Alphabet Shares in Luxembourg – Case Law Update

For many years, practitioners have advised and used the so-called “alphabet shares” mechanism in Luxembourg.

The position of the legal and tax practitioners was that it was possible to divide the share capital of a Luxembourg company in classes of shares as long as the guidelines laid down by the Luxembourg Tax Authorities (“LTA”) were respected: (i) limitation to ten different classes of shares (commonly A shares, B shares… until J shares), (ii) existence of the classes as from the inception of the company (or at least as from the first capital injection after incorporation) and (iii) different economic rights between the various classes.

The alphabet shares are offering to investors the flexibility to repatriate profits free from withholding tax by redeeming a full class of shares in ten different instances. Indeed, the implementation of alphabet shares allows the shareholders of the company to repatriate profits through a share class redemption. Such redemption is construed from a legal standpoint as a partial liquidation and is, from a tax standpoint, not subject to the withholding tax normally applicable to dividend distributions. In the silence of the law, the alphabet shares tax treatment was confirmed by advance tax agreements (the so-called “rulings”) and the practitioners kept following the rules set even after the end of the rulings (which were practically abolished further to the LuxLeaks scandal). However, the mechanism was in a grey area as it was not foreseen by law and no longer periodically confirmed by the rulings issued by the LTA.

In this context, the lower Administrative Court of Luxembourg issued an interesting judgment on January 27, 2023, in a case involving the purchase of an entire class of its own shares by a Luxembourg resident company, followed by their cancellation.

In the case at hand, a Luxembourg company had organised its share capital in ten different classes of shares (from A to J) in addition to one class of ordinary shares. The alphabet shares had been put in place after the incorporation of the company, had all the same economic features and were all held by a single shareholder. At some point, shortly after the realisation of its participation in a subsidiary (not being followed by the reinvestment of the proceeds of the sale), the company redeemed the entire class J to the profit of its sole shareholder for a price exceeding the nominal value of the shares. The company treated the redemption followed by the cancellation of the class J shares as a partial liquidation not subject to withholding tax in Luxembourg (as liquidation proceeds are not subject to such tax).

The LTA considered that the positive difference between the redemption price and the nominal value of the shares could not be considered as liquidation proceeds in the scope of a “partial liquidation” assimilated to a tax-exempted liquidation. The reason given was that the shares in each different class did not attract different economic rights. As a consequence, such allocation was re-characterised as a distribution and subject to 15% withholding tax. The taxpayer appealed to the Administrative Court

The Administrative Court reminded the existing possibilities for a company to repatriate proceeds to its shareholder(s): dividend distribution (subject to withholding tax), reduction of share capital (which requires economic justification for the withholding tax exemption) and partial liquidation (free of withholding tax) and the Court ruled that, in the case at stake, the redemption by the company of a full class of shares and its subsequent cancellation was to be construed as a partial liquidation (hence not subject to withholding tax).

However, given that the redemption price paid by the company was excessive compared to the number of shares redeemed, the Court considered that the said redemption price did not match the fair market value of the shares redeemed (i.e., the price a third party would have paid for these shares). The Court ruled that the qualification of hidden dividend distribution (subject to withholding tax) claimed by the LTA was justified but only for the part of the redemption price that exceeded the fair market value of the redeemed shares.

Although specific to this case and subject to appeal, this judgment has many merits, the main one being that it confirms that the alphabet share mechanism (share class redemption followed by its cancellation) must be construed as a partial liquidation and not as a profit distribution.

There are however a few blind spots remaining. The Administrative Court did not rule on how the fair market value of a class of shares shall be determined and in which situations there might be an abuse of law.

It is therefore recommended that Luxembourg companies willing to implement alphabet shares properly document them and assess the fair market value of the shares prior to the share redemption.