Anti-Tax Avoidance Directive II – Luxembourg Implements ATAD II Directive
With the law of 20 December 2019, Luxembourg has implemented the EU Directive ATAD II into national law with effect from 1 January 2020 by Articles 168ter and 168quater of L.I.R. The directive as well as the law are intended to address so-called “hybrid mismatches” between associated enterprises and, in general, to take stronger action against tax-saving schemes (“structured arrangements”) and dual resident companies, which result in tax advantages for cross-border structures. The law aims to eliminate mismatches in tax outcomes that arise from double tax deductions of payments or from tax deduction of a payment without inclusion on the recipient side. Payments of arrangements that fall within the scope of the law are therefore either not tax deductible or can only be deducted one time. A payee benefitting from a tax exemption, for example, as in the case of payments made to investment funds, or because the payment is subject to preferential taxation at the payee’s end, should not give rise to mismatches in tax outcomes. In addition, Luxembourg has removed investment funds with the legal form of partnerships from the scope of the provisions on “reverse hybrid mismatches”. Upon request of the tax authorities, the companies concerned must be able to prove, by submitting suitable documents, that no hybrid mismatch exists or that the various scopes of the law do not apply. In this context, we recommend to analyze if the law might affect any existing structures.
History and Introduction to ATAD II
Triggered by the financial crisis in 2008, the OECD, on the initiative of the G20 countries, published 15 potential national and international action points in 2015 to prevent profit shifting between countries and thus to ensure that taxation takes place in the country in which value is created (“BEPS Measures”). In order to implement parts of the BEPS Measures taken at OECD level in the EU Member States, the European Council adopted the Anti-Tax Avoidance Directive on 12 July 2016 (“ATAD I”) and its successor on 29 May 2017 (“ATAD II”). In Luxembourg, the provisions of ATAD I were implemented on 1 January 2019 with the law of 21 December 2018 (no. 7318) and the new Article 168bis of L.I.R. With the law of 20 December 2019, Luxembourg implemented the EU Directive ATAD II into national law with effect from 1 January 2020 by Articles 168ter and 168quater of L.I.R.
While ATAD I dealt with measures against tax structuring by implementing an interest limitation rule, provisions on exit taxation, general anti-abuse rules, and CFC rules (see also our newsletter dated 12 December 2018 at www.aiqunited.com/blog), ATAD II as well as the law mainly aim to address cross-border “hybrid mismatches” of associated enterprises resulting in double tax deductions of payments or a tax deduction without inclusion in the country of the payee (“mismatches”). In addition, action is to be taken against “tax-saving schemes” (in the Directive, they are referred to as “structured arrangements”) and against tax optimization in respect of dual resident companies.
Hybrid Financial Instruments and Companies in General
Financial instruments that have features of both debt and equity are generally referred to as “hybrid financial instruments”. In the case of cross-border financing between associated enterprises, it is now possible that one country may consider the financial instrument in question to be equity while the other country regards it as debt. As such, remuneration on the instrument may, on one hand, qualify as interest and, on the other hand, as a dividend, which may result in the interest payments in the payer country being a tax-deductible expense but may be in the country of the payee deemed a tax-exempt dividend (“mismatch”).
Hybrid entities exist in an international context, e.g. if a partnership having foreign shareholders is considered a corporation in the company’s country of residence (potentially for tax purposes only). As a result, as far as taxation of profits is concerned, the partnership may not be taxed in the country of its registered office as it is not a taxable entity in this country; instead, its foreign shareholders are regarded as taxable entities (this is known as “transparency” for tax purposes). But, as a general rule, they cannot be taxed by the country of their registered office because they are resident abroad. However, in our example, from the point of view of the country of residence of the shareholders, the foreign partnership is considered a corporation and thus a taxable entity in the country of its registered office. Therefore, the shareholders’ country of residence will not tax the shareholders. This can lead to the situation that neither the country in which the registered office is located nor the country of residence of the company will tax the income of the partnership.
The reasons for hybrid financial instruments lie in the fact that there is no uniform definition of equity or debt capital at international level, and that there is no higher-level (tax) legal system for companies.
In addition to companies subject to corporate tax in Luxembourg, the law also applies to permanent establishments of corporations that are resident for tax purposes in a country outside of Luxembourg, including third countries.
Furthermore, Luxembourg partnerships may also fall within the scope of the law if they are treated as corporations under the rules of the shareholders’ foreign country of residence (“reverse hybrid mismatches”).
Hybrid Mismatches and Associated Enterprises
The objective of the law and the Directive is to address “mismatches” in tax outcomes (double deduction of payments, deduction of payments and non-inclusion on the recipient side) in associated enterprises that arise from cross-border hybrid mismatches. If an arrangement falls within the scope of the law, the mismatches are eliminated by restrictions on deduction or unilateral taxation.
The law distinguishes between the following categories of hybrid mismatches, which can be broken down into several groups:
a) Payments for (hybrid) financial instruments
For example, this is the case if a payment made by a corporation resident in Luxembourg is deductible as a tax-deducting business expense in the form of interest expense, but the recipient considers it to be a dividend that is tax-exempt under the national legislation of the recipient’s country of residence.
However, according to the law, mismatches do not arise if the reason for the tax reduction is based on the tax status of the payee (e.g. exempt investment fund), or if the payee’s income is subject to a preferential (tax) regime.
b) Payments to or from a hybrid entity
When payments are made to a hybrid entity, mismatches may arise if cross-border payments to a hybrid entity are allocated differently by the countries involved. The country in which the hybrid enterprise has its registered office as the payee allocates the payment to the shareholders of the hybrid enterprise; the country of the shareholders of the hybrid enterprise allocates the payment to the hybrid enterprise. A mismatch arises from a deduction without inclusion.
Mismatches in payments from a hybrid enterprise may arise because the hybrid enterprise making payments to its shareholder is deemed a corporation in the country of its registered office but is considered a partnership in the country of its shareholder where the payment is not taken into account for tax purposes.
c) Payments to a company with permanent establishment(s)
These arrangements are subject to conflicts of allocation of payments. An example of such arrangements is interest payments made by an enterprise to a (foreign) permanent establishment of an associated enterprise (parent company). From the perspective of the country of the payer, this is a deductible interest payment. From the perspective of the country of the associated enterprise (parent company), the payment is to be allocated to the permanent establishment and is therefore not taxable. From the perspective of the country in which the permanent establishment is located, the payment is to be allocated to the parent company. This results in a mismatch due to deduction and non-inclusion.
d) Payments to disregarded permanent establishments or deemed payments between the head office and the permanent establishment or between permanent establishments
For payments to a disregarded permanent establishment, the same circumstances apply as mentioned in point c). However, the difference is that the permanent establishment does not exist at all from the point of view of the country in which it is located, only from the point of view of the parent company, which allocates the payment to this permanent establishment (which in its view exists).
Deemed payments between a permanent establishment or head office may be imposed by national tax regulations under which payments made by a permanent establishment are tax deductible but do not generate an inflow of capital for the recipient.
e) Imported mismatches
These are tax-deductible payments for a non-hybrid (financial) instrument made by Luxembourg companies to one or more associated enterprises in a third country that have entered into a hybrid mismatch abroad. Payments are not eligible as tax deductions in Luxembourg if, whether directly or indirectly, they result in the financing of hybrid structures in other countries, and the third country involved has not yet neutralized the hybrid mismatch itself pursuant to national regulations.
Associated enterprises are those where one enterprise (or taxpayer) has effective control over another enterprise. Examples are a direct or indirect capital ownership or voting rights of 50% or more, or a right to receive a share of profits of at least 50%. This also includes companies in a consolidated group or companies where the taxpayer can exercise significant control over the management.
If the hybrid mismatch is a payment under a financial instrument, the 50% limit will be reduced to 25%.
A person who acts together with another person in respect of the voting rights or capital ownership of an entity shall be treated as holding a participation in all of the voting rights or capital ownership of that entity that are held by the other person. However, in the case of participations in investment funds, this applies only if the person or entity holds, either directly or indirectly, at least 10% of the shares, and if the profit participation right is at least 10%. This should apply subject to evidence to the contrary.
It is important to note that the law also applies without the existence of associated enterprises if a “structured arrangement” is in place. This is the case if the two companies that are not associated with each other are aware of the tax consequences, and the arrangement was ultimately designed for tax purposes.
Reverse Hybrid Mismatches
In addition to the above-mentioned provisions of Article 168ter of L.I.R., the new provision of Article 168quater of L.I.R. has entered into force and addresses so-called reverse hybrid mismatches. These exist if companies with a majority shareholding in a Luxembourg partnership (hybrid entities) are resident in another country (EU or third country) in which, contrary to the classification in Luxembourg, this partnership is considered a taxable entity.
The objective is to avoid double non-taxation. By amending Article 4 of the Luxembourg Wealth Tax Law, cases that fall under Article 168quater of L.I.R. are explicitly excluded from wealth tax. Trade tax is also not affected by reverse hybrid mismatches.
Mismatches in Tax Residency
Mismatches in tax residency exist in the case of arrangements where a taxpayer is considered to be resident for tax purposes in two countries at the same time, and payments result in double deduction of business expenses. This may be the case if the company’s registered office is located in one country, but the place of management is in another country. In cases of dual residency, Luxembourg will exclude the deduction of business expenses to the extent that the deduction of business expenses is granted in the other country but is not offset against income to be allocated to Luxembourg. However, Article 168ter paragraph 4 of L.I.R. specifically introduced for this purpose does not apply if the taxpayer is deemed to be exclusively resident in Luxembourg under a double taxation treaty concluded between Luxembourg and the other country. In these cases, the deduction is generally granted in Luxembourg.
As stated above, mismatches in payments for financial instruments do not fall within the scope if the mismatch is within the tax status of the payee. Therefore, this applies to tax-exempt undertakings for collective investment (UCI), such as specialized investment funds (SIF) or reserved alternative investment funds (RAIFs).
Luxembourg has also decided to exempt undertakings for collective investment (UCI), such as specialized investment funds (SIF), reserved alternative investment funds (RAIF) or venture capital investment companies (SICAR), from the regulation governing reverse-hybrid mismatches. As a result, the new Article 168quater of L.I.R. does not apply to these fund structures.
Burden of Proof
According to the draft Article 168ter paragraph 6 of L.I.R., the burden of proof is on the taxpayer to demonstrate to the tax authority, upon request, that an anti-abuse rule does not apply.
The regulations defined in ATAD II came into force on 1 January 2020. However, contrary to the other regulations of ATAD II in Luxembourg, Article 168quater of L.I.R. on reversed hybrid mismatches will not be applicable until 1 January 2022.
To-Dos – Conclusions
In connection with the introduction of the new Articles 168ter and 168quater of L.I.R. transposing ATAD II into Luxembourg law, cross-border groups of companies should verify whether they fall within the scope of Articles 168ter and 168quater of L.I.R. In particular, the following should be assessed:
- whether associated enterprises exist;
- whether there are conflicts of eligibility between the countries of these companies with regard to cash flows (e.g. whether business expenses are deductible in one country and revenues are tax-exempt in another); or
- whether reverse hybrid mismatches exist in companies.
In cases where one of the provisions of Articles 168ter or 168quater of L.I.R. does or may apply, it is recommended to prepare appropriate documentation ahead of time in order to be ready for questions from the tax authority.
Such documentation may include, for example:
- proof of residence of associated enterprises;
- evidence of taxation of payments received in the country of residence of the associated enterprise;
- evidence that payments made to a company are not neutralized by a hybrid mismatch.
We are happy to assist you in the evaluation and, where applicable, optimization of your company structure in these and other matters and look forward to providing you with comprehensive advice.
 Bill no. 7466.
 Luxembourg Income Tax Act – „Loi du 4 décembre 1967 concernant l’impôt sur le revenu“.
 BEPS: “Base Erosion and Profit Shifting”.
 EU Directive 2016/1164.
 EU Directive 2017/952.
 Bill no. 7466.
 Luxembourg Income Tax Act – “Loi du 4 décembre 1967 concernant l’impôt sur le revenu”.
 Loi du 16 octobre 1934 concernant l’impôt sur la fortune.