Recent Luxembourg case law on the commercial activity of partnerships: between clarifications and interrogations (Part 2)

In continuation of the first part of our article on the decision of the Luxembourg Administrative Court of 8 February 2018 (the "Court") covering the commercial activity of a partnership from a Luxembourg tax perspective, this second part of the article focuses on the application of the double tax treaty between Germany and Luxembourg, as applied at the date of the case (the "Treaty"), with respect to the income or gains received by a partnership.

Background

In 2006, an individual, resident in Germany (the "Plaintiff") subscribed shares into a German limited partnership (GmbH & Co.KG[1] - the "Partnership") which acquired an asset-linked note (the "ALN"). The general partner of the Partnership was a German corporate entity (GmbH[2] - the "GP"). Due to the poor performances of the underlying assets and significant interest payments due by the Partnership under the loan which financed the acquisition of the ALN, the ALN was sold before its maturity and the proceeds (including a portion of accrued interest and a capital gain - the ("Proceeds")) for the purposes of reimbursing part of the shareholders' investments.

In the meantime, the Plaintiff became a Luxembourg resident for tax purposes and did not include the Proceeds received from the Partnership in his taxable basis. In consequence of an automatic exchange of information between the German and Luxembourg tax authorities, the Luxembourg tax authorities were informed of the income received by the Plaintiff and reassessed his taxable basis to include the Proceeds taxing the income accordingly.

The Plaintiff challenged this reassessment with the director of the Luxembourg tax administration (the "Director") on the grounds that such proceeds should qualify as business profits and consequently it was necessary to take into consideration the losses incurred by the Partnership pro rata to his participation therein. The Director confirmed that the Proceeds qualified as income from movable property and capital gains and not as business profits since the Partnership did not carry out a commercial activity. As the decision of the Director was partially overruled by the Luxembourg Administrative Tribunal, the Luxembourg government lodged an appeal with the Administrative Court.

Decision of the Administrative Court

As a preliminary step, the Court confirmed the tax transparency of the Partnership from a Luxembourg tax perspective. In consequence, the Plaintiff was to be taxable in Luxembourg, pro rata to his share in the Partnership, on any net income or gain deriving from the Partnership, subject to the relevant provisions of the Treaty.

The next step involved the Court determining which provision of the Treaty should apply, and notably whether article 5 (1) of the Treaty regarding business profit was relevant. Due to the Treaty being based on a model before 1963[3], the term "profits from a commercial enterprise" was not defined. As a result and according to article 2 of the Treaty, the Court decided to refer the matter to domestic law in order to interpret the term.

From a Luxembourg tax perspective, the Court ruled that the Partnership had carried out a "deemed commercial activity" according to article 14 paragraph 4 of the Luxembourg Income Tax Law (refer to the first part of this article). Although the Luxembourg tax legislation was initially based on German legislation, the Partnership was not considered as exercising a deemed commercial activity from a German tax perspective since one condition was missing (the legislation of each country was amended and divergences appeared between both countries over the time). The question was thus whether a deemed commercial activity should fall within the scope of article 5 (1) of the Treaty. To answer this question, the Court referred to a German case law[4] which clearly excludes "deemed commercial income" from the definition of business profits for the purposes of the German/USA double tax treaty on the grounds that only income from real commercial activities should fall within the scope of the provisions of the treaty relating to business profits. Given that Luxembourg and German legal concepts are relatively similar, the Court decided to follow the approach taken by the German courts and considered that article 14 (3) relating to interest and article 16 relating to other income were applicable for the purposes of the Treaty. Furthermore, the Court pointed out that a diverging interpretation of the provisions of the Treaty (i.e. business profit from a Luxembourg perspective and interest/other income from a German perspective) would be contrary to the purpose of  the Treaty.

Despite the non-applicability of the deemed commerciality theory for double tax treaty purposes, the Court highlighted that the qualification of the income/gains chosen for the purposes of the Treaty was only relevant when determining the taxing rights between two countries but did not affect the qualification of the income/gains for domestic tax purposes. As a result, the Court considered that the income/gains realised by the Plaintiff qualified as "business profits" for Luxembourg tax purposes and should be taxed accordingly.

Conclusion

This case law reflects the pragmatic approach of the Luxembourg courts when it comes to attribute taxing rights between two States which are party to a double tax treaty. In order to avoid differences of qualification of income between Luxembourg and another country, the Court decided to align its interpretation of certain provisions of the Treaty on the one of the other contracting State (i.e. Germany). This approach is in line with BEPS Action 6 which  proposes an inclusionof a preamble in double tax treaties a preamble stating that a double tax treaty may not be used to create opportunities to avoid or reduce or lead to non-taxation situation. Furthermore, the Court confirmed its position according to which the qualification of income for the purposes of a double tax treaty does not preclude another qualification for domestic tax purposes.



[1]               Gesellschaft mit beschränkter Haftung & Compagnie Kommanditgesellschaft

[2]               Gesellschaft mit beschränkter Haftung

[3]               Double tax treaty signed between Luxembourg and Germany dated 23 August 1958 (terminated on 1 January 2014).

[4]               Bundesfinanzhof of 28 April 2010 (I R 81/09, BFHE 229,252)

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