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When a business has a financing requirement to meet, it may take out a loan to obtain the necessary funds. The loan may be obtained from its partners / shareholders, or from a third party entity.
When it repays the borrowed capital, the company also pays interest which may be deducted from its taxable amount, under certain conditions.
To establish whether this interest is deductible, the following must be considered:
- on the one hand, the type of lender:
- shareholders and management or;
- third parties (e.g. a bank);
- on the other hand, the legal form of the borrowing company:
In no case is the repayment of borrowed capital ever deductible.
Who is concerned
Any business, whether it is a sole proprietorship, a partnership or a capital company, may take out a loan (or seek financing by means of debt).
In principle, the business may deduct all interest paid to third parties.
However, the business may only deduct interest paid to its partners when the latter are separate from the company (in the case of capital companies) and subject to certain limits.
How to proceed
Loan taken out with a third party
The borrowing business, irrespective of its legal form, may deduct interest paid on borrowings from its taxable base to an unlimited extent (no ceiling), regardless of the rates of interest applied or the amounts borrowed, provided that the loan is granted by a third party, i.e. an economic agent other than a shareholder.
When a sole trader borrows privately on behalf of the business, the interest relating to these loans is regarded as payable as part of the business' interest, and not as part of the interest payable by the business manager in a personal capacity. It is therefore deductible from the business profit.
The deductibility of interest on loans taken out with third parties is unlimited, but with certain restrictions in the case of bonds and equity loans.
- simple bonds, which are transferable securities constituting long-term debt in respect of which the holder receives an annual fixed (or variable) rate of interest. The borrowing business may deduct interest paid in respect of simple bonds from its operating income;
In the case of "
deferred interest" simple bonds, meaning that interest is paid in full at the security's maturity date, the interest is not fully deductible at the date of the actual payment, but in tranches split over time.
- composite bonds, which include:
- bonds convertible into shares, which allow holders to eventually become shareholders of the company to which they have loaned money, according to the terms of the issuing contract (often a lower rate of interest, owing to the conversion rights).
The borrowing business may deduct the interest paid in respect of these bonds from its taxable base until they are converted into shares;
- participating bonds, which allow holders to obtain a share of the annual profit and/or the liquidation profit, and thus have a similar status to shares.
The ACD (Luxembourg Inland Revenue) treats these payments as a dividend distribution and applies withholding tax to both the variable interest (depending on the result) and any applicable fixed interest.
However, the borrowing business may deduct the portion of paid fixed interest from its taxable amount.
Equity loans allow the lender to be remunerated based on the business' profitability (a share in the profits and/or losses and possibly a fixed rate of interest).
The borrowing business may deduct interest paid from its taxable amount, as is the case for any loan.
However, the ACD also applies withholding tax to interest paid.
Loan taken out with partners / shareholders
Sole proprietorships / partnerships
Sole proprietorships and partnerships may not deduct loan interest paid to their partners from their taxable amount.
Indeed, owing to the difficulty in separating the business from the entrepreneur, the latter may not deduct the interest that he pays to himself from his taxable profit.
Interest paid by the business to its owner constitutes a private withdrawal and not expenses that are deductible from the business profit.
Capital companies may deduct loan interest paid to their partners from the taxable business profit.
The partner could therefore be tempted to opt to finance the company through loan capital rather than by way of a capital contribution, thus choosing to be remunerated through interest (deductible for the company) rather than in the form of dividends (non-deductible).
However, in order to prevent companies from seeking financing from loan capital alone in order to reduce their tax base, tax law sets certain limits.
Limits (capital companies)
A company that borrows from its partners must comply with certain limits in order to avoid excessive rates of interest and excessive debt relative to the capital contributions.
- Excessive interest: when the company pays its creditor-partner a rate of interest that exceeds the rate that would have been agreed upon in the terms and conditions prevailing between third parties, the ACD may deem this rate of interest to be excessive. It will reclassify the excessive portion of interest as hidden distribution of profits, for which the tax regime applicable will be that applicable to dividend distributions, even if the amount of debt is not in itself excessive;
Example: SA Lux has a capital of EUR 31,000. One of the partners grants a loan with an annual interest rate of 20%, while the market rate is 4%. =>16% is likely to be reclassified as a
hidden dividend distribution.
- Excessive debt: when a company has excessive borrowings relative to its equity capital with the aim of reducing its tax base as much as possible, the ACD may deem the company to be under-capitalised.
In general, the maximum accepted debt ratio is 15/85: the assets held must be at least 15% financed by equity and no more than 85% financed by debt.
The following are considered to be equity (own funds):
Above this ratio, the ACD may reclassify the excessive portion of debt as a hidden contribution and the interest remunerating that excessive part of the debt as a hidden distribution of profits.
- the paid-up share capital;
- the share premium;
- reserves and profit/loss carried forward.
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