5% of the share capital.

Now that we have set the scene, let’s go to the issue at stake.

Having proceeded to the redemption of the Class J shares followed by their cancellation (the exact price is not disclosed but seems to follow the rules provided by the Company’s articles and in practice is more or less equal to the amount of cash available to the Company) and given the facts and circumstances described above, the Luxembourg tax authorities considered that the corresponding payment by the Company to its shareholder should be treated entirely as a dividend distribution, in which case a 15% withholding tax would be due.

Conversely, the Company claimed that such operation should actually be analyzed as a disposal by the shareholder, irrespective of the further cancellation of the shares, in application of a ruling by the Administrative Court (Cour Administrative) dated 23 November 2017 (number 39193C).

The use of alphabet shares is a mechanism well-known to reward shareholders as a reliable alternative to dividend distribution, along full shareholder withdrawal or share capital depreciation or share capital reduction.

The decision actually provides a helpful reminder of the global tax treatment of the different mechanisms set out under articles 97, 100 and 101 of Luxembourg income tax law (LITL).

A first angle for the Luxembourg tax authorities was to consider that, given the implementation process of the alphabet shares as well the absence of distinctive legal features other than reverse alphabetical features, the operation could not be qualified as a partial liquidation under article 101 LITL.

Therefore, the Luxembourg tax authorities would then conclude that the redemption of the shares followed by the immediate cancellation of those shares was an undue way to circumvent the appropriate way to reward the shareholder, which would have been according to the authorities either through an ordinary dividend distribution or share capital reduction.

And of course, the existence of an abuse of law could then justify that the tax treatment applicable to (hidden) dividend distribution would then be substituted to the capital gain qualification by the taxpayer.

However, the Tribunal Administratif took another position, which follows the 2017 ruling referred to above: the acquisition by a company of its own shares from one of its shareholders must be treated as a disposal from the perspective of the latter and therefore the dividend withholding tax has to be ruled out. Based on the Tribunal Administratif’s arguments, the qualification as “disposal” would apply irrespective of the terms and conditions of the alphabet shares, i.e. the presence (or absence) of specific legal and economic terms attached to each class of shares or time of implementation.

Indeed, one of the conclusions from the Tribunal Administratif here, following the Court’s 2017 ruling is that whenever the substance of the participation is altered and/or when the beneficiary loses ownership of the asset which generates the income, then the transaction has to be qualified as a disposal, and the relevant income thereof should be qualified as a gain. And the circumstance that the shares are then self-owned by the Company and immediately cancelled and/or the fact there is a single shareholder does not change that qualification.

Notwithstanding the above, the legal and economic features of each class of shares will play a key role in probably the biggest issue at stake: the valuation of the redemption price.

The 2017 decision already ruled that redemption of shares was an acceptable practice, provided that the redemption price was set at arm’s length terms.

The same conclusion is drawn by the Tribunal Administratif in its decision here: the valuation of the proper market value of the redemption price will set the threshold above which the 15% withholding tax will apply. Indeed, any amount paid in excess of an arm’s length price will then be considered a hidden dividend distribution.

The Tribunal Administratif, unfortunately, does not give any guidance on how the appropriate (market) price should be determined, even though it gives an interesting element: the mere inclusion of reverse alphabetical order does not per se justify that the first redeemed class sweeps the entire (net asset) value of the company. So then comes another question: how can the redemption of 5% of the issued shares justify catching more than 5% of the company’s value? In practice, the use of tracking shares (i.e. tracking a specific underlying asset or income) or actual differentiated economic rights for each class may solve that issue. Further guidance and confirmation by the tax authorities or the Court would help in this respect.

As a conclusion, this decision has to be welcomed as it validates the alphabet shares mechanism. Taxpayers should however be able to justify the redemption price and value of the shares redeemed.

If you require additional information, please don’t hesitate to contact our tax team.