As tax professionals in the world’s second-largest fund hub, Simmons & Simmons’ Pierre-Régis Dukmedjian and Alejandro Dominguez explore the potential impact for taxpayers.
The OECD's BEPS final report contained a number of action plans to deal with base erosion and profit shifting. Published on October 5 2015, these include neutralising the effects of hybrid mismatch arrangements (Action 2), computation of controlled foreign company income rules (Action 3), limiting base erosion involving interest deductions and other financial payments (Action 4), and preventing the artificial avoidance of permanent establishment (PE) status (Action 7).
The EU Council stressed the need to find solutions at an EU level consistent with the OECD's BEPS conclusions. Accordingly, EU directives were considered as the "preferred vehicle" to implement such conclusions.
As a result, these action plans are reflected in the EU Council Directive 2016/1164 of July 12 2016, laying down rules against tax avoidance practices that directly affect the functioning of the internal market (ATAD).
Accordingly, Luxembourg recently transposed the ATAD into domestic law (ATAD Law) on December 21 2018. This law also includes some additional measures not specifically mentioned in the ATAD.
This article considers the main measures adopted in the ATAD Law and what they mean in practice for taxpayers.
Hybrid mismatches rules
Hybrid mismatches exploit differences in tax treatment of an entity, or a payment (financial instrument) under the legal framework of two jurisdictions, which results in double deduction (taxation) in two states or the deduction in one state without inclusion in the other.
Luxembourg had already introduced measures to combat the use of hybrid financial instruments by transposing the EU Directive 2014/86/EU of July 8 2014, amending EU Directive 2011/96 on the common system of taxation applicable in the case of parent companies and subsidiaries of different member states. These amendments include a specific anti-abuse rule and a "mirror rule", under which dividends received by a Luxembourg company give rise to a deductible charge at the level of an EU subsidiary, may not be exempt in Luxembourg.
Under the ATAD rules, from January 1 2019, Luxembourg closes the gap for the use of hybrid instruments and entities in the context of qualifying related entities.
In effect, Luxembourg may deny a deduction for an interest payment from a tax perspective in situations where the same payment generates a double deduction or deduction (without inclusion in Luxembourg and in another EU member state respectively).
For these purposes, Luxembourg's tax administration may request evidence to prove that such payment didn't also give rise to a deduction in the other EU member states, or that it was subject to tax in such jurisdiction.
Controlled foreign company rules
Controlled foreign company (CFC) rules aim to mitigate the risk of the income of CFC entities (i.e. companies and PEs) not taxed, or those taxed at a significantly lower rate than in the parent's jurisdiction.
Accordingly, from January 1 2019, undistributed income of a CFC entity which arises from 'non-genuine' arrangements that have been put in place for the essential purpose of obtaining a tax advantage will be taxed at the level of the controlling taxpayer.
An arrangement or a series of arrangements will be regarded as 'non-genuine' to the extent that the CFC entity would not own the assets or would not have undertaken the risks which generate all (or part) of its income, if it were not controlled by a company where important functions relevant to those assets and risks are ensured and play an essential role in generating the CFC income.
Scope of CFC rules
A CFC entity is an entity which is controlled by the taxpayer either by itself or together with its 'associated enterprises' through holding a direct or indirect participation of more than 50% of the voting rights. Alternatively, it may directly or indirectly own more than 50% of capital, or being entitled to receive more than 50% of the profits of that entity. An 'associated enterprise' requires a direct or indirect holding a 25% of voting rights, capital or profit entitlement.
It is also a requirement that a CFC entity is taxed at a low rate, meaning an effective tax rate below 9%.
The allocation of the CFC's net income should be carried out by considering those assets and risks which are linked to important functions carried out by the controlling company. The attribution of CFC net income must be calculated in accordance with the arm's-length principle.
Furthermore, CFC net income must be allocated on a pro rata basis considering the participation on the CFC entity. Only positive CFC net income is allocated, but a carry forward of negative net income is possible. Effective distributions by the CFC, as well as relevant capital gains, must also be deducted from the tax base of the controlling taxpayer if they were previously included as CFC net income.
Exclusions to CFC rules
The CFC rules do not apply to a CFC that makes a commercial profit which does not exceed €750,000 ($847,000) on its balance sheet, or that makes a profit which does not exceed 10% of its operating expenses (determined by special criteria) during the relevant fiscal period.
Interest limitation rules
The ATAD Law has introduced a restriction on interest deductibility. Under this rule, tax deductions for net interest expenses (i.e. 'exceeding borrowing cost') is limited to 30% of the fiscal earnings before interest, tax, depreciation and amortisation, or EBITDA (i.e. the taxpayer's net revenue plus fiscal amortisations and depreciations excluding exempt income and expenses in relation to such income), or up to an amount of €3 million, whichever is higher.
'Borrowing cost' is defined as interest expenses on all forms of debt and other costs economically equivalent to interest and expenses incurred in connection with raising finance 'exceeding borrowing costs' means the excess of deductible 'borrowing costs' (i.e. in relation to taxable income) over taxable interest and equivalent revenues.
A qualifying taxpayer which is a member of a consolidated group (for accounting purposes) can deduct its net interest expenses if it can evidence that its equity ratio (over its total assets) is equal to or higher than the corresponding equity ratio of the group, subject to specific conditions.
Deductible net interest expenses which are not utilised in the accounting period in which they are incurred can be carried forward for up to five years.
Scope of interest limitation rules
In practice, taxpayers receiving income other than interest (e.g. dividends), which does not qualify for the Luxembourg participation exemption regime, and which is financed by interest bearing debt, may be adversely impacted as the net interest expense will be generated, and deductions for such net interest may be limited.
A "grandfathering rule" applies in relation to loans entered into before June 17 2016, provided they are not amended after that date.
Subject to certain qualifying conditions, the interest limitation rules do not apply to loans financing a long-term EU infrastructure project.
Certain 'financial undertakings' subject to certain EU regulations (e.g. undertakings for collective investments in transferrable securities, or UCITS; alternative investments funds managed by alternative investment managers; Luxembourg securitisation vehicles subject to specific EU regulations) are outside the scope of the rules, and the relevant net interest excess should remain tax deductible.
Also, 'stand-alone entities' will be excluded (i.e. entities which are not part of a consolidated group accounting wise, and have no associated enterprise or PE). Most notably, Luxembourg orphan securitisation companies cannot benefit from this exclusion since they are considered as having an associated enterprise or PE in a state other than Luxembourg.
Based on the Luxembourg 2019 budget draft bill, the interest limitation rule may be calculated at the level of tax consolidated groups. This option was not originally implemented in the ATAD Law.
Exit taxation rules
Moving tax residence and/or the location of assets may offer the possibility of avoiding taxation in the jurisdiction where the economic value was generated. Therefore, exit taxes aim to ensure that if such a move takes place, any unrealised capital gain is taxed.
As such, Luxembourg introduced exit tax rules with effect from January 1 2020.
The taxpayer will be subject to tax based on the fair market value at the time of exit in case of:
1) A transfer of assets from a Luxembourg enterprise is to a PE situated in another state; and
2) A transfer of assets of a Luxembourg PE is to an enterprise (or a PE) or its head office situated in another state.
In both of the above cases, Luxembourg loses its taxing rights over the assets transferred.
3) A change of domicile, habitual abode, registered office or central administration, except where the assets remain effectively linked to a local PE and their accounting value is maintained, and
4) The transfer of a local PE's activity to another state, Luxembourg losing its taxing rights over the assets transferred.
In the case of transfers within the European Economic Area (EEA), it should be possible to pay such tax by instalments over five years, subject to meeting certain conditions.
The new rule does not apply to certain assets that will return to Luxembourg in less than 12 months, provided that:
1) The assets are related to the financing of securities; and
2) The assets are posted as collateral, and such assets are transferred to satisfy prudential capital requirements or in relation to liquidity management.
General anti-abuse rule
The new general anti-abuse rule (GAAR) provides that for tax abuse to exist, there must be:
1) A use of forms and institutions of law;
2) Such use must have as main purpose, or one of the main purposes, to avoid or reduce tax, that defeats the object or purpose of the applicable tax law; and
3) Is not genuine, having regard to all relevant facts and circumstances. This is expressed in such arrangements or series of arrangements not being put in place for valid commercial reasons that reflect economic reality.
The new GAAR further adds that in the case of abuse, taxes should be collected as if the transaction has been implemented in a normal, non-abusive manner, taking into account all the relevant facts and circumstances.
From January 1 2019, the possibility to defer corporate tax upon conversion of convertible debt into capital is no longer available. Therefore, the conversion of debt into capital will no longer be treated as tax neutral, and will instead be considered as a sale of the loan and a subsequent acquisition of shares.
Furthermore, the definition of a PE in Luxembourg domestic law is updated. Aiming to resolve conflicts of interpretation on the existence of a PE as a result of inconsistencies between domestic law and double tax treaties, it is now provided that the treaty definition should supersede the domestic law definition to determine if the Luxembourg taxpayer has a PE abroad.
Luxembourg may ask for certification from other jurisdictions as to the existence of the PE in that other jurisdiction to avoid double non-taxation.
Next steps for Luxembourg
Another EU Council Directive (2017/952) on May 29 2017 (the ATAD 2) amending the ATAD's hybrid mismatches with third countries is expected to be transposed in the coming months.
Considering Luxembourg is the second largest fund hub in the world (after the US), a principal securitisation destination and a mainstream holding jurisdiction, the impact of the ATAD Law, as well as further legislative steps which are expected to amend this law, should be closely monitored to assess their impact on existing structures and future transactions.
Pierre-Régis is a qualified lawyer in France since 1998 and was first registered with the Luxembourg Bar in 2011. Before joining Simmons & Simmons Luxembourg office from its opening in 2015, Pierre-Régis was the tax partner of a boutique firm in Luxembourg and he previously worked for a Big 4, a reputed tax advisor firm and a magic circle firm in Luxembourg.
He is a member of the International Bar Association and the Association of the Luxembourg Fund Industry.
Alejandro is a supervising associate in the Luxembourg tax team and has extensive experience in corporate tax and international tax planning. His expertise includes the tax treatment of financial products issued by investment funds, asset managers and financial institutions, and tax issues in real estate transactions.
Alejandro also advises international clients, mainly private equity firms, real estate funds and multinational companies, on Luxembourg and international taxation in the context of cross-border transactions and reorganisations (e.g. mergers and acquisitions, corporate reorganisations, and cross-border restructurings), securitisation and project financing related matters. Alejandro also has specific expertise in the field of exchange of information (FATCA and CRS) as well as on indirect tax/VAT law.
Alejandro was admitted as Avocat au Barreau de Paris in 2017 and as Abogado in Colombia in 2013.
He is a member of the International Fiscal Association and the Luxembourg Fiscal Studies Association.