On June 6 2025, the Luxembourg Administrative Tribunal issued a decision that underscores the interplay between hidden capital contributions, profit distributions, and the arm’s-length principle.
The players
Company AA was wholly owned by company AA1 and held a significant stake in subsidiary BB. Company AA granted a loan to subsidiary BB bearing an interest rate of 12%. The loan was financed by bonds issued to company AA1, with interest rates influenced by several factors, including the interest rate on the loan receivable.
As a result of financial difficulties faced by subsidiary BB, the loan receivable was refinanced, and two contracts were entered into:
A ‘settlement agreement’ that acknowledged reduced interest payouts for the past year; and
A ‘facility agreement’ introducing a lowered interest rate of 6% going forward.
Hidden capital contribution
Because the taxpayer did not produce any convincing evidence (e.g., no transfer pricing report) that the reduced rate was in line with the arm’s-length principle, the tribunal considered that the settlement agreement should be viewed as a ‘taxable’ hidden capital contribution. This means that AA should report all the interest earned at a rate of 12%, and then consider half of this interest as a contribution back to its subsidiary, BB.
While the 12% interest rate and the margin left at company AA were not challenged, the fact that a portion of the interest income was waived through the settlement agreement led to it being viewed as a hidden capital contribution. This is because the waiver:
Increased the net invested assets of subsidiary BB by reducing its liabilities and increasing its commercial income;
Was motivated by the shareholder relationship; and
Was granted without adequate consideration.
Even if subsidiary BB was experiencing financial difficulties and company AA had an economic interest in granting the waiver to preserve its investment, the taxpayer did not demonstrate that the consideration was at least equivalent to waiving 50% of the interest income, nor did it substantiate that it was in line with the arm’s-length principle such that a third-party creditor would have accepted it.
Hidden dividend distribution
Company AA was also not allowed to deduct the increase of the interest rate on the bonds issued to company AA1 from 11.85% (arm’s-length rate in the transfer pricing report) to a higher amount. This was again found not to be in line with the arm’s-length principle as even a moderately diligent manager would not have granted such additional remuneration to a third party.
The tribunal recharacterised such an increase as a hidden dividend distribution; i.e., a transaction where, among others, a shareholder directly or indirectly receives benefits from a company and the shareholder would not have benefited from such benefits but for the shareholding relationship.
The tribunal also made it clear that the 12% rate on company BB’s loan remains the only arm’s-length rate corroborated by tangible elements, preventing any adjustment of the 11.85% rate on the bonds issued to company AA1. It was determined that the contentious amounts originated from the company’s own accounting and fiscal documentation. Without additional evidence, the tribunal decided that company AA could not successfully challenge the existence of an advantage granted to company AA1 through an increased interest rate.
Key takeaway
The case of company AA highlights the need for robust evidence – particularly transfer pricing documentation – to validate the remuneration on financial transactions under the arm’s-length principle. This decision serves as a potent reminder: multinational corporations should thoroughly document and substantiate financial agreements within their corporate structures, ensuring they align with established transfer pricing and corporate tax principles.
