Luxembourg Tax Authorities issue guidance on the “equity escape clause” under interest limitation rules

Executive summary

On 2 June 2021, the Luxembourg Tax Authorities updated the Circular originally issued on 8 January 2021ⁱ  clarifying certain technical aspects of the interest limitation rules introduced in the Luxembourg legislation by law in 2018 (the Law). The Law implements the European Union (EU) Anti-Tax Avoidance Directive 2016/1164 (2016) (ATAD)ii.  These rules limit the deductibility of taxpayers’ borrowing costs to the higher of 30% of taxable EBITDA (Earnings (taxable profits) before Interest, Tax, Impairments, Depreciation and Amortization) or €3 million. 

The updated Circular introduces a specific section dedicated to the safeguard clause for entities in a consolidated group, referred to as the “equity escape clause”. Under the equity escape clause, where the taxpayer is a member of a consolidated group for financial accounting purposes, it may, upon request, deduct the entire amount of its exceeding borrowing costs if it can demonstrate that the ratio of its equity over its total assets is lower by not more than two percentage points, equal to or higher than the equivalent ratio of the group. Exceeding borrowing costs are defined as the excess of borrowing costs (i.e., interest expenses on all forms of debt, other costs economically equivalent to interest, as well as expenses incurred in relation with the raising of finance) over interest income and other economically equivalent taxable revenues.

This Alert details the various comments and clarifications provided by the Circular on the application of the equity escape clause. 

Detailed discussion

Scope

In line with the Law, the Circular confirms that the equity escape clause is an exceptional rule giving a taxpayer, under certain conditions, the possibility to deduct the full amount of the exceeding borrowing costs it has incurred in a given financial year. 

Eligibility requirements

In order for the equity escape clause to apply, several conditions and requirements must be cumulatively met, which the Circular details as follows:

• The taxpayer must be a member of a consolidated group for financial accounting purposes, which is not to be confused with the concept of integrated group for tax purposes (fiscal unity). 
  
  The Circular states that the taxpayer must be fully consolidated (i.e., on a line-by-line basis; proportional consolidation or equity method are excluded). Where there are several consolidated groups whose financial statements, as prepared under a legal requirement, could prima facie be used as a basis for the application of the safeguard clause, the Circular specifies that the consolidated accounts prepared by the ultimate consolidating entity are to be used.
  
  Absent any legal requirement to prepare consolidated financial statements, the Circular clarifies that the use of voluntarily prepared consolidated financial statements is accepted for the purpose of applying the equity escape clause. Voluntarily prepared consolidated financial statements must be prepared in accordance with an eligible financial reporting framework (see below) and must comply with the applied financial reporting framework, in particular as regards the determination of fully consolidated entities. Moreover, the same requirements regarding consolidation by the ultimate consolidated entity apply to voluntary consolidations. 
  
  
• The consolidated financial statements must be prepared in accordance with an eligible financial reporting framework, i.e., in accordance with International Financial Reporting Standards (IFRS) or with the national financial reporting framework of a Member State, which does not only cover the accounting standards applicable in each Member State but also those whose conformity or equivalence is officially recognized or demonstrated by official accounting procedures. The Circular indicates that this equivalence may be formally recognized on the basis of legal acts that are taken at the EU level. Reference is made to the European Commission, which formally recognized, in its implementing decisions 2008/961/ECiii and 2012/194/EU3, the equivalence of generally accepted accounting principles of Japan, the United States of America, the People’s Republic of China, Canada and the Republic of Korea.
  
  
• The financial reporting framework to be applied is determined on the basis of the provisions governing the legal consolidation requirement applicable to the ultimate consolidating entity. In the case of consolidated financial statements prepared voluntarily, the financial reporting framework to be applied is to be determined on the basis of the legislation governing the accounting consolidation that would have been applicable in the jurisdiction of the ultimate consolidating entity if that entity had been required by that legislation to prepare such consolidated financial statements. However, according to the Circular, consolidated financial statements may be prepared in accordance with IFRS, even where such legislation does not require its application. 
  
  
• The consolidated financial statements must be audited by a professional authorized to audit consolidated financial statements under the national law of the ultimate consolidating entity. The Circular gives the example of a company incorporated under Luxembourg law and required by Luxembourg law to prepare consolidated financial statements. Under that same law, the company is required to have them audited by one or more réviseurs d'entreprises agréés (approved statutory auditors). The audit of the consolidated financial statements may be carried out as part of a statutory engagement or as part of a contractual engagement carried out at the request of the taxpayer or another entity of the consolidated group, provided that such a contractual engagement is carried out in accordance with standards equivalent to those which would have been applicable in the context of a statutory audit of the consolidated accounts or, failing that, in accordance with standards equivalent to Luxembourg auditing standards applicable in the field of statutory audit.

Application of the equity escape clause

Adjustment and adaptation of the financial statements

The equity escape clause requires a comparison of the taxpayer's ratio of equity over its total assets (taxpayer's ratio) with the consolidated group's ratio of equity over total assets (consolidated group's ratio). This may require some adjustments and adaptations to be made to the taxpayer’s financial statements and the group consolidated financial statements of the closing date of the financial year concerned. 

With reference to the provisions of the Law, the Circular first underlines that the comparison of ratios requires an identity of methods, i.e., all assets and liabilities of the taxpayer must be valued according to the same method as that used in the consolidated financial statements. This means that the taxpayer's annual financial statements must be prepared in accordance with the same accounting rules as those used in the consolidated accounts of the ultimate consolidating entity, which may require an adaptation of the taxpayer's annual financial statements. The Circular gives as an example the case of consolidated financial statements of the ultimate consolidating entity being prepared in accordance with IFRS: If the taxpayer does not use IFRS for the preparation of its annual financial statements, the financial statements must be adapted in accordance with IFRS in order to be able to carry out the necessary comparison of ratios.

An adaptation of the consolidated financial statements is required where a consolidated group includes entities that have been consolidated using a consolidation method that differs from the full consolidation method (e.g., proportionate consolidation or equity method). In such case, the adaptation is to be made as if these other consolidation methods did not exist.

Comparison of ratios 

Once the required adjustments and restatements to the taxpayer’s annual financial statements and the group consolidated statements, if any, have been made, the ratios are compared, considering the following:

• The two ratios to be compared are obtained by dividing the amount of the equity by the amount of the assets (balance sheet total), both at the level of the taxpayer and at the level of the consolidated group.
• Where the taxpayer's ratio is equal to or higher than that of the consolidated group, the equity escape clause may be applied. According to the provisions of the Law, the taxpayer's ratio is considered to be equal to the consolidated group's ratio when the taxpayer's ratio is less than the consolidated group's ratio by a maximum of two percentage points. This means in practice that if the taxpayer's ratio, increased by two percentage points, is equal to or higher than the consolidated group's ratio, the equity escape clause can be applied. 

Practical aspects of the application of the equity escape clause

The Circular recalls that the application of the equity escape clause is subject to a request. Such request is to be made for each financial year for which the taxpayer opts to apply said clause.

The Circular provides a list of items to be included in the tax return for the years for which the equity escape clause is to be applied, including details on the financial reporting framework applied, details of adjustments made to the financial statements as well as the equity and assets used for the calculation of the ratios. 

The Circular further specifies that upon request of the competent taxation office, the taxpayer is obliged to provide the consolidated financial statements used in the context of the equity escape clause, the audit report relating to those consolidated financial statements or the equivalent document to such an audit report prepared by the auditor of the consolidated financial statements and/or a certificate issued by a person qualified to audit the financial statements and having adequate accounting knowledge proving that the adjustments and adaptations as described above have been properly made. 

The effects of the equity escape clause

As a result of the application of the equity escape clause, the taxpayer will be entitled to deduct the entire amount of exceeding borrowing costs incurred during a given financial year, irrespective of the 30% taxable EBITDA limit.

The Circular outlines that given the exceptional character of the equity escape clause, its application prevents that any unused capacity to be carried forward to materialize, and that exceeding borrowing costs incurred and considered non-deductible in respect of a previous year cannot be deducted in the year during which the equity escape clause is applied.

[i] Circular L.I.R. n°168bis/1 of 8 January 2021; see EY Global Tax Alert, Luxembourg Tax Authorities issue guidance on interest limitation rules, dated 12 January 2021.

[ii] See EY Global Tax Alert, Luxembourg: A detailed review of the EU ATAD implementation law, dated 28 December 2018.

[iii] Commission Decision of 12 December 2008 on the use by third country issuers of securities of certain third country national accounting standards and International Financial Reporting Standards to prepare their consolidated financial statements.