The tax rules governing capital companies, and hence the rules for determining their operating result, are generally the same as those applicable to sole proprietorships and partnerships, with the exception of certain specific aspects that have to be taken into account.
Tax rules specific to capital companies
Recognition of transactions concluded with partners
For sole proprietorships, tax law defines all possible operations that may be carried out by the business manager with his business: when he pays himself a salary, the business manager is making a private withdrawal; when he sells a building to the business, he is making an additional contribution, etc.
Capital companies have a fiscal and legal personality and are therefore considered to be separate from the shareholder, with whom/which transactions can be concluded as with a third party. For this reason, a salary paid by the company to a shareholder for work performed in the business remains a salary, and the sale of a real estate asset by a partner to the company remains a sale.
Distinction between the creation of income and the use of income
As for sole proprietorships and partnerships, a distinction must be made between expenses incurred by the company to generate profits (deductible expenses) and expenses that require the use of income (non-deductible expenses).
The same applies to expenses and income relating to transactions concluded with partners, which must be incurred solely by the activities of the company. Failing this, said expenses and income cannot influence (reduce/increase) the company profits.
A distinction should be made between 2 cases, according to whether the book profit is abnormally reduced or artificially inflated as a result of transactions carried out with partners:
Hidden distribution of profits
When a partner directly or indirectly receives benefits from the company that would not normally have been received if the person were not a partner, the company suffers a loss of earnings or a reduction in its assets.
In such a situation, the transaction carried out must be replaced by the transaction that would have taken place if the partner had been a third party. The company has distributed a hidden dividend in the form of an unusual benefit granted to the partner.
The company sells a building worth 1,000 at a price of 800 to the shareholder; the purchase cost of the building was 400.
The sale is therefore deemed to have taken place at the price of 1,000 and not 800.
The tax gain therefore increases by 600 (1,000 - 400) and not only 400 (800 - 400).
The hidden dividend in this case equals 200 (600 - 400).
Hidden capital contributions
If one of the partners enabled the company to make a profit that it would not have made if the transaction had been carried out with a third party (debt write-off by the partner, transfer of assets at a price below the market price, etc.), the book profit must be reduced by the abnormally acquired benefit.
This benefit is then deemed to be an additional contribution to the company.
Contribution by a partner of a building worth 1,000 for a price of 600.
Hidden contribution = 1,000 - 600 = 400.
The building will appear on the tax balance sheet for 1,000, and the tax capital of the company will increase by 400.
The income from movable assets in the form of major holdings is exempt from tax under certain circumstances. This regime known as the parent subsidiary regime (formerly known as the 'SOPAFI' or 'SOPARFI' regime - Société de Participations Financières - holding company) aims to eliminate the double taxation of dividends (once at the level of the subsidiary and once at the level of the parent company).
Similarly, capital gains made on the sale of company securities, which are taxable in principle, may be exempt under certain conditions.
The tax treatment of dividends varies, with 3 possible options:
Full exemption of the dividend
Dividends received by a company benefit from full exemption if the following conditions are met:
- the parent company must be a capital company resident in Luxembourg or a Luxembourg permanent establishment of a capital company resident in a country covered by a tax agreement;
- the subsidiary must be an eligible holding, in other words:
- either a fully taxable capital company resident in Luxembourg;
- or an EU company covered by the parent/subsidiary directive (in short, a capital company);
- or a capital company established in a non-EU country with or without a tax agreement with Luxembourg, provided that it is subject to tax in that country which can be compared to the tax to which it would have been subject in Luxembourg. Tax is deemed to be comparable if the effective tax rate is at least 10.5 % (administrative practice, half of the corporate income tax rate);
- the securities must represent at least 10 % of the share capital of the subsidiary. However, the 10 % threshold is not enforced if the purchase cost of the holding is at least EUR 1.2 million;
- exemption will only be granted if the parent company holds or undertakes to hold the participating interest for an uninterrupted period of 12 months and if the percentage is respected during this period;
- income generated by equity holdings must be dividends or similar income (liquidation proceeds).
Partial exemption of 50 % of the gross dividend
Where the conditions for benefitting from full exemption are not satisfied, either because the percentage holding falls short or because the holding period of 12 months is not respected, the dividends will benefit from an exemption of 50 % of the gross amount of the dividend received, provided that the other conditions for full exemption are fulfilled. The dividends must therefore come from an eligible holding.
Full taxation of the dividend
Dividends that are neither fully nor partially exempt are fully taxable (example: dividends paid by non-eligible holdings such as companies established in a tax haven, etc.).
- SA1 has held a 15 % stake in a French subsidiary SA2 for 2 years.
=> The dividends received from SA2 are exempt in Luxembourg.
- SA1 bought a holding of 5 % in a non-EU company SA2 at a price of EUR 2 million. SA2 is taxable at a rate of 30 %. SA1 has held this stake for more than one year.
=> The dividends received from SA2 are exempt in Luxembourg.
- On 15 April 2005 SA1 acquires shares in a French company SA2. SA1 sells its SA2 shares on 30 June 2005 just after receiving dividends from SA2.
=> The dividends received from SA2 are 50 % exempt in Luxembourg.
- SA1 has held a 100 % stake in an Ivory Coast company SA2 for 5 years. SA2 is taxable at a rate of 5 %.
=> The dividends received from SA2 are fully taxable in Luxembourg.
- the parent company and the subsidiary must satisfy the same conditions in order to receive fully exempt dividends and the parent company must also hold at least 10 % of the share capital of the subsidiary or have acquired the subsidiary at a cost of at least EUR 6 million;
- exemption will only be granted if the parent company has held or undertakes to hold a significant stake for a period of at least 12 months. When the company sells its holding in stages, the condition concerning the holding duration must be respected with regard to a holding of 10 % or EUR 6 million.
Exceptionally taxable capital gains
In certain cases, capital gains that fulfil all the exemption conditions nevertheless remain taxable. Such is the case where excess expenses were incurred prior to the sale and reduced the tax amount in the past, or generated a loss carryforward for the company; the legislator will subject the gain to tax amounting to the excess expenses incurred in the past.
SA pays interest of 100 relating to its holding during financial years 1 and 2.
In year 3, SA sells its holding with a gain of 270.
170 of the capital gain will be exempt and 100 will be taxable (since the 100 has already been deducted from previous tax bases).
The consolidated profit regime: tax consolidation
Tax integration or consolidation is a tax regime whereby the subsidiary of a parent company is regarded as a simple permanent establishment in such as way as to offset the profits and losses of the two companies, even where they are two different taxpayers.
- the consolidating company must be a resident capital company or a Luxembourg permanent establishment of a non-resident capital company subject to a tax regime similar to the Luxembourg regime;
- the companies to be consolidated must all be fully taxable resident capital companies (the indirect holding of fully taxable resident capital companies through transparent companies preserves the possibility of benefiting from the tax consolidation regime). International tax consolidation is not possible;
- the consolidating company must hold at least 95 % of the capital of the subsidiary to be consolidated (this rate may be lowered to 75 % with the approval of the Minister of Finance. The holding must also be recognised as being particularly suitable for the economic development of the country);
- the companies to be consolidated must submit a request to the tax authorities. Consent is given for a minimum period of 5 years. Offsetting can only be carried out as from the date of approval.
SA1 holds 98 % of SA2.
SA1 makes a profit of 500 while SA2 records losses of 400.
The taxable consolidated profit is 100 (500 – 400).
Deduction of directors’ remuneration
The remuneration paid to directors for day-to-day management constitutes deductible salaries even if the director in question is also a partner in the company. Other income paid to them is called a percentage of profits (tantième) and is not deductible from the tax base of the company.
Deduction of financial expenses
The interest paid by the capital company on loans that it has taken out is in theory tax deductible. Deductibility is granted regardless of the type of lender (the interest paid to the lending bank is deductible, as is the interest paid on partners’ current accounts) or tax status (deduction is allowed whether the interest is paid to a fully taxable person or to a non-taxable person).
There is therefore a strong temptation for partners to opt to finance the company through current account advances rather than a capital contribution. The partner is remunerated in the form of interest which is deductible for the company rather than non-deductible dividends. If a partner (shareholder), via the loan he granted, receives benefits that he would not normally have received if he had not been a partner, the interest paid shall be reclassified as a hidden dividend distribution.
Tax law therefore penalises excessive rates where the rate exceeds the interest rate that a third party would have demanded in the same situation (only the excess is classified as a hidden dividend), as well as the excessive indebtedness of capital companies (the consequences of under-capitalisation are the reclassification of loan capital as owned capital and of interest paid on a loan amount deemed to be excessive as hidden dividends).
Note that as a general rule a debt ratio of 15 to 85 (15: owned capital, 85: debt) is acceptable where the company takes out a loan from the shareholder with regard to the acquisition of a holding.
No debt ratio has to be adhered to if the loan is granted by a third party, generally a bank.
Expenses relating to exempt dividends
Expenses relating to exempt income are not deductible. This rule implies that the interest paid on loans taken out to finance the acquisition of a holding is not deductible if the dividends received from the holding are partially or fully exempt.
However, this rule does not apply to the portion of interest exceeding the dividends received (excess expenses), so the excess part of the interest remains tax deductible.
SA1 has holdings in SA2, with the following income:
- year 1: dividends 100 and interest 50
- year 2: dividends 30 and interest 50.
Since the dividends are exempt from tax, the interest incurred in year 1 is not deductible. Interest in the amount of 20 is deductible in year 2. The calculation is carried out for each year separately.
=> Fully exempt dividends: the general rules apply.
=> Partially exempt dividends: note that the income received is taxable at 50 %. The expenses are therefore only 50 % deductible.
=> Fully taxable dividends: the expenses relating thereto are also fully deductible.