Luxembourg companies frequently structure their share capital as comprising ten classes of shares with the classes being named A to J, thus the term alphabet stock. The benefit of such a capital structure is that a payment made by the company to a holder or holders of an entire class following a redemption and cancellation of that class should not be treated as a dividend but rather as a payment pursuant to a partial liquidation of the company. Unlike dividends, partial liquidation payments are not subject to Luxembourg withholding tax, the default rate being 15 per cent of the amount of the payment. Typically the amount of the payment made on redemption is largely determined by reference to the amount of the net shareholder equity of the company.

The Luxembourg administrative tribunal issued a judgement on 27 January 2023 in relation to the tax treatment of a payment made pursuant to the redemption and cancellation of a class of shares. The matter was brought to the court by the Luxembourg company concerned in order to contest a decision taken by the tax authorities that the payment in this case should be subject to 15 per cent withholding tax. The shareholder in question was an entity incorporated in the Cayman Islands and thus the default rate of withholding tax applied.

The tribunal noted, in line with previous decisions, that the share redemption transaction would in principle be treated as a disposal of shares by the shareholder to the company and therefore the principal tax consequence would be whether the payment received resulted in a capital gain for the shareholder. The tribunal recognised that, from the perspective of the company, partial liquidation treatment could in certain circumstances be applied, and that it appeared to apply on the facts of the case. However, this would not prevent a court from examining whether the payment made should, given the particular circumstances, be treated as a hidden dividend payment to the extent that the amount paid was in excess of the market value of the shares being redeemed.

Certain factors appeared to lead the court to focus on the requirement that the amount paid for the shares should not exceed their market value. These factors appeared to be the following:

• The fact that each of the share classes could not be distinguished by reference to having different economic rights attached to them. It should be noted that the court did not accept the argument of the taxpayer that each class had different economic rights, due to the fact that each class was required to be redeemed in a particular order (namely a reverse order from J to A as is typically the case). At the moment of each sequential redemption, the redemption amount would necessarily be different.
• The fact that the shares were held by a single shareholder and the share classes were created at the same time and after incorporation.

While the court did not form a definitive view on the value of the share class in question and sent that particular aspect back to the tax authorities for them to determine, they appeared to lean to the view that, in this case at least, the value should reflect the proportion of nominal share capital represented by the share class.

One of the principal arguments raised by the tax authorities in arguing for hidden dividend treatment was that the use of alphabet shares in this instance was an abuse of law. Although some of the factors described above might typically be relevant to determining whether the use of share classes could be treated as abusive, the court chose not to deal with the abuse of law point given the decision taken on the hidden dividend and market value points.

It can be expected that this decision will be the subject of further analysis and comment in particular as to where the hidden dividend treatment might apply and to determining the market value of the shares being redeemed. It was unfortunate that the court did not express a view on the abuse of law point and so no doubt there will be ongoing speculation as to the merits of the arguments raised by the tax authorities.

It is worth noting that the judgement could be taken on appeal. The taxpayer has forty days from the date of the judgement to do so.