A new set of Luxembourg tax rules in compliance with ATAD

On 18 December 2018, the Luxembourg Parliament adopted the bill of law N°7318 (the Law) transposing into Luxembourg legislation the five anti-abuse measures introduced by the EU Anti-Tax Avoidance Directive 2016/1164 of 12 July 2016 (ATAD). The Law further introduces two adjustments to existing tax provisions.

Subject to the expected exemption of a second vote to be granted by the Luxembourg State Council, the Law will enter into force on 1 January 2019 (except for the exit taxation rules, which will apply as from 1 January 2020 only).

The measures as implemented by the Law are of particular relevance for Luxembourg corporate taxpayers and can be summarised as follows:

CFC rules

Until now, the Luxembourg tax legislation did not include any provisions regarding controlled foreign companies (CFC). In order to bring it in line with the ATAD, the Law introduces CFC rules which aim, in essence, to attribute to a Luxembourg parent or head office undistributed profits of a subsidiary or permanent establishment located in a low tax jurisdiction. As a consequence, CFC income will be subject to corporate income tax in Luxembourg (but not to municipal business tax).

A CFC is targeted if (i) the taxpayer alone (or together with its associated enterprises) holds a direct or indirect participation of more than 50% in voting rights, capital or profit entitlement of that entity and (ii) the actual corporate income tax paid by the entity or permanent establishment on its profits is lower than 50% of the corporate income tax charge that would have been payable in Luxembourg, had the entity or permanent establishment been resident or established in Luxembourg. If these two tests are met, the Luxembourg taxpayer must include in its taxable basis the undistributed income of the entity or permanent establishment, but only to the extent arising from non-genuine arrangements that have been put in place for the essential purpose of obtaining a tax advantage.  

Luxembourg chose ATAD option B (transfer pricing based method) over option A (passive income based method), which, in a nutshell, means that the recognition of profits allocable to Luxembourg should be limited to an "at arm's length" amount generated through assets and risks linked to significant functions carried out by the taxpayer.

Certain exceptions are foreseen, notably in case of CFCs with limited accounting profits. 

Interest deduction limitation rules

The Law also introduces a limitation for the deduction of borrowing costs in excess of the taxable interest revenues and other economically equivalent taxable income of the taxpayer. 

Tax deductions of net interest expenses will be capped to an amount equal to the higher of either (i) EUR 3 million, or (ii) 30% of the so-called EBITDA, defined in the Law as the total net income increased by excessive borrowing costs, deductible depreciation and amortisation (exempt income and expenses related to such exempt income are excluded from the EBITDA definition). The Law does not provide for any definition or guidance for interpretation of what constitutes interest revenue and other economically equivalent taxable income. However, it is expected that interest revenue should be defined by symmetry, and thus include at least the items listed in the Law under the definition of borrowing costs.

Carry forward rules apply with respect to exceeding borrowing costs not deductible in a tax period (without time limitation) and to interest capacity which cannot be used in a given tax period (for a period of 5 years maximum).

Interest deduction under a debt instrument or agreement concluded before 17 June 2016 should not fall within the scope of these rules (unless the instrument or agreement is subsequently modified). 

Credit institutions, insurances or reinsurances entities, pension funds, alternative investment funds, UCITS, regulated securitisation vehicles and stand-alone entities are excluded from the scope of these rules. Limitations also apply, for instance, for a member of a consolidated group if it can demonstrate that the ratio of its equity to its total assets is equal to, or higher than, the equivalent ratio of the group.

For fiscal unity groups, the Law, as it currently stands, foresees that the above limits should be computed on a stand-alone basis. However, the Luxembourg Government has committed to introduce the possibility to compute these limits at the level of the integrated group as a whole (this should be implemented via a separate measure having retroactive effect as from 1 January 2019). Also, the Luxembourg Parliament has invited (via a legislative motion) the Government to reanalyse the application of the deduction limits in the context of non-regulated securitisation vehicles.

Exit taxation rules

Capital gains on assets transferred outside Luxembourg should be immediately taxable. Pursuant to the Law, a deferral may apply in case of transfer of assets to a Member State, or to an EEA State with which Luxembourg or the EU has an agreement on the recovery of taxes. Taxpayers will in that case have the option to pay the exit tax in equal instalments during a maximum period of five years (without guarantees or interest).

Certain temporary asset transfers, not exceeding 12 months, will not be subject to exit tax (for instance, in case of assets posted as collateral or asset transfers related to the financing of securities). 

The Law should not impact deferrals granted for exit tax due in relation to accounting years ending before 1 January 2020. 

In parallel with the above, a step-up in basis will be granted, under certain circumstances, for assets transferred to Luxembourg (taking into account the fair market value established by the exit jurisdiction). The Law makes it clear that the acquisition date of the assets will not change as a result of their transfer.

General anti-abuse rule (GAAR)

The Law amends the existing Luxembourg domestic GAAR to further align the latter with the wording of the GAAR as provided in the ATAD. 

Based on the amended GAAR, an abuse exists in the presence of the following three elements: 

(i) the use of forms and institutions of law (a transaction);

(ii) the main purpose or one of the main purposes of the transaction is to obtain a tax advantage that defeats the object or purpose of the applicable tax law;

(iii) the transaction is not genuine, which is the case when, having regard to all relevant facts and circumstances, it was not chosen for sound commercial reasons that reflect economic reality.

While the amended GAAR maintains the principal elements of the current GAAR, its scope of application is broader. It will notably apply to non-genuine transactions where one of the main purposes is to obtain a tax advantage in contrast to the current GAAR where a transaction is considered abusive only if, in essence, its sole purpose is to obtain a tax advantage.

In case of abuse, the Luxembourg tax authorities will disregard the elements of the transaction which are not genuine and, considering all relevant facts and circumstances, tax the transaction accordingly. The commentaries to the Law provide that specific anti-abuse provisions should prevail over the GAAR.

Anti-hybrid rules

A Luxembourg taxpayer will be denied the deduction of an expense or loss when, by virtue of a difference in the legal qualification of a financial instrument or undertaking (a Hybrid Mismatch), an arrangement structured between the Luxembourg taxpayer and a party in another Member State, or the commercial or financial relations between the Luxembourg taxpayer and a related party in another Member, leads to one of the following situation:

(i) the expense or loss is already deductible in the other Member State, where the expense or loss has its source (double deduction cases); and

(ii) the expense or loss is sourced in Luxembourg and the corresponding income is not included in the overall net income determined in the other Member State (deduction without inclusion cases). 

These anti-hybrid rules will apply within the EU (but not with third countries). They should be replaced by broader anti-hybrid rules following the adoption by the Council of the EU, on 29 May 2017, of a directive amending the ATAD regarding hybrid mismatches with third countries (ATAD 2). Member States have until 31 December 2019 to transpose the provisions of ATAD 2 for an application from 2020 (measures on reverse hybrids shall be transposed by no later than 31 December 2021 with effect from 1 January 2022).

Additional non-ATAD specific amendments

Tax neutral conversion of loans into shares

The Law deletes the provision in the Luxembourg Income Tax Law that foresees the option  for a Luxembourg taxpayer to do a tax neutral conversion of a loan into shares in the capital of the borrower. Such conversion will be considered as a transfer of the loan at fair market value, followed by the acquisition of the shares at fair market value. Any capital gain resulting from such conversion should be subject to tax.

Amendments to the definition of permanent establishment

The  Law amends § 16 of the Tax Adaption Law, which defines a permanent establishment, to end possible conflicts arising from diverging domestic law and tax treaty provisions. The recognition of a permanent establishment will be determined solely on the basis of the criteria resulting from the applicable tax treaty. The Law clarifies that a taxpayer should have a permanent establishment in a Contracting State if its activity in such State constitutes an independent activity and represents a participation in the general economic life. It is furthermore specified that the Luxembourg tax authorities may request the taxpayer to justify that the other Contracting State recognises the existence of a permanent establishment.

Some of these new rules are a real novelty in the Luxembourg tax framework. Given their complexity, one should closely monitor their potential impact. 

Several aspects remain yet to be clarified. Notably it is to be further specified how these new rules will interact with domestic and tax treaties provisions.

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