Opting for a 'pure' capital reduction
Until the end of 2017 you could choose which part of the authorised capital you could charge a capital reduction to. Only the repayment of capital actually paid-up is tax free. If the entire procedure is conducted in accordance with the rules and the repayment goes to the contributions actually paid-up by the shareholders, then this is considered a 'pure' capital reduction and no tax is due. Where these conditions are not met, it can be considered a dividend payment, on which 30 percent withholding tax is payable.
The pro rata rule determines the tax exemption status
The Summer Agreement ended this freedom of choice. As of 01 January 2018 the entire capital reduction is deemed to come, on a pro rata basis, from the paid-up capital (tax-exempted), the taxed reserves and the exempted reserves incorporated in the capital (which are taxable as a dividend). This means that a part will always be subject to withholding tax.
The proportions are determined as follows:
Paid-up capital + equivalent sums
Numerator + taxed reserves + exempted reserves incorporated in the capital
The result of this fraction determines the percentage that is deemed to come from the paid-up capital, and is consequently tax-exempt.
Not taken into account in this calculation are the statutory reserves up to the statutory minimum, the liquidation reserves and the unavailable reserves for own shares.
What about the internal liquidation reserves?
The Summer Agreement's pro rata rule does not apply to the arrangement for 'internal liquidation reserves' (known as vastgeklikte reserves).
This arrangement allows dividends to be paid out at 10 percent withholding tax if the net dividend is incorporated in the capital.
If these 'internal liquidation reserves' are retained in the capital for at least four years (for SMEs) or eight years (for other companies), then a subsequent capital reduction is not subject to further taxes, insofar as those taxes could be charged to the 'internal liquidation reserves'. This might be appealing from a tax perspective, but in order to avoid any fights with the tax authorities, it would be best to account for such an action using non-tax motives too.
A capital reduction after the contribution of shares
Prior to 1 January 2017 the contribution of shares was deemed to be paid-up capital for tax purposes. So if the capital reduction pertained to the capital already formed, it was exempt from taxation.
But the tax authorities keep a beady eye on this approach, and they will often attempt to demonstrate that the contribution and the capital reduction can be considered as a single transaction, performed with the specific intention of avoiding the withholding tax on dividends. While the Ghent Court of Appeal recently ruled against the tax authorities in a case such as this, that does not mean that the story is over. And so accounting for non-tax motives in such a transaction is becoming ever more important.
Since 1 January 2017 the contribution of shares to the paid-up capital for tax purposes consists solely of the purchase price of the contributed share. In the event of a later capital reduction the tax-exemption will only apply to that paid-up capital for tax purposes. If the taxed reserves are also paid out in the form of capital (which was formed by this contribution), then it becomes a dividend distribution, on which 30 percent withholding tax is payable.
Insufficient cash to pay out
Once the capital reduction has occurred, the company might have insufficient cash resources to pay out the shareholders. When that happens this shortfall is outstanding as debt, and the company might have to pay interest on it.
Certain case law states that this interest is not deductible by the company, as it is not deemed as a cost for obtaining or retaining taxable income. Once again, you will have to present non-tax motives in order to account for deducting this interest.
In summary, a capital reduction will only be tax-free under extremely rigid conditions. Moreover, the tax authorities not only expect you to comply with the rules, they also expect you to motivate such an action with non-tax related arguments.
If you are considering performing a capital reduction, seek advice in advance. We'll be happy to help. Feel free to get in touch.