On 8 January 2021, the Luxembourg tax authorities published circular LIR 168bis/1 on the interpretation of the interest deduction limitation rule, which is applicable as from tax years starting on or after 1 January 2019. The long-awaited guidance notably clarifies the notion of borrowing costs and the grandfathering rule for loans predating 17 June 2016. Taxpayers should review their positions taken in respect of the application of the interest deduction limitation rule in light of this new guidance.
The interest deduction limitation rule
The interest deduction limitation rule (IDLR) limits the deductibility of so-called exceeding borrowing costs, i.e., the amount by which otherwise deductible "borrowing costs" exceed taxable interest and economically equivalent revenues. The deduction is capped at the highest of 30% of the fiscal EBITDA or EUR 3 million. Save for certain exceptions, the IDLR applies to Luxembourg resident corporate taxpayers and to Luxembourg permanent establishments of non-resident taxpayers. So far, key concepts, such as borrowing costs and income economically equivalent to interest lacked clarity.
Definition of borrowing costs and interest revenues
Borrowing costs consist of interest expenses on all forms of debt, other costs economically equivalent to interest and expenses incurred in connection with the raising of finance. The circular provides guidance on a non-exhaustive list of borrowing costs. The most noteworthy clarifications are:
- Interest on, and issuance and redemption premiums linked to financial instruments, such as zero-coupon bonds, exchangeable bonds and convertible bonds qualify as borrowing costs;
- Foreign exchange gains and losses which are in connection to interest under a debt qualify as borrowing costs. This is not the case for foreign exchange gains and losses in connection with the principal amount of the loan; and
- Costs incurred in relation to a mortgage or other forms of guarantees on financing operations qualify as borrowing costs.
While "interest and economically equivalent revenues" is not defined in the law, the circular confirms that a symmetric approach should apply. Hence, the definition of borrowing costs should be of help for taxpayers in assessing whether given income qualifies as interest or economically equivalent revenues.
Application of the grandfathering rule
Exceeding borrowing costs related to debt instruments entered into before 17 June 2016 are excluded from the application of the IDLR, but the exclusion is not extended to subsequent modifications. The circular provides for a non-exhaustive list of amendments which are not considered to be "subsequent modifications", and which therefore do not affect the deductibility of the full amount of interest on these grandfathered loans:
- Amendments of the term and the interest rate of a loan after 17 June 2016, which were contractually agreed upon before 17 June 2016 (and for the term, provided the extension of the duration does not require the agreement of the parties);
- Drawdowns under an existing credit facility after 17 June 2016 in accordance with the terms and conditions contractually agreed before 17 June 2016;
- Loans granted to a company before 17 June 2016 which subsequently migrates its registered office or central administration to Luxembourg, to the extent the terms and conditions of the loans are not modified.
In case of a subsequent modification of the terms and conditions of a loan after 17 June 2016, the circular confirms that a "to the extent" approach applies. Hence, the grandfathering rule still applies to the exceeding borrowing costs linked to the initial terms and conditions of the loan, and the IDLR only applies to the additional exceeding borrowing costs arising as a result of the modification.
Other exceptions from the IDLR
The circular further illustrates in detail the workings of the public infrastructure exception, whereby exceeding borrowing costs related to debt incurred to fund a long-term public infrastructure project in the EU are excluded from the IDLR subject to certain conditions.
As regards the exception for standalone entities, i.e., entities that have no associated enterprise and satisfy certain other conditions, the circular emphasises that the association test is to be interpreted economically and that the 25% association threshold needs to be assessed both in a downward (subsidiaries) and upward (shareholders) manner.
Interactions with other rules
In line with the principle that the IDLR should only apply to otherwise "deductible" borrowing costs, the circular states that the IDLR applies after other Luxembourg tax rules that may deny the deductibility of interest charges have been taken into account.
The circular also explains the interaction between the IDLR and the "recapture" rule included in the Luxembourg participation exemption on capital gains. Expenses in relation to an exempt participation are deductible to the extent they exceed the exempt income in the same year, but the deducted amount is put in recapture and could result in a portion of a subsequent capital gain on the exempt participation being taxable. The circular confirms that only the borrowing costs which remain deductible under the IDLR need to be accounted for under the recapture rule.
Some unaddressed topics
Despite the need for legal certainty, in particular for credit funds and securitisation companies, the circular does not explicitly address whether capital gains realised on distressed or discounted debt may (partly) qualify as interest-like income.
Also, the circular does not address the formal notice of the European Commission dated 14 May 2020, which questions the inclusion of securitization special purpose entities falling within the scope of the EU Securitisation Regulation 2017/2402 in the list of financial undertakings benefiting from an IDLR exemption.
Moreover, the circular does not specify how negative interest should be treated for purposes of the IDLR.
Finally, the circular also does not indicate how to allocate non-deductible exceeding borrowing costs between different debts. This may in particular have an impact on the amount to be put in recapture, in case some of the debts finance one or more exempt participations.
Actions to be taken
The circular is administrative guidance that binds the Luxembourg tax authorities but not the taxpayers. Nonetheless, filing positions that deviate from the circular are likely to be challenged by the tax authorities.
Taxpayers which use financing instruments generating a return other than standard interest should reassess whether the return qualifies as borrowing cost in light of the circular's guidance. Taxpayers with debts and debt facilities predating 17 June 2016 should reassess the application of the grandfathering rule taking into account the additional guidance.
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.