In a judgment dated 20 December 2022, the Luxembourg Higher Administrative Court (Cour administrative, hereinafter the "Court") ruled on the application of paragraph 205, sub-paragraph 3 of the General Tax Law (Abgabenordnung or "AO") in the context of the examination of a claim by the Director of the Direct Tax Administration ("DTA").
In the present case, a taxpayer (the "Taxpayer") challenged on 29 July 2016, by way of a claim, the income tax and long-term care insurance contribution in the tax assessments issued by the DTA for the fiscal year 2014. The Director of the DTA considered the claim well founded and reformed the income tax assessment in pejus. In particular, according to the Director, the activities carried out by the Taxpayer were of a commercial nature so that the tax authorities should have taxed such income as business profit and not as capital income in the meaning of Article 97 of the Luxembourg Income Tax Law ("LITL").
The Taxpayer brought the matter to the Lower Administrative Court (Tribunal administratif), which decided to annul the Director's decision on the grounds that the Director failed to comply with the obligation set out in paragraph 205, sub-paragraph (3) AO. The DTA filed an appeal against this decision. The Higher Administrative Court recalled that pursuant to paragraph 205, sub-paragraph (3) AO the DTA is under the obligation, prior to the issuance of a tax assessment, to communicate the elements in respect of which the DTA intends to diverge from the taxpayer's tax return. According to the Higher Administrative Court, this provision is applicable in the same way to the claim procedure as to the taxation procedure. As a result the Director is obliged to respect the provision of paragraph 205, sub-paragraph (3) AO when examining a claim, which implied, in the present case, that the Director must have informed the Taxpayer of its intention to requalify the declared income.
The Higher Administrative Court further recalled that paragraph 205, sub-paragraph (3) AO applies only to substantial modifications ("wesentliche Abweichung") to the detriment of the taxpayer, including cases in which the competent tax authority intends to take into account a legal or factual factor which (i) is likely to affect the taxation decision and (ii) differs from the situation declared by the taxpayer.
Furthermore, the substantial modification to the detriment of the taxpayer must result from a divergence in the information and documents provided to the tax authorities, and subsequently to the Director, and should not be a simple matter of application and interpretation of the tax law.
However, in the present case, the requalification made by the Director resulted not only in a substitution of the category of income concerned, but also in a fundamental modification in the method of determining that income, which is such as to influence the level of income to be retained. Indeed, while capital income is determined by the difference between the income and the expenses, in accordance with the Article 103 of LITL, business profit is, by contrast, computed by comparison of the net asset value of the investments between the beginning and the end of the financial year, in accordance with Article 18, paragraph (1) of the LITL.
Hence, the requalification of income in the present case cannot be considered as the result of an analysis of a simple matter of application and interpretation of the law.
By failing to inform the Taxpayer in advance of his intention to requalify the capital income as business profit, the Director did not allow him to provide clarification in relation to factual elements newly made necessary and relevant for the determination of profit based on the comparison of the net assets invested.
The fundamental principle of "Recht auf Gehör" as enacted by paragraph 205, sub-paragraph (3) AO is of application within the claim procedure so that the Director therefore fails to comply with this principle when substantial modifications affecting the tax position of the taxpayer are contemplated and the taxpayer is not put in a position to provide factual elements to clarify his tax situation.