What is this draft law?
On 30 March 2020, the Luxembourg Government introduced a draft law targeting certain payments made to recipients established in countries on the European Union (EU) list of non-cooperative jurisdictions in tax matters. Today, this list includes American Samoa, Fiji, Guam, Oman, Palau, Panama, Samoa, Seychelles, Trinidad and Tobago, the US Virgin Islands, Vanuatu but also the Cayman Islands, which are present in many private equity (“PE”) fund structures.
This draft law expands the existing list of expenses that are not tax-deductible[1] at the level of Luxembourg corporate income tax payers: it now includes interest or royalties paid or owed to related[2] entities established in those countries. If passed, this new provision would apply as of 1 January 2021.
It should be noted that, for the deduction to be denied, the actual beneficial owner of the payments is to be considered. Hence, in the presence of e.g., a Cayman fund, it is most likely that the unit holders, rather than the fund, would be considered as the beneficial owners. In addition, only payments of interest or royalties made to “corporate entities”[3] established in one of the listed jurisdictions are affected, meaning that payments made to partnerships (provided these partnerships are comparable to Luxembourg flow-through entities) are not. In such cases, an analysis of whether the conditions for non-deduction are applicable would need to be made at the level of the first beneficiary of the interest or royalties that is not a partnership.
Moreover, the provisions of the draft law will not apply if the taxpayer proves that the transaction giving rise to the interest or royalties paid or owed “is used for valid economic reasons which reflect economic reality”.
Another point to note is that the draft law only addresses the issue of deductibility, and therefore, even if those interest or royalty payments are considered non-deductible, they should continue to be exempt from withholding tax. Furthermore, other types of payment made to recipients established in the targeted jurisdictions, such as (partial) liquidation proceeds, are not covered in the draft law.
Finally, the draft law will be based on a list of jurisdictions to be proposed by the Luxembourg Government during the second half of 2020. The proposal will replicate the EU list of non-cooperative jurisdictions as it stands at that date and will subsequently be updated once a year. Interest or royalties paid or owed will fall in or out of the scope of the new provisions as of these effective dates:
i) for added jurisdictions - 1 January of the year following the update, and
ii) for removed jurisdictions - the date of publication, in the Official Journal of the EU, of the updated EU List.
With respect to the Cayman Islands, and following commitments made by its government in this respect back in February, it is expected to be removed from the EU list of non-cooperative jurisdictions later this year.
What are the consequences for PE Cayman fund structures?
From a practical perspective, structures involving deductible interest payments made to Cayman entities by Luxembourg companies could be affected negatively by the new measures, but only to the extent they involve a Cayman fund that is both the beneficial owner of the payments and a corporate entity.
Consequently, it is recommended that anyone involved with such PE structures assesses the impact of the draft law on those structures and carefully monitors changes to the list.
In the context of this changing tax environment – consider recent Danish court cases, ATAD I and II, BEPS, and those three-letter acronyms that are MLI, PPT and MDR – Luxembourg is a prime location as a central hub for investments not only for SPVs but also for funds and AIFM, and on-shoring future funds to Luxembourg seems now, more than ever, the best way forward.
[1] For corporate income tax based on article 168 of the Luxembourg Income Tax Law (“ITL”)
[2] According to article 56 ITL, i.e. 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
[3] Corporate entities within the meaning of article 159 ITL, being mainly public or private limited liability company and partnership limited by shares
