30 Mar Capital decrease after internal capital gains: risk of tax abuse?

In the past, many entrepreneurs have realized so-called ‘internal capital gains’. Internal capital gains are gains realized by a private individual in the event of a contribution in kind (or sale) of shares in an operating company in(to) a holding company. In practice, such gains often remained untaxed since they were deemed, in principle, to have been realized in the framework of the normal management of one’s private estate. Indeed, such schemes were often underpinned by non-tax motives such as concentration of power, family concerns, the aim to attract (external) financing or the structuring of additional acquisitions.

From a tax perspective, these schemes frequently proved to be interesting as well. Without an intermediary holding company, the dividends paid out by the operating entity to the private individual shareholders were subject to withholding tax. Through the contribution of the operating company into a holding company, however, (fiscally paid-up ) capital is created on the level of the holding company. Subsequent dividend distributions from the operating company to the holding remained free from withholding tax and were subject to an effective tax of a mere 1,7% at the level of the holding (the 95% dividends received deduction at the level of the holding). Subsequently, the holding (now having sufficient cash following the dividend distribution by the operating company) could perform a tax-free capital decrease to the benefit of the private individual.

To safeguard the tax-free nature of the abovementioned set-up, often a ruling was sought with the Belgian ruling commission. Provided the presence of sufficient non-tax motives and provided that certain commitments were taken (such as respecting a stand-still period for three years before decreasing the capital of the holding company), often a positive ruling was issued.

The question remained, however, whether this set-up could be qualified as tax abuse, a result of which (even after the stand-still period of three years) the capital decrease was recharacterized into a dividend for tax purposes (resulting in withholding tax becoming due). This question was traditionally not dealt with in the rulings that were issued in the past.

As a result, this set-up became a thorn in the side of the tax administration and, these past few years, the pressure from their side has been raised significantly. The same holds true from the side of the legislator, through inter alia the enactment of the Program Act of 25 December 2016. Therein is stipulated that, the capital created through the contribution of the shares of the operating company does no longer qualify as fiscally paid-up capital and thus, going forward, can no longer be distributed free of withholding tax. It was also confirmed that it is possible to assess whether the capital decrease meets the (new) general anti-abuse provision (article 344, §1 ITC92, as amended in 2012).

Combined with the more recent Corporate Tax Reform Act of 25 December 2017, the scheme of internal capital gains has been put to a halt, at least for the future. Indeed, the Act provided for a pro rata allocation of the capital decrease to the fiscally paid-up capital on the one hand and the taxed reserves on the other hand.

The reality is, however, that many entrepreneurs that made use of the scheme and created a holding company that is still in existence, are now confronted with the question whether the future capital reduction can be challenged based on the (new) general anti-abuse provision and recharacterized in a dividend distribution that is subject to withholding tax. Some of them have already completed the full-set up (internal capital gain and capital decrease) but can still be audited. Others have not (yet) reduced the capital, but planned to so in the future, and now question whether this will or will not trigger the general anti-abuse rule.

A recent judgment (Court of First Instance of Bruges, 19 February 2018) points out that such capital decrease can be recharacterized in a taxable dividend distribution. The Court also concluded that decreasing the capital of the holding was, on the basis of the general anti-abuse provision, a de facto dividend distribution, subject to dividend withholding tax. In the case at hand, the set-up was rather aggressive, since the capital of the company concerned decreased from 50 million EUR to 630,000 EUR between 2006 and 2013 and since each capital decrease by the holding company was preceded by a dividend distribution from the operating company to the holding in (more or less) the same amount. In our opinion, however, this does not allow each capital decrease to be recharacterized into a dividend distribution. The judgment remains significant, however, since it goes to show that one must reassess the non-tax motives of the capital decrease in these kinds of cases.

Taxpayers that have recently decreased the capital of their holding company (or plan to do so in the future) must essentially demonstrate sufficient non-tax motives to pass the test of the general anti-abuse provision. The fact that, in the past, a positive ruling was issued (and the stand still period of three years was respected), does not alter this conclusion. For the capital decrease specifically, the taxpayer will have to demonstrate sufficient non-tax motives. This is also confirmed in more recent ruling practice, in which the Ruling Commission was asked to conform that such capital decreases further down the road do not constitute tax abuse. Non-tax motives include, inter alia, the (lack of) a controlling stake, the presence of personnel and operating activities at the level of the holding (active holding company), the distribution of funds generated after the creation of the holding etc.

If you are a taxpayer contemplating to reduce the capital of your holding company, or if you done so in the recent past, it is strongly advised to assess the risks associated therewith and, as a minimum, create a defense file demonstrating the non-tax motives underpinning your decision. It can also be to your benefit to apply for a ruling, in the interest of legal certainty on the matter.

Mythra Tax Lawyers have ample experience on this topic and can assist you. Do not hesitate to contact us.