Share classes are also often used in the Private Equity sector to structure investments and navigate complex relationships among various stakeholders. Indeed, share classes enable Private Equity Funds to customize the rights and privileges of different investors, align incentives among management, founders and investors, manage risk and return profiles (e.g. through preferred dividends or asset-linked remuneration), balance control and governance within a company, and comply with regulatory requirements. Moreover, issuing multiple classes of shares can facilitate capital raising from diverse sources and can be tailored with exit strategies in mind. Therefore, the use of different classes of shares in private equity serves as a strategic tool to tailor investment structures, manage risk, align incentives, facilitate capital raising, and optimize governance and control.
To establish a legal framework for situations in which a company’s net assets are practically divided, the Luxembourg Government recently approved a draft law to provide clarifications.
The tax treatment of share classes, particularly concerning their redemption, has recently been clarified through several rulings of the Luxembourg Courts. The case law now clearly supports the notion that the redemption and cancellation of a class of shares can be considered a partial liquidation. Consequently, the redemption of a class of shares generally triggers a capital gain. Provided the redemption price adheres to the arm’s length standard and the transaction does not constitute an abuse of law, the redemption of a share class should not be subject to Luxembourg withholding tax.
To establish a legal framework for situations in which a company’s net assets are practically divided, the Luxembourg Government recently approved a draft law to provide clarifications. This draft law is based on recent case law and sets certain minimum standards and specific cumulative conditions to be met.
As a result of these proposed clarifications, when a shareholding in a corporate entity, including classes of shares (or corporate units), is repurchased (or withdrawn), and there is a corresponding capital reduction, the net assets of that entity are deemed to be divided up for the fraction corresponding to the said shareholding or class of shares. Consequently, the redemption of classes of shares will be considered as partial liquidations, and the redemption price should be treated as a capital gain, therefore not subject to Luxembourg withholding tax.
For the application of the partial liquidation regime to share classes, according to the draft law, the repurchase or withdrawal of a class of shares (or corporate units) must simultaneously meet the following conditions:
1. The redemption relates to an entire class of shares;
2. The classes of shares are established at the time of the incorporation or capital increase of the undertaking;
3. Each class of shares has distinct economic rights from those of the other classes of shares;
4. The redemption price of a class of shares may be determined based on criteria laid down in the undertaking’s articles of association or any other document referred to in these articles, allowing the reflection of the estimated market value of the said class of shares at the time of redemption.
The redemption of classes of shares will be considered as partial liquidations, and the redemption price should be treated as a capital gain, therefore not subject to Luxembourg withholding tax.
Hence, the determination of distinct economic rights as provided in the bylaws and the fair market value of share classes will be crucial. Based on the commentary to the draft law, a distinct economic right is characterised by a specific right in relation to the rights of other classes of shares or corporate units, in particular, shares giving entitlement to preferred dividends, securities giving an exclusive right to the profits of a specific or determinable period, or securities whose respective financial rights are linked to the performance of one or more assets or activities of the entity.
The clarification concerns both corporate and individual shareholders. However, where the redemption a class of shares held directly by an individual with a significant shareholding (i.e. more than 10%) in the resident corporate entity in question, the latter will have to provide, as part of its annual income tax return, the information enabling such an individual to be identified.
For the private equity industry, these clarifications are welcomed as it enhances legal certainty, thereby facilitating capital raising efforts.