On 8 August 2019, Bill No. 7466 (the "Bill") implementing the Anti-Tax Avoidance Directive (EU) 2017/952 on hybrid mismatches ("ATAD2") into Luxembourg domestic law was published.
ATAD2 amends Directive (EU) 2016/1164, which has already introduced a first set of rules targeting certain hybrid mismatches between EU Member States ("ATAD1"). ATAD2 extends the scope of ATAD1 hybrid mismatch rules to cover a wider variety of mismatches and mismatches between EU Member States and third countries.
The Bill's content largely reproduces that of ATAD2. The Bill also provides some useful clarifications, notably on the concept of "acting together". It is welcome that the Bill also implements ATAD2's carve-outs. Accordingly, the Bill addresses the four categories of hybrid mismatch arrangements provided for in ATAD2, namely:
- - Hybrid arrangements arising from payments made under financial instruments;
- - Hybrid arrangements arising from payments made to a hybrid entity or a (disregarded) permanent establishment;
- - Hybrid arrangements arising from payments made by a hybrid entity or deemed payments made between the head office and the branch or between two branches;
- - Double deductions resulting from the payments made by a hybrid entity or a branch.
As a preliminary remark, it is to be noted that the scope of the hybrid mismatch rules will be limited to mismatches arising between "associated enterprises", between a taxpayer and an associated enterprise, between a head office and its PE, between two or more PEs of the same entity or under a structured arrangement.
The concept of "associated enterprises" and "acting together"
An "associated enterprise" is defined as (i) an undertaking in which the taxpayer directly or indirectly holds a participation in terms of voting rights or capital ownership of 50 percent or more, or is entitled to receive 50 percent or more of the profits of that entity, or (ii) an individual or undertaking which directly or indirectly holds a participation in terms of voting rights or capital ownership in a taxpayer of 50 percent or more, or is entitled to receive 50 percent or more of the profits of the taxpayer. The 50 percent threshold is decreased to 25 percent where the mismatch is due to the hybrid instrument) or (iii) an undertaking which is part of a consolidated group for accounting purposes or (iv) an enterprise in which the taxpayer exercises a significant influence on the management or an enterprise which exercises a significant influence on the management of the taxpayer.
In order to determine whether the thresholds of 50% or 25% under (i) and (ii) of the definition are met, the direct and indirect interests of persons who are deemed "acting together" have to be aggregated.
The Bill provides important clarification on the concept of "acting together" for the fund industry. Under a rebuttable presumption, an investor in an investment fund would not be considered as acting together with another investor of the same fund if he/she/it directly or indirectly holds less than 10 percent in, and is entitled to receive less than 10 percent of the profits of, the investment fund. According to the Bill's commentary, an investment fund is a collective investment undertaking which raises capital from a number of investors for the purpose of investing them in accordance with a defined investment policy for the benefit of such investors. The definition is wide and should cover undertakings for collective investment (UCIs) under the Law of 2010, specialised investment funds (SIFs) under the Law of 2007, Luxembourg reserved alternative investment funds (RAIFs) under the Law of 2016 and alternative investment funds (AIFs) falling into the scope of the Law of 2013.
The Bill does not provide any further clarification on the terms or concepts used to define "associated enterprises" and notably on the term of "profits" or the concept of "significant influence" (to the extent an associated enterprise also means an entity that has a significant influence in the management of the taxpayer).
Hybrid financial instrument mismatches
A hybrid financial instrument mismatch concerns situations where the tax treatment of a financial instrument differs between two jurisdictions and leads to a situation in which a payment is deducted from the tax base in one jurisdiction without a corresponding inclusion within a reasonable period of time of that payment in the tax base of a taxpayer in another jurisdiction. In order to neutralise this mismatch, the primary rule is that the deduction should be denied in the state in which the payer is resident. If the deduction is not denied by the (third country) payer jurisdiction, as a secondary rule, the payment should be included in the income in the payee jurisdiction.
As with ATAD2, the Bill also covers hybrid transfers. A hybrid transfer covers any arrangement to transfer a financial instrument where the underlying return on the transferred instrument is treated for tax purposes as derived simultaneously by more than one of the parties to the arrangement (e.g. structuring loans as a share sales and repos). To the extent that a hybrid transfer is designed to produce a relief for tax withheld at source on a payment derived from a transferred financial instrument to more than one of the parties involved, the jurisdiction of the taxpayer shall limit the benefit of such relief in proportion to the net taxable income regarding such payment.
The Bill provides for the following exemptions:
- (i) Certain financial instruments that have been issued with the sole purpose of meeting the issuer's loss-absorbing capacity requirements are excluded from the scope of the hybrid rules until 31 December 2022. The carve-out will not apply if it arises under a structured arrangement or is done for the purpose of avoiding tax;
- (ii) A payment representing the underlying return on a transferred financial instrument is excluded from the scope of the hybrid rules where the payer jurisdiction under an "on-market hybrid transfer" requires a financial trader to include all amounts received under the transferred financial instrument as income.
In line with ATAD2, the Bill makes it clear that no hybrid mismatch rule applies if the non-inclusion at the level of the beneficiary is only due to (i) its tax status (e.g. a tax-exempt investment fund or a tax-exempt sovereign fund) or (ii) the fact that the instrument is held subject to the terms of a special tax regime. In addition, differences in tax outcomes that are solely attributable to differences in the value ascribed to a payment, including through the application of transfer pricing rules, would not be treated as giving rise to a hybrid mismatch.
Hybrid entity mismatches
A hybrid entity is any entity or arrangement that is treated as a taxable entity under the laws of one jurisdiction but is disregarded under the laws of another jurisdiction.
- - Hybrid entities treated as taxable entities under the laws of their jurisdiction but disregarded under the laws of the investors' jurisdiction:
- A payment made by such a hybrid entity gives rise to a mismatch outcome where that payment is tax deductible from the tax base of the hybrid entity without a corresponding inclusion in the tax base of the investor.
- As a primary rule, the deduction shall be denied in the payer jurisdiction. If the deduction is not denied by the payer jurisdiction (i.e. a non-EU Member State), as a secondary rule, the payment should in principle be included in the net income of the beneficiary.
- A payment made by such a hybrid entity could also result in a double deduction. As a primary rule, the investor's jurisdiction should deny the deduction (to the extent there is no dual-inclusion income). If the deduction is not denied in the investor's jurisdiction, as a secondary rule, the deduction should be denied in the payer's jurisdiction.
- - Hybrid entity disregarded under the laws of its jurisdiction but treated as a taxable entity under the laws of the investors' jurisdiction
- A payment made by such a hybrid entity gives rise to a mismatch outcome where the payment is tax deductible from the tax base of the payer without a corresponding inclusion in the tax base of the investor.
- In such a case, the deduction shall be denied in the payer jurisdiction. Interestingly, the Bill took the option offered by ATAD2 to exclude the application of the secondary rule (i.e. mandatory income inclusion) in case of a reverse hybrid undertaking (notably).
- It is noteworthy that the so-called "reverse hybrid" entities established in Luxembourg will be subject to a specific rule applicable as from 2022 (see below). Meanwhile (as from 2020 until 2022), the Bill's Commentary implies that the general rule will be applicable to all "reverse hybrid" entities (whether established in Luxembourg or not).
Reverse hybrid mismatches
As from 2022, a specific hybrid mismatch rule applies to tax transparent entities established in Luxembourg (for example limited partnerships such as a société en commandite simple (SCS) or a société en commandite spéciale (SCSp)) that are regarded as opaque in the jurisdiction of the investor. In this case, a mismatch outcome may arise if payments made to the reverse hybrid entity are deductible from the tax base of the payer while not included in the tax base of the investor.
As a remedy to this hybrid mismatch, the reverse hybrid entity shall be regarded as a resident of Luxembourg and shall be subject to Luxembourg corporate income tax. The Bill's Commentary clarifies that reverse hybrid entities should however not be subject to Luxembourg net wealth tax in this case. Such clarification would also be welcomed for dividend withholding tax.
The Bill provides for the "collective investment vehicles" ("CIV") exemption of ATAD2. The commentaries to the Bill clarifies that this covers UCIs, SIFs and RAIFs. AIFs shall also be excluded from the reverse hybrid rule to the extent that they are widely held, hold a diversified portfolio of securities with limited market risk exposure and are subject to investor-protection regulation. No reference is made to the investment company in risk capital (SICAR) under the Law of 2014 established in the form of an SCS or an SCSp while such an entity could also meet the conditions required for an AIF. As mentioned above under the section related to hybrid entity mismatches, as from the tax year 2020 until 2022, such reverse hybrid entities (i.e. those established in Luxembourg) could fall under the scope of the general rule related to hybrid entities. In relation thereto, it must be noted that the general rule of hybrid entities does not provide for the same CIV exemption as the specific rule applicable to reverse hybrid entities applicable as from 2022.
Hybrid PE mismatches
Hybrid PE mismatches concern situations where the business activities in a jurisdiction are treated as being carried out through a PE by the head office jurisdiction whereby such jurisdiction exempts the income derived from the PE while those activities are not treated as being carried on through a PE in the PE jurisdiction, resulting in an exemption with no inclusion of the relevant items of taxable income. The Bill addresses the same PE mismatch scenario (along with corresponding remedies to neutralise such mismatches) as ATAD2. It is clarified in the commentaries that the applicable explanations and examples in the 2017 OECD BEPS report on branch mismatch arrangements should be used as a source of illustration or interpretation.
Imported hybrid mismatches
An imported mismatch occurs when a payment (by a Luxembourg payer) that does not directly result in a hybrid mismatch outcome, funds another payment that does result in a hybrid mismatch outcome and which has not been neutralised by the third country jurisdictions. To neutralise these imported mismatches, the deduction of the payment under a non-hybrid instrument is denied if the corresponding income from that payment is directly or indirectly set off against a deduction that arises under a hybrid mismatch arrangement giving rise to a double deduction or a deduction without inclusion between third countries. This rule should not apply to the extent that one of the third country jurisdictions involved in the transaction has made a hybrid mismatch adjustment in respect of the imported hybrid mismatch. There are many practical issues arising from the application of this rule that the Bill does not address (especially when several taxpayers fall into the scope of the imported mismatch rules in relation to the same hybrid arrangement). In absence of any further clarification, guidance in BEPS Action 2 should then be followed.
Dual resident mismatches
To the extent that [a deduction for payment, expenses or losses of a taxpayer which/who is a resident for tax purposes in two (or more) jurisdictions is deductible from the taxable base in both jurisdictions, the EU Member State of the taxpayer shall deny the deduction to the extent that the other jurisdiction allows the duplicate deduction to be set off against non-dual inclusion income (i.e. any item of income that is not included under the laws of both jurisdictions where the hybrid mismatch outcome arose). If both jurisdictions are EU Member States, the deduction shall be denied in the EU Member State in which the taxpayer is not deemed be resident according to the double taxation treaty entered into between both EU Member States.
According to the Bill's Commentary, the taxpayer must provide relevant documentation demonstrating that the hybrid mismatch provisions do not apply to his/her/its case, upon simple request by the tax authorities,.
The Bill will enter into force once approved by the Luxembourg Parliament. This must be achieved before the end of the year. Meanwhile, it will go through the legislative process, i.e. it will be subject to different opinions of concerned agencies (professional bodies), but especially to the opinion of the Council of State and may thus still be amended before the final vote of the Parliament.
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.