On 19 June 2018 Bill of Law nr. 7318 (the Bill) was introduced before the Luxembourg Parliament, with the purpose of, amongst others, transposing Council Directive 2016/1164 laying down rules against tax avoidance practices that directly affect the functioning of the internal market (ATAD I). The provisions of ATAD I shall apply from 1 January 2019, with the exception of those related to exit taxation which will become effective as of 1 January 2020.
ATAD I is the answer of the EU to the recommendations formulated under the base erosion profit shifting (BEPS) initiative which is the common project of the OECD and the G20 to tackle tax avoidance following the abuse of diverging national tax systems by multinational companies in particular. Whilst the BEPS initiative merely set forward recommendations, the EU, in a concern for a harmonized implementation of the rules in the EU, transformed the recommendations into minimum standards. The latter result in the absence of a level playing field, which nevertheless was a pre-requisite for Luxembourg to adhere to the BEPS project.
Luxembourg however has used the leeway given by ATAD I to a maximum extent in order to stay as competitive and attractive as possible for foreign investors.
The newly introduced rules will apply to both resident - and non-resident corporate taxpayers, provided the latter derive profits through a permanent establishment in Luxembourg. As a result, all entities listed by article 159 LIR as well as article 160 (1) LIR are subject to the new provisions, which relate to the following five main areas:
- Interest deduction limitation;
- Controlled foreign companies;
- Hybrid mismatches within the EU;
- General anti-Abuse Rule;
- Exit taxation.
- Interest Deduction Limitation
A new article 168 bis LIR determines that in a given fiscal year, a taxpayer can only deduct net borrowing expenses up to (i) 30% of its EBITDA or (ii) an amount of € 3,000,000 (whichever is higher). As a result, the deduction of interest expenses is not limited to the extent the latter are offset against interest income or "economically equivalent" income (no further guidance has been given on the latter notion). Unused deduction capacity can be carried forward during 5 years, and net borrowing expenses exceeding the above limits may be carried forward indefinitely. Fiscally integrated Luxembourg entities will be subject to the above rules on a stand-alone basis, i.e. the above limits will be computed on each level separately.
Luxembourg opted to exclude interest expenses incurred on loans concluded before 17 June 2016, to the extent the latter have not subsequently been amended in terms of duration or principal amount. Moreover, the rule will not apply to stand-alone entities (i.e. not being part of a group of companies) and to long-term infrastructure projects in the EU.
In addition, certain financial undertakings are excluded from the interest deduction limitation rule, such as credit institutions, alternative investment fund managers (AIFM) as meant by the AIFMD (EU Directive 2011/61/EU), insurance - and reinsurance companies, pension undertakings, alternative investment funds who have appointed an AIFM, UCITS, and securitisation vehicles as covered by the EU regulation 2017/2402.
The interest deduction limitation rule will have no impact on the recapture rule applicable to expenses economically connected to qualifying participations or on the deductibility of debt for net wealth tax purposes.
- Controlled Foreign Companies (CFC)
The Bill will for the first time introduce CFC rules based on Action 3 of the BEPS initiative. The rules will be laid down in a new article 164 ter LIR which aim to allocate income realised but not (yet) distributed by a low-taxed subsidiary of a Luxembourg taxable entity to the latter in order to subject such income to corporate income tax (CIT) (currently levied at the rate of 18%) in Luxembourg, but not to Luxembourg municipal business tax.
A subsidiary constitutes a CFC if the Luxembourg entity holds, directly or indirectly, 50% in voting rights, share capital or profit entitlement and if the actual corporate income tax due is less than 50% of the CIT due should the income be realised at the level of the Luxembourg parent company. Luxembourg has opted to limit the CFC income to the income that has arisen from non-genuine arrangements having been put in place in essence to obtain a tax advantage. As a result, only the income that has actually been generated through the assets and risks linked to significant people functions carried out by the Luxembourg controlling entity will be subject to taxation in Luxembourg (transfer-pricing based method – option b under ATAD I).
Previously taxed CFC income will be deducted when such income is eventually distributed. The same rule applies when capital gains are realised upon alienation of a CFC.
Entities with accounting profits less than (i) € 750,000 or (ii) 10% of its operating costs are excluded from the CFC rules.
- Hybrid Mismatches within the EU
Following new article 168 ter LIR, a hybrid mismatch consists in financial instruments or entities concluded or respectively existing between a Luxembourg taxpayer and a party established in another EU Member State, which result in either a deduction of the same expenses in both Luxembourg and the other EU Member State (double deduction) or a deduction of expenses in Luxembourg and no corresponding inclusion of the income in the taxable basis in the other EU Member State (deduction without inclusion). In both cases, the mismatch is due to a different legal qualification of the instrument or entity given by Luxembourg and the other EU Member State.
In case of double deduction, the deduction shall only be allowed in the Member State where the payment has its source, while in case of deduction without inclusion, the deduction of the expense shall be denied. In case of conflict with the anti-hybrid rule introduced by the amended EU Parent-Subsidiary Directive, the latter will have priority (no exemption if the payment has been deducted at the level of the paying entity). Hence, the impact of article 168 ter LIR should be limited.
However, it should be noted that the Council of the European Union has already passed the Directive 2017/952 (ATAD II), intended to amend the anti-hybrid mismatch rule by widening its geographical and material scope to include hybrid mismatches between EU States and third countries and broaden the variety of cases where a deduction would not be granted (introducing imported mismatches, residency mismatched, hybrid transfers, reverse hybrids, etc.). ATAD II is due to be transposed by 31 December 2019 (except for reverse hybrids which will only apply after 31 December 2021).
- General Anti-Abuse Rule (GAAR)
The general anti-abuse measure already laid-down in article 6 of the Luxembourg Adaptation Law (Steueranpassungsgesetz - StAnpG) will be slightly amended further to the GAAR introduced by ATAD I. The latter aims to target non-genuine transactions based on the absence of valid commercial reasons that reflect economic reality, whereas the existing anti-abuse provision is based on the "abuse-of-law" principle. By virtue of the amended provision, a transaction that is not genuine will be ignored and taxes will be computed on the basis of the genuine or normal route, if, based on all facts and circumstances, the main or one of the main purposes is to obtain a tax advantage. The tax authorities must identify the constitutive elements of the abuse, but the taxpayer needs to demonstrate the commercial valid reasons for the transaction.
- Exit Taxation
ATAD I requires a change of the existing exit taxation rules embedded in Luxembourg tax legislation when assets or enterprises are transferred cross-border. The value of the assets entering Luxembourg should be determined on the basis of the operating value of the assets as established by the leaving state (step-up in value) and the date of acquisition is the historical acquisition date. In case of a (i) transfer of assets or an activity (a) from a Luxembourg head office to a permanent establishment (PE) in another Member State or (b) from a Luxembourg PE to a PE or its head office in another Member State, or (c) a transfer of residence or effective seat of a Luxembourg entity to another Member State, the operating value of the assets upon transfer will constitute the transfer price and taxation will occur immediately (and no longer only when the assets are sold) insofar Luxembourg loses its taxation right.
The taxable basis is determined as the difference between the value recorded in the opening balance sheet and the operating value upon exit (i.e. the fair market value). The existing tax payment deferral will however be limited to five years for transfers within the EU and EEA but no guarantee needs to be constituted nor will late payment interest apply. Taxation will not apply in certain cases (such as the transfer for financial security purposes, compliance with foreign debt/equity ratios, or short-term transfers, i.e. retrocession happens within 12 months) and deferrals granted for periods ending before 1 January 2020 will not be affected.
- Other anti-abuse provisions
Other than implementing the provisions of ATAD I, the Bill has also abolished the roll-over relief currently applying to the conversion of loans into shares under article 22 bis (2) nr.1 LIR following the State Aid investigation by the EU Commission (Engie case).
Finally, article 16 StAnpG (domestic definition of PE) has been completed with a new paragraph 5 which aims to avoid situations of double non-taxation in presence of a PE abroad for which the taxation rights of the other contracting state are limited following the latter's interpretation of the double tax treaty, whilst the treaty does not allow Luxembourg to refrain from exempting the income.
It goes without saying that the above rules will have a significant impact on many Luxembourg taxpayers and their structures which may therefore have to be revisited and potentially amended. Nonetheless, the choices that Luxembourg made under ATAD I in terms of implementation (to the extent such faculty was left by the EU) should be welcomed, especially the exclusion of certain financial undertakings of the interest deduction limitation rule and the option for the transfer-pricing based method to determine CFC income. The favorable options followed by Luxembourg will certainly help to maintain its attractiveness within the EU, but additional efforts, such as a further decrease of the corporate income tax rate, would be desirable to strengthen its position across the EU external borders.
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.