On 19 June 2018, the Luxembourg Government has presented a bill to transpose the European Directive laying down rules against tax avoidance practices into Luxembourg law (Council Directive (EU) 2016/1164 of 12 July 2016). EU Member States must implement this Directive in national law by 31 December 2018. Hence, the new rules will apply from 1 January 2019. The aim of the European Directive is to tackle tax avoidance practices by setting a minimum level of protection across the EU.
The following measures are covered by the Directive and will be transposed into Luxembourg law by 1 January 2019:
- limitations to the deductibility of interest payments (“interest limitation rule”);
- measures on exit taxation;
- a general anti-abuse rule (“GAAR”);
- controlled foreign company rules (“CFC”);
- rules to tackle hybrid mismatches.
The new rules are discussed in detail in the following sections. Please note that a detailed presentation of these rules would go beyond the scope of this newsletter. Therefore, we ask you to contact us directly with any questions you may have.
- Interest limitation rule
The interest limitation rule already exists under German tax laws and aims to limit the so-called “exceeding borrowing costs”. Exceeding borrowing costs refer to expenses on borrowing costs such as interest to the extent that they exceed the interest income of the taxpayer. Such exceeding borrowing costs are deductible in the financial year in which they are incurred only up to 30% of the EBITDA, but at least up to EUR 3 million. Non-deductible exceeding borrowing costs can be carried forward to subsequent tax periods.
The interest limitation rule applies to entities subject to corporate tax as well as to foreign permanent establishments of entities subject to corporate tax. Generally, partnerships do not fall within the scope of this rule.
The following financial undertakings are exempt from the interest limitation rule:
– investment firms as defined in the MiFID II Directive;
– AIFs, including AIFs in the form of a SICAR (investment companies in risk capital);
– securitization companies as defined in Regulation (EU) 2017/2402.[²]
The rule will not apply to loan agreements concluded before 17 June 2016, but only if such agreements have remained unchanged. Furthermore, an exemption from the interest limitation rule is provided for the funding of public infrastructure projects.
In addition, Luxembourg corporations that are subject to group taxation and that are fully included in consolidated financial statements drawn up in accordance with the International Financial Reporting Standards (IFRS) or the Luxembourg commercial law may apply the exemption from the interest limitation rule if the following conditions are met:
– The company’s financial statements are prepared under the same accounting standards as the group’s financial statements (i.e. in case of a consolidated balance sheet prepared under IFRS, each company has to also prepare a balance sheet under IFRS).
– The ratio of equity to total capital of each company must not be lower than the ratio of equity in the consolidated balance sheet of the group.
Actions to be taken:
- Check the application of the interest limitation rule using a cash flow analysis.
- Check the loan agreements concluded before 17 June 2016.
- Exit taxation
If a company relocates from one state to another, so far, any hidden reserves included in the assets and liabilities of the company had to be disclosed and taxed in the exit state. Based on the case law of the CJEU over the last few years, such exit taxation is to be deferred by five years with no interest in case of a relocation within the EU. Due to the legislative initiative, this case law will now be transposed into Luxembourg law.
Action to be taken:
- Check if there are any plans to relocate or transfer the place of management outside of Luxembourg.
- General anti-abuse rule (“GAAR”)
The new general European anti-abuse rule will be incorporated into Luxembourg law and seeks to address harmful tax practices. In particular, wholly artificial arrangements whose purpose is to obtain an unfair tax advantage are to be covered by the new rule. According to the GAAR, such “artificial” arrangements are not taken into account when determining taxes in Luxembourg or in the respective Member State, i.e. they do not result in a tax reduction. However, currently, there is a great deal of uncertainty as to how the GAAR will be applied in practice since the rule is abstract and susceptible to interpretations of tax authorities. In fact, the Court of Justice of the European Union (CJEU) has further restricted the application of such global anti-abuse rules by providing that the burden of proof for the existence of an artificial arrangement initially lies with the tax authorities.
Action to be taken:
- For example, for dividends, interest and royalty payments made by foreign subsidiaries to Luxembourg group companies, it should be checked that the Luxembourg holding company has “substance” (office, staff, telephone line, email connection, etc.).
- Controlled foreign company rules (“CFC”)
As with the interest limitation rule, a controlled foreign company rule will also be implemented at European and Luxembourg level. Profits of foreign subsidiaries (non-EU countries and third countries) or permanent establishments with lower tax rates in which Luxembourg entities have a (direct or indirect) shareholding of at least 50% will be taken into account when calculating the taxable income of the latter entities. Lower taxation exists if the subsidiary or permanent establishment of a Luxembourg parent company is subject to corporate tax of less than 9%. In this case, profits of the subsidiary of the Luxembourg parent company will also be included and taxed, even without a dividend payout. If the foreign subsidiary distributes profits to the Luxembourg parent company, and if those distributed profits are included in the taxable income of the Luxembourg parent company, income previously included in the tax base of the Luxembourg parent company based on the controlled foreign company rules will be deducted from the tax base when calculating the amount of the tax to be levied on the distributed profits in order to avoid double taxation.
Action to be taken:
- Check if there are any foreign subsidiaries or permanent establishments with lower tax rates.
- Hybrid mismatches
The bill also includes rules on hybrid mismatches. Hybrid mismatches are the consequence of differences in the legal characterization of financial instruments or entities and those differences surface in the interaction between the legal systems of two jurisdictions. Therefore, such varying characterizations can result in a double deduction (i.e. deduction in both states) or in a double non-taxation (i.e. a deduction of the income in state A without inclusion in the tax base of state B) (so-called “hybrid mismatches“). According to the new legal provisions laid down in Paragraph 168ter of LIR, for hybrid mismatches resulting in a double deduction, the deduction must be given only in the Member State where such payment has its source. To the extent that a hybrid mismatch results in a deduction in state A without inclusion in state B, state A (state of the payer) must thus deny the deduction of such payment. Luxembourg legal provisions will only take effect if a Luxembourg company and an associated company[³] in Luxembourg or within the EU are involved in hybrid mismatches.
In this regard, we would like to give an example from the past: the financing of a Luxembourg company by issuing profit participation rights to its German parent company. This instrument of corporate financing has been partially shown as equity in Germany (state B) and therefore exempt from taxation as dividends (at 95%) based on the participation exemption rule (Schachtelprivileg), whereas profit participation rights in Luxembourg (state A) were considered debt instruments and thus allowed for a deduction of “interest payments” as operating expenses. Such double non-taxation of hybrid instruments within the EU will now be prevented by denying deduction at Luxembourg level.
Action to be taken:
- “Sanity check” of the structure regarding potential hybrid mismatches.
An investment firm as defined in MiFID II means any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.
[²]For the purpose of this Regulation „securitization“ means a transaction or scheme, whereby the credit risk associated with an exposure or a pool of exposures is tranched, having all of the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or of the pool of exposures; (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme; (c) the transaction or scheme does not create exposures which possess all of the characteristics listed in Article 147(8) of Regulation (EU) No 575/2013.
[³] An association between two companies assumes that (i) one of the companies holds a participation of at least 25% or is entitled to receive at least 25% of the profits or that (ii) a common parent company (directly or indirectly) holds a participation of at least 25% in both entities. In the case of hybrid entities, 25% is replaced by 50%.