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Executive summary
On 25 March 2022, the Luxembourg Tax Authority updated the Circular originally issued on 8 January 2021 and thereby clarified1 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)2. These rules limit the deductibility of taxpayers’ borrowing costs to the higher of 30% of tax EBITDA (Earnings (taxable profits) before Interest, Tax, Impairments, Depreciation and Amortization) or €3 million.
The updated Circular first confirms that a loan contracted before 17 June 2016 that is modified in order to reflect the end of the London Interbank Offered Rate (LIBOR) can, under certain conditions, continue to benefit from the grandfathering clause, according to which loans contracted before 17 June 2016 and not subsequently modified are excluded from the scope of application of the interest limitation rules.
The updated Circular also clarifies how the interest limitation rules interact with the participation exemption. According to the Luxembourg participation exemption, dividends and capital gains derived from a qualifying participation are, under certain conditions, tax exempt. Expenses (and notably interest expense on loans financing a qualifying participation) in turn are not deductible up to the amount of the tax-exempt dividend. Deductible expenses in relation to exempt participations are “recaptured” upon the realization of a tax-exempt capital gain derived from the disposal of the participation, meaning that the amount of tax-exempt capital gain is reduced by the amount of expenses deducted in previous tax years (which then become taxable). Until now, it was unclear how to concomitantly apply those two rules providing for a non-deductibility of expenses.
Finally, the updated Circular further clarifies the definition of tax EBITDA.
This Alert details the clarifications provided by the updated Circular.
Detailed discussion
LIBOR and grandfathering clause
The Law contains a grandfathering clause according to which interest on loans that were concluded before 17 June 2016 is excluded from the interest limitation rules, but the grandfathering will not apply to any subsequent modifications of such loans. The original Circular already provided for a non-exhaustive list of the changes that should be considered as subsequent modification of a loan, among which a modification of the interest rate or the calculation of the interest as of 17 June 2016, when such modification was not contractually foreseen before 17 June 2016.
The updated version of the Circular confirms that a modification of the loan to reflect the end of the LIBOR should in principle not constitute a harmful subsequent modification, provided that, inter alia, the said modification of the loan:
- Is strictly necessary to take account of the end of the LIBOR or the loss of its representativeness
- Does not modify the economic substance of the loan
- Does not include other changes which could qualify as “subsequent modification” within the meaning of the grandfathering clause
The Circular also highlights that the application of the grandfathering clause will be refused in presence of an abuse of law, on the basis of the general Luxembourg anti abuse-rule.
Interaction between the interest limitation rules and the participation exemption
Under the Luxembourg participation exemption, dividends and capital gains derived from qualifying participations may benefit from a tax exemption. The corollary of this exemption is that operating expenses (including interest expense on loans financing a qualifying participation) with a direct economic link to the tax-exempt income are deductible only for the amount exceeding said income. The amount of deducted expenses is “recaptured” upon the sale of the participation: The tax-exempt capital gain will be reduced by the total of all operating expenses that have reduced the tax base in the year of the disposal and in previous years.
The interest limitation rules apply in addition to the aforementioned rule. The taxpayer must allocate any exceeding borrowing costs between its various activities, including the holding of participations. The question if and to what extent exceeding borrowing costs that remain deductible after having applied the interest limitation rules are possibly subject to recapture is crucial, as it directly influences the tax-exempt amount of a possible future capital gain realized upon the disposal of a qualifying participation.
The updated Circular clarifies this through an illustrative example.
The interest limitation rule applies after all other rules of the income tax law have been taken into account. As a consequence, the rule embedded in the participation exemption that borrowing costs with a direct economic link up to the amount of tax-exempt dividend income are non-deductible applies first. Only the amount of borrowing costs that remain deductible after the application of this rule will be taken into account for purposes of determining exceeding borrowing costs under the interest limitation rules.
Example:
|
||
|---|---|---|
|
Dividend income from a qualifying participation P |
30 |
|
|
Interest income |
|
|
|
Borrowing costs in direct economic link with qualifying participation P |
75 |
|
|
Other borrowing costs |
255 |
|
|
Determination of exceeding borrowing costs |
|
|
|
Borrowing costs in direct economic link with qualifying participation P |
75 |
|
|
./. Non-deductible portion (up to the amount of tax-exempt income) |
- 30 |
|
|
= Deductible borrowing costs in direct economic link with qualifying participation P (subject to recapture) |
45 |
|
|
+ Other borrowing costs |
255 |
|
|
= Deductible borrowing costs prior to application of interest limitation rule |
300 |
|
|
./. Interest income |
- 0 |
|
|
= Exceeding borrowing costs |
300 |
The amount of deductible exceeding borrowing cost is determined in the next step.
In order to determine the amount of non-deductible exceeding borrowing costs to be allocated to the financing of participations (which is relevant for the determination of a future exempt capital gain), the updated Circular uses a prorating mechanism, which consists in comparing, for each tax year, the amount of deductible borrowing costs that have a direct economic link with a participation, with the total amount of deductible borrowing costs for the same tax year (borrowing costs referring to the amount before application of interest limitation rules but after application of the rules relating to the deduction of expenses linked to exempt participations). This percentage is then applied to the non-deductible exceeding borrowing costs (i.e. the amount of borrowing costs that is non-deductible as a result of the application of the interest limitation rules) of the same tax year.
The amount of deductible expenses with direct economic link to a participation (and subject to recapture if a tax-exempt capital gain is realized on the participation) for that tax year thus corresponds to the amount of deductible borrowing costs with a direct economic link to a qualifying participation before application of the interest limitation rules reduced by the amount of non-deductible exceeding borrowing costs determined by application of the aforementioned percentage.
Example (continued):
|
Deductible borrowing costs in direct economic link with qualifying participation P 45 _____________________________________ = ____ = 15% Deductible borrowing costs 300 |
|---|
For purposes of this example, the tax EBITDA is 600, leading to non-deductible exceeding borrowing costs of 120 (i.e. tax EBITDA 600 x 30% = 180 vs. exceeding borrowing costs of 300).
Amount of non-deductible exceeding borrowing costs to be allocated to the participation:
120 x 15% = 18
Amount of deductible borrowing costs related to the participation that are deductible in 2020 but subject to recapture if a capital gain is realized on the participation in the future:
|
Deductible borrowing costs in direct economic link with qualifying participation P |
45 |
|---|---|
|
./. Portion of non-deductible borrowing costs: |
- 18 |
|
= Amount of expenses subject to recapture as at 31.12.2019 |
27 |
The mechanism does not have an impact on the tax result for year 2020 and only contributes to determining the taxable portion of a capital gain on a qualifying participation that may be realized in the future.
The Law foresees the possibility for the taxpayer to carry forward non-deductible exceeding borrowing costs without limitation in time. As a result, if a taxpayer’s exceeding borrowing costs during a given financial year are below the higher of 30% of its taxable EBITDA or €3 million, it may still deduct, in addition to the exceeding borrowing costs of the current financial year, those exceeding borrowing costs that were not deductible in previous financial years (within the limits of the higher of 30% EBITDA or €3 million limit of the same year).
The updated Circular provides for a mechanism to adjust the amount of expenses subject to recapture in case the taxpayer deducts (part of) exceeding borrowing cost carried forward in a subsequent tax year. In that case a new calculation must be made in order to determine the amount of additional exceeding borrowing costs that become deductible in the subsequent year (using the pro-rata for the year when the expenses were originally incurred). This amount will then be added to the deductible expenses in direct economic link with a participation that are subject to recapture.
Example (continued):
In tax year 2020, the taxpayer incurred, after apportionment of non-deductible borrowing costs, additional borrowing costs in direct economic link with qualifying participation P for an amount of 70. It is furthermore assumed that for the same year, the percentage amounts to 25%, and the non-deductible exceeding borrowing to be carried forward to 80, leading thus to a total amount of exceeding borrowing to be carried forward of 200 (120 + 80).
In tax year 2021, the taxpayer incurs further deductible borrowing costs in direct economic link with participation P of 90, and has, after deduction of the exceeding borrowing costs of the year, still sufficient EBITDA to deduct exceeding borrowing costs carried forward for an amount of 100. According to the Law, the oldest exceeding borrowing costs carried forward are used first, meaning that the taxpayer will be able to deduct 100 of the carry-forward of 120 from tax year 2019. Given that part of this amount was considered to be linked to the qualifying participation P, the fact that it becomes deductible in 2021 requires an update to the calculation of amounts subject to recapture.
|
97 |
|
|---|---|---|
|
+ Deductible borrowing costs in direct economic link with qualifying participation P |
90 |
|
|
+ Pro-rata of exceeding borrowing costs from 2019 deducted in 2021using the percentage of 2019 (100 x 15%) |
+ 15 |
|
|
= Amount of expenses subject to recapture as at 31.12.2021 |
202 |
If the taxpayer uses in one tax year exceeding borrowing costs carried forward from different tax years, the allocation of expenses to the amount subject to recapture has to be determined on a year-by-year basis (by applying the specific percentage of the relevant year to the amount of exceeding borrowing costs of the same year).
Example (continued):
In tax year 2022, the taxpayer again incurs deductible borrowing costs in direct economic link with participation P of 90, and has, after deduction of the exceeding borrowing costs of the year, still sufficient tax EBITDA to deduct the remaining exceeding borrowing costs carried forward amounting to 100 (consisting of 20 relating to 2019 and 80 relating to 2020).
The additional amounts subject to recapture post the deduction of exceeding borrowing costs carried forward will be determined as follows:
Exceeding borrowing costs from 2019 = 20 x 15% = 3
Exceeding borrowing costs from 2020 = 80 x 25% = 20
The deduction of 100 in 2022 of exceeding borrowing costs carried forward from previous years thus requires the amount of expenses in direct economic link with qualifying participation P to be increased by 23.
As at 31 December 2022, the expenses subject to recapture thus amount to 315 (202 as at 31.12.2021 + 90 deductible borrowing costs in direct economic link with participation P incurred in 2022 + 23 adjustment due to the use of exceeding borrowing costs carried forward from previous years).
The example of the updated Circular also clarifies that in the year of the sale of a qualifying participation any borrowing costs in direct economic link with that participation, incurred during the tax year, will be considered as non-deductible up to the amount of the tax-exempt capital gain.
Definition of tax EBITDA
Tax EBITDA is defined as the total of net taxable income as per the Luxembourg Income Tax Law, increased by exceeding borrowing costs, and the tax values of impairments, depreciations and amortizations that have reduced taxable income.
The updated Circular clarifies that no further increase or correction is required to determine the tax EBITDA. No correction to the tax EBITDA of year N would for example be required upon reversal, in year N, of an impairment booked in N-1 and that has increased the tax EBITDA of that year.
Endnotes
1. Circular L.I.R. n°168bis/1 of 25 March 2022; see EY Global Tax Alert, Luxembourg Tax Authorities issue guidance on interest limitation rules, dated 12 January 2021 and EY Global Tax Alert, Luxembourg Tax Authority issues guidance on the “equity escape clause” under interest limitation rules, dated 16 June 2021.
2. See EY Global Tax Alert, Luxembourg: A detailed review of the EU ATAD implementation law, dated 28 December 2018.
Summary
On 25 March 2022, the Luxembourg Tax Authority updated the Circular originally issued on 8 January 2021, thereby clarifying certain technical aspects of the interest limitation rules introduced in the Luxembourg legislation by law in 2018. These rules limit the deductibility of taxpayers’ borrowing costs to the higher of 30% of tax EBITDA or €3 million.
The updated Circular confirms that a loan contracted before 17 June 2016 that is modified in order to reflect the end of LIBOR can, under certain conditions, continue to benefit from the grandfathering clause. It also clarifies how the interest limitation rules interact with the participation exemption, and it further clarifies the definition of tax EBITDA.