The Luxembourg draft law on non-deductibility of payments to non-cooperative jurisdictions. A closer look at the impact on the Cayman Islands’ fund industry.
T
he Cayman Islands are the leading jurisdiction to raise capital globally, with 10,992 funds regulated under the Mutual Funds Law at the end of 2018 and 10,916 at the end of the first quarter of 2019[1]. The industry's positive outlook is reflected in the Cayman Islands Monetary Authority's (CIMA) statistical digest for 2018 which shows a net asset value of reporting funds of USD 3.916 trillion in 2018[2]. This figure represents approximately half of the global alternative fund flows.
The path towards the Luxembourg Draft Law
The European Union (EU) published its list (the EU List) of non-cooperative jurisdictions for the first time on 5 December 2017, comprising in Appendix I at that time 17 jurisdictions deemed to have failed to meet the relevant criteria around tax transparency, fair taxation and implementation of anti–base erosion and profit shifting (BEPS) measures. Since the first release of the EU List, there have been multiple changes to its composition based on recommendations made by the EU’s Code of Conduct Group[3] (COCG). Annex I to the EU List currently includes 12 jurisdictions (American Samoa, the Cayman Islands, Fiji, Guam, Oman, Palau, Panama, Samoa, Seychelles, Trinidad and Tobago, the U.S. Virgin Islands and Vanuatu), some of them[4] having entered into double tax treaties with Luxembourg.
On 25 November 2019, the Council of the European Union (the Council) published a report from the COCG (the report) that encompasses the work of the COCG in the second half of 2019. Among other topics, the report included a detailed state of play on the EU List along with new guidance on defensive measures towards non-cooperative jurisdictions[5]. The guidance invited all Member States to apply legislative defensive measures in taxation vis-à-vis the listed jurisdictions starting 1 January 2021, aiming to encourage those jurisdictions’ compliance with the Code of Conduct screening criteria on fair taxation and transparency. The report was endorsed during the Economic and Financial Affairs Council (ECOFIN) meeting of 5 December 2019. As further background, Luxembourg was reproached for not addressing measures of its tax system that were allegedly facilitating aggressive tax planning by means of outbound payments.[6]
On 31 March 2020, Luxembourg has taken a first step to implement the above guidance. A Draft Law aimed at disallowing, under certain circumstances, the deduction of interest and royalties paid or owed by Luxembourg corporate taxpayers to related enterprises that are corporations established in a country listed on the EU List, was transmitted to the Luxembourg Parliament.
[1] Figures taken from the Mutual Funds and Mutual Fund Administrators (Annual and Quarterly) in the Investment Fund Statistics and Regulated Entities section of the CIMA website:
www.cimoney.com.ky
[2] CIMA: Investments Statistical Digest 2018
[3] The COCG is composed of high-level representatives of the Member States and the European Commission; it conducts and oversees the screening process.
[4] This is the case of the Seychelles, Trinidad and Tobago, Panama and once ratified, Oman.
[5] The COCG suggests 4 different types of defensive measures: 1) non deductibility of certain costs and payments to listed jurisdictions; 2) CFC rules: include the income of a company resident or permanent establishment situated in a listed jurisdiction in accordance with the CFC rules of the Anti-Tax Avoidance Directive; 3) withholding tax on certain payments such as interest, royalty, service fee or remuneration to listed jurisdictions; 4) limitation of the participation exemption on profits arising from listed jurisdictions.
[6] Country Report Luxembourg 2020 accompanying the communication dated 26 February 2020 from the European commission to e.g. the EU Parliament and the EU Council. 2020 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011. Page 62.
Understanding of the defensive measure
The Draft Law provides for a denial - under certain conditions - of the deduction by corporate taxpayers of interest or royalties paid or owed. This deduction is denied, when the beneficial owner[7] of such interest or royalties meets the following conditions cumulatively:
- The recipient of the interest or royalties is a corporate entity as per the definition of Luxembourg Income Tax Law. This means that only payments to Cayman corporations such as LLCs as opposed to partnerships are covered by the Draft Law;
- The recipient is a related enterprise under the meaning of the Luxembourg transfer pricing provision of Article 56 of the Income Tax Law[8]; and
- The recipient of the interest or royalties is established in a jurisdiction or territory that is on the EU List.
[7] The Commentary to the bill refers to the “beneficiaire effectif.”
[8] The concept of “related enterprise” covers any enterprise participating, directly or indirectly in the management, control or capital of another enterprise, or situations where the same persons participate, directly or indirectly, in the management, control or capital of two enterprises.
The concept of beneficial owner
The above criteria need to be assessed in relation to the beneficial owner. There is no definition, however, of “beneficial owner” under Luxembourg law. This concept is not to be confused with the Luxembourg concept of economic owner[9] where the economic owner of an asset is the one bearing the economic risks (gain or loss) in relation to such asset and has the decision-making rights associated with it.
In absence of a domestic definition, it may be useful to refer to EU law. The Interest and Royalty Directive (IRD)[10] and the Savings Directive[11] both refer to the concept of the beneficial owner. While the IRD does not have a definition of beneficial owner, the Savings Directive referred to “any individual who receives an interest payment or any individual for whom an interest payment is secured, unless he provides evidence that it was not received or secured for his own benefit (…)”. As one can read, the definition of the Savings Directive provides for little clarification. This Directive was repealed on January 1, 2017.
In the end, the best source may be the so-called “Danish cases” rendered on 26 February 2019[12] in which the Court of Justice of the European Union (CJEU) discusses the concept of beneficial owner versus what constitutes a conduit company. According to the CJEU, the following factors are indications of a conduit company:
• Funds received by the interposed entity are (almost) immediately passed on to entities that do not fulfil the conditions of the withholding tax exemption, leaving behind only an insignificant taxable margin;
• Inability to have economic use of the funds received (contractually or in substance);
• Sole activity of the company is the receipt of dividends/interest and their transmission to the beneficial owner or other conduit companies.
While the above indications may be useful to assess the concept of beneficial owner, it may make things more complicated sometimes. For instance, the question may arise whether payments made to a feeder fund incorporated under the legal form of a corporation (e.g. Jersey, Guernsey) that is ultimately held by multiple investors investing through Cayman corporate vehicles could be caught by the rules. Is the beneficial owner not the feeder fund but rather the investor investing through a Cayman company or is the beneficial owner the ultimate investor?
The reference to the beneficial owner was justified in the Commentaries to the Draft Law to ensure that the defensive measure is effective and can catch indirect payments made to jurisdictions on the EU List through vehicles resident in jurisdictions that are not on the EU List. A typical case would be where payments are made as part of back-to-back financing or licensing activities.
[9] See for instance Court Case dated 26 June 2008, n°24061C
[10] Council Directive 2003/49/EC dated 3 June 2003
[11] Council Directive 2003/48/EC dated 3 June 2003
[12] CJEU Joined Cases C116/16; C117/16; C 115/16; C 118/16; C 119/16 and C 299/16.
Exception to the rule: Payments made for valid commercial reasons which reflect economic reality
The deduction of interest or royalties will not be refused if the taxpayer can prove that the transaction was implemented for “valid commercial reasons that reflect economic reality” (economic reality test). It would not be sufficient to state economic reasons, but such reasons need to be considered “real” and representing an economic benefit that exceeds a potential tax benefit resulting from the operation.
The relationship between the concept of economic reality and the abuse of law
The concept of economic reality is also foreseen in the General Anti-Abuse Rule (GAAR) of Article 6 of the Luxembourg Adaptation Law (which reflects the GAAR provision of the Anti-Tax Avoidance Directive (ATAD)). Given the identical wording between the GAAR and the Draft Law, it raises the question whether the standard applied should be the same. Both provisions mean to achieve the same objective, albeit in a different manner. The economic reality concept of the Luxembourg GAAR is meant to allow the preservation of a tax benefit which would have otherwise been denied if it was not for the economic reality of the arrangement. Similarly, the objective of the economic reality concept under the Draft Law is to reinstate a tax benefit that would have otherwise been denied. If no such explicit exception had been provided in the Draft Law, taxpayers would not have been able to invoke the GAAR’s “valid commercial reasons” argument to assert that deductibility should be allowed. To avail itself of the aforementioned exception, the burden of proof falls on the taxpayer. In the context of the GAAR, the burden of proof falls first on the Luxembourg tax authorities who have to make the absence of economic reasons plausible (to which the taxpayer can then respond)[13].
For the above reasons, and because of the exact wording, it appears clear to us that the standards of the economic reality should be interpreted in the same manner. On this basis, and in light of the recent cases of the CJEU[14], this may be quite a high bar to meet in practice, even for the investment fund industry in spite of their well-justified commercial use of Cayman vehicles. One may wonder if the approach taken in France,[15] pursuant to which one is able to demonstrate instead that the payments correspond to a real provision of services and are in line with the arm’s length character, is not a more reasonable test to meet.
Definition of interest
The Draft Law defines interest largely based on definitions provided under article 2 of the IRD, i.e. as “interest paid or owed from debt claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits and, in particular, interest from securities and bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures; penalty charges for late payment shall not be regarded as interest”. This would for instance cover certain payments made as part of the Islamic Finance such as sukuk[16].
[13] See for instance Tribunal Administratif dated 3 February 2016 # 35671. Page 18.
[14] CJEU Joined Cases C116/16; C117/16; C 115/16; C 118/16; C 119/16 and C 299/16 “Danish cases”.
[15] See section 238 A of the “C.G.I” or French income tax code which provides that payments made to jurisdictions benefiting from a privileged tax regime are deductible only under certain conditions.
[16] See circular #55 dated 12 January 2010, see paragraph 3.2.
Selected considerations in respect of the Luxembourg securitization market
According to the Luxembourg Securitization Law, a securitization vehicle’s (SV) commitments to remunerate investors for issued bonds or shares and other creditors qualify, at the level of the investors at least, as interest on debt even if paid as returns on equity. Those commitments are deductible under certain conditions, for instance subject, where relevant, to the application of the interest limitation rules.
It is important to bear in mind that the Draft Law only applies to payments to related enterprises[17], which may limit the Draft Law’s application to SVs in practice.
Evolution of the EU List
As the EU List is frequently evolving and there may be an increased political impetus to expand this list in the future, there may be more and more countries on such list that have entered into double tax treaties with Luxembourg.
As a result, any disallowed payments made to entities tax resident in jurisdictions with which Luxembourg has a double tax treaty[18] may be at odds with the non-discrimination clause of those double tax treaties[19]. In this context, an exception to the Draft Law’s disallowance of deductibility of payments made to residents of those double tax treaty jurisdictions may be necessary.
In terms of timing, the Draft Law also sets down the criteria for drawing-up the initial version of the EU List and for updating it subsequently. The Luxembourg Government will propose to Parliament to complete the provision with a (domestic) list, effective 1 January 2021, the content of which will be based on the latest version of the EU List as published in the Official Journal of the EU (OJEU) at the time such proposal will be made. This list will apply to interest/royalties paid or owed as from 1 January 2021. This domestic list[20] will be updated only once a year, again upon proposal to be made by the Government to Parliament as follows:
- Effective 1 January of the calendar year following the year of the proposal and applicable to interest/royalty paid or owed as from the same date, the list is updated with those countries and territories that are included in Annex I of the EU List (as published in the OJEU) at the date of such proposal.
- Removals from the list at the occasion of subsequent updates of the domestic list are taken into consideration regarding interest/royalty paid or owed as from the date of publication in the OJEU of the EU List enacting the removal of a country or territory from the EU List.
[17] See footnote 5.
[18] This is not a theoretical issue since Luxembourg has entered into double tax treaties with e.g. ; the following jurisdictions : Andorra, Bahrein, Barbados, Brunei, Guernsey, Jersey, Hong Kong, Isle of Man, Mauritius, Monaco, Oman, Panama, San Marino, Seychelles, Singapore, Switzerland, Trinidad and Tobago, United Arab Emirates and Uruguay.
[19] Paragraph 3 of the OECD Model provides that “ (…) interest, royalties paid by an enterprise of a Contracting Party to a resident of the other Contracting Party shall, for the purposes of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the other Contracting Party.”
[20] For the avoidance of doubt, the domestic list can only include countries that have been listed on the EU List.
By Alex Pouchard, Partner, Tax
