Luxembourg: Luxembourg Budget 2013 - Tax Measures Impacting The Private Equity Industry

Introduction

Today the Luxembourg Parliament approved the bill n° 6497 modifying the Luxembourg Income Tax Act ("LIR") in certain areas, some of which will impact the private equity industry. This legal alert will focus on certain specific points impacting this industry.

Avoiding the retirement cliff

Public deficit or surplus is the difference between government receipts and government spending in a single year. Running a country with a constant public deficit is almost universal in the 21st century. The 2007-2009 financial crisis led to a dramatic increase in the public deficits of many advanced economies, with many of them experiencing their highest levels of debt since World War II. Presented as a percent of gross domestic product (GDP), total deficit for OECD countries went from -1.2% of total OECD GDP in 2006 to -6.6% in 2011. Some countries have had rather severe deficits over the last few years, including, for 2011, a -10% deficit in the United States and -9.4% in the UK. Economic powerhouses such as the United States and the UK may well be able to deal with the additional government debt resulting from those deficits. Even so, the recent ongoing discussions regarding the risks of the U.S. economy tumbling off the fiscal cliff - with $600 billion in tax increases and spending cuts - show that even the largest economies may not continuously run public deficits without getting punished at some moment in time.

Luxembourg, as a tiny country, though seen as punching above its weight, has always considered it necessary to avoid putting itself into positions similar to those of competitors such as Ireland and Cyprus who run a -10.3% deficit and -6.3% respectively, seemingly without really attempting to address the state of their public finances. With an expected public deficit of -1.5% for 2013, and an expected public debt of broadly 20% of GDP (compared to the Irish public debt of 120% and the Cyprus debt of 60.8%), Luxembourg appears to be top of the class. Nonetheless, the government has decided to cut back on expenses by some €538 million and to increase the tax receipts by €414 million approximately, in order to reduce the public deficit to approximately 0.8% of GDP.

The reason for these policy measures has nothing to do with concerns such as those encountered in Ireland where the cost of servicing public debt is moving towards 20% of tax revenues. That cost in Luxembourg is well below 1%. However, as is the case for any other country, Luxembourg needs to solve the pension puzzle. Indeed, reforming pensions is one of the biggest challenges of the 21st century. All OECD countries have to adjust to the ageing of their populations and re-balance retirement income provision to keep it adequate and ensure that the system is financially sustainable. Luxembourg has decided to tackle this issue in its 2052 Agenda by trying to ensure that the presently healthy State pension system remains in good shape throughout that period. This has led to several changes to the State pension system taking effect in 2013. Ensuring, through a careful running of the annual budgets, that surpluses rather than deficits are being generated, the Luxembourg government further seeks to prevent public debt from ever becoming a burden for the next generation. Quite simply, it does not seem right to the Luxembourg policy makers for the government to use debt to provide extra consumption for the older generation, and then subsequently tax the younger generation to repay the debt. By scaling back expenses for 2012, by temporarily increasing the tax rates for individuals, by introducing a new minimum tax for all the businesses, and by increasing the already existing minimum tax for certain businesses, the Luxembourg government seeks to place Luxembourg public finances on a healthy footing for years to come.

The alternative minimum tax constrained by international law

In 2011, Luxembourg Parliament introduced a minimum corporate tax (the "alternative minimum tax" or "AMT") for certain Luxembourg corporations ("Financial Luxcos"), being those entities whose assets consist almost entirely (> 90% of the total balance-sheet) of financial assets (loans, participations, cash at bank etc.). This amount has now been increased with effect for 2013 to 3,000 €. At the same time, Luxembourg Parliament has decided to also introduce for the other corporate taxpayers ("Other Luxcos") an AMT ranging from 500 € to 20,000 € depending upon the total balance-sheet of the respective Luxco (the cap of 20,000 € will be reached as of a total balance-sheet of 20,000,000 €).

Applying the above rules to private equity Luxcos, the expected tax liability (assuming the actual taxable income does not already lead to a higher tax) would normally be as follows:

1. Luxcos holding targets for a future sale: 3,000 €

2. Luxcos providing debt financing to group companies: 3,000 € (although the margin taxation would in most cases anyway lead to a higher amount of tax)

3. Luxcos holding real estate: 20,000 € (since the acquisition cost of most real estate assets would exceed 20,000,000 €).

The above rules may however lead to unintended consequences which may be illustrated with two examples.

Let us take the example of a Financial Luxco essentially holding financial assets. The Financial Luxco was subject, as of 2011, to an annual tax of 1,500 €. In its 2011 version, the minimum tax of 1,500 € was still viewed as a toll charge aiming at compensating the enrolment and annual administrative costs incurred by the tax authorities when dealing with companies not paying any income tax in Luxembourg, mainly because all of their income was exempt under the participation exemption regime. By doubling the minimum tax to 3,000 € however, it would no longer be possible to consider the AMT as mere compensation for costs incurred by the Luxembourg tax authorities when processing the file. The AMT essentially turns into an alternative minimum income tax. However, in doing so, new issues consequently arise. Indeed, a Financial Luxco may generate only dividend income which is tax-exempt under a specific tax treaty or under the EU Parent-Subsidiary Directive. By levying the AMT, Luxembourg in fact taxes income that should be tax-exempt under a tax treaty or EU law. It hence commits a treaty override, which is not possible under Luxembourg law, or an EU override, which is equally prohibited under EU law, if it levies the AMT in those circumstances.

A similar comment may be made as regards certain Other Luxcos, being those that mainly hold real estate in a tax treaty jurisdiction. With sixty-four tax treaties presently in force, and some twenty pending, the bulk of real estate investments any Other Luxco would conceivably wish to consider buying would be located in tax treaty countries. Under any tax treaty entered into by Luxembourg, the net rental income as well as the capital gain upon disposal of the real estate may only be taxed in the source country, hence by the tax authorities of the treaty partner. Subjecting these entities as Other Luxcos to an alternative minimum income tax of 20,000 € effectively leads to a taxation of real estate income in situations where the relevant tax treaty does not grant any taxing rights to Luxembourg.

The alternative minimum tax should only apply to income over which Luxembourg has retained the right to tax, though in reality it does also tax Luxco, even if its income is exempt as a result of international law

The COFIBU (the Commission of Finance and Budget of the Parliament), which is the special commission of Parliament dealing with budget matters, when reviewing the draft bill, expressly stated that the AMT should not be due in circumstances where Luxembourg no longer has the right to tax the income under tax treaty law or EU law.

However, this position does not appear to be reflected under applicable statute provisions. Indeed, an additional paragraph was added by the COFIBU to article 2 of the final version of the draft bill amending paragraph 6 of article 174 LIR, ostensibly in order to deal with this point. This additional paragraph however only states that "the minimum tax is to be viewed as an advance corporation income tax payment for future years, to the extent it exceeds the tax calculated for the year. As an exception to article 154 § 7 LIR (which provides the condition under which an excess tax is to be repaid to the taxpayer), the minimum tax may not get reimbursed to the taxpayer". The apparent consequence of this provision, which has been copied from the Austrian Income Tax Code, is to reserve the right of the tax authorities to levy the AMT, even in those circumstances where all of the income is exempt from tax under international law. Indeed, the AMT would not directly tax income that is exempt under international law; it would rather constitute an advance payment on Luxco's future tax liability. That tax liability may not be known yet, but is expected according to the Income Tax Act to arise sooner or later as a result of future taxable income. Since the income that is exempt under international law is not taxable, either this year, or in any subsequent year, the advance payment of income tax implicitly but necessarily refers to other sources of income that Luxco may have in due course.

In reality, this is nothing but a disguised though very real taxation of income Luxembourg simply cannot tax. Take for instance the example of a Luxco property company which holds one single asset in a treaty country. Any income Luxco would realise, be it the initial rental income or the subsequent capital upon disposal of the real estate, may only be taxed under the treaty in the source country. As the Luxco has no other taxable income, and, for the sake of argument, is being liquidated upon sale of the real estate, there is simply no room for levying the AMT. Doing so should be seen in due course as being a breach of the relevant provisions of the tax treaty and hence should lead the tax courts to rule in favor of a refund of the AMT. There, of course, exists no guarantee on the matter, since being in court is always a little like being in open sea, without a rudder or compass, but at the very least the chances of success in case of litigation are real and not just purely hypothetical.

Conclusion

The AMT is an unfortunate step taken by the government which appears to have been ill advised, not only on what is at stake, but also as regards its technical merits. Given the international nature of Luxco's activities, the levying of the AMT would more often than not lead to treaty and EU law overrides. It would have been far better, had the Luxembourg Parliament given itself further time to reflect rather than rushing ill-drafted legislation through the approval process.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.