The bill of law implementing the amended EU anti-tax avoidance directive (ATAD2) in Luxembourg was published on 9 August 2019. Subject to parliamentary approval, it will extend the scope of the existing anti-hybrid rules to mismatches with third countries and to a wider array of hybrid mismatches. These rules will have effect for tax years starting on or after 1 January 2020, except for the reverse hybrid rules which will apply only as of tax year 2022. The content is very similar to the one of ATAD2, with some tailoring to adapt to Luxembourg tax law concepts and to implement ATAD2’s optional carve-outs (notably for hybrid instruments issued by banks to meet loss absorbing capacity requirements until 31 December 2022). The bill of law also contains some clarifications, e.g., on the notion of “acting together” introduced by ATAD2 and which increases the situations in which two enterprises are considered associated.
Background and scope of new rules
ATAD2 was adopted in 2017 and must be implemented by all EU Member States for tax years starting on or after 1 January 2020, save for the reverse hybrid rules. It seeks to prevent mismatch outcomes that arise as a consequence of the hybridity of a financial instrument, legal entity or permanent establishment (PE). For the rules to apply, the mismatch must arise between associated entities or as part of a structured arrangement.
Targeted mismatch outcomes are:
- Deduction without inclusion: a tax deductible payment made by a taxpayer which is not correspondingly included in the taxable income at the level of the recipient;
- Double deduction: a taxpayer deducts the same payment in two countries or two taxpayers take a deduction for the same payment in two different countries; and
- Double non-taxation or double tax credits: there is a mismatch in the allocation of income between a PE and its head office or between two or more PEs of the same taxpayer, or income is allocated to a disregarded PE, or the same income generates a tax credit in the hands of two different taxpayers as a result of a hybrid transfer of the income-generating asset.
Depending on the specific case, the new rules may lead to the denial of the tax deductibility of a payment made by a Luxembourg taxpayer or to the inclusion of exempt income in the Luxembourg tax base. Reverse hybrid rules, if applicable, could result in Luxembourg tax transparent entities (e.g., limited partnerships) becoming subject to corporate income tax on all or part of their income.
Clarifications in the draft implementing law
Acting together concept
Pursuant to ATAD2, when a person acts together with another person with respect to the voting rights or capital ownership in an entity, their participations in such entity will be aggregated in order to determine whether they are “associated” to that entity. The bill of law provides that, in the absence of evidence to the contrary, an investor who owns (directly or indirectly) less than 10% of the interests in an investment fund and is entitled to less than 10% of the profits of said fund will not be considered as acting together with another investor in the same fund.
Reverse hybrid rules
In line with ATAD2, the entry into force of these rules is deferred to tax year 2022. A reverse hybrid is a transparent entity for Luxembourg tax purposes, but that is seen as opaque in the jurisdiction(s) of (some of) its investors. If associated investors resident in such jurisdiction(s) hold at least 50% of interest in a Luxembourg reverse hybrid entity, the latter will be treated as a resident taxpayer and subject to corporate income tax on its income to the extent it is not taxed in the hands of its investors (either in Luxembourg or in a foreign jurisdiction, or under Luxembourg non-resident taxation rules). Luxembourg reverse hybrids will, however, not become subject to net wealth tax. Further to this, Luxembourg has opted to implement the carve-out for collective investment vehicles as provided for by ATAD2: reverse hybrid rules will not apply for Luxembourg regulated investment funds (UCITs, Part II UCIs (2010 law), SIFs and RAIFs), and any AIF that is widely-held, holds a diversified portfolio and is subject to investor protection rules.
In line with ATAD2, the commentary to the bill of law clarifies that the mismatch rules denying the deduction at the level of the Luxembourg payer should not apply if the absence of a corresponding inclusion at the level of the foreign investor/recipient is due to its tax status (e.g. tax exempt investment fund or sovereign wealth fund) or due to a special tax regime.
Burden of proof
Taxpayers will have to provide the tax administration, upon request, with relevant documentation reasonably proving the absence of hybridity or that another country has already tackled the hybrid mismatch. Relevant documents include tax returns and certificates from foreign tax authorities.
Interim carve-out for banks
Luxembourg plans to implement the optional carve-out for hybrid instruments issued by banks to meet loss absorbing capacity requirements. This carve-out provision would be applicable until 31 December 2022 under the conditions provided for in ATAD2.
Treaty override (intra-EU)
In case where a disregarded PE of a Luxembourg company is located in another Member State and the tax treaty concluded by Luxembourg with that Member State requires Luxembourg to exempt the income allocable to the PE, the ATAD2 rule will prevail over the treaty and Luxembourg will have to include income of the disregarded PE in the tax base of the Luxembourg head office. This is in line with the European Commission’s stance. It should have a (very) limited impact, as this kind of mismatches is rare between Luxembourg and other EU Member States.
Order of application of rules
In line with ATAD2, the bill of law provides that specific anti-hybrid mismatch rules of other EU directives apply in priority, and that reverse hybrid rules and rules on disregarded PE income apply before the other ATAD2’s anti-hybrid rules.
Timing and next steps
The bill of law will now go through the usual parliamentary process and may be amended prior to the approval, which can be expected towards year end. Most rules will apply for tax years starting on or after 1 January 2020. Reverse hybrid rules are due to enter into force two years later.
All structures in which a Luxembourg entity is directly or indirectly involved in a hybrid mismatch need to be reviewed. It is irrelevant whether a taxpayer actually intended to create a hybrid mismatch outcome, as the ATAD2 measures are applied objectively. Fund managers setting up new investment funds should consider adapting disclosure language in fund documentation (notably the limited partnership agreement and the private placement memorandum).