The Luxembourg law implementing the Anti-Tax Avoidance Directive (ATAD) 2 (the Law) was published in the Official Gazette (Mémorial) on 23 December 2019.
T
he Law expands the scope of the hybrid mismatch provisions under ATAD 1 that will no longer apply only to hybrid financial instruments and hybrid entities, but also to a number of other hybrid mismatch situations.
Hybrid Financial Instruments
A hybrid financial mismatch means, in general, a situation involving a taxpayer where: a payment under a financial instrument gives rise to a deduction without inclusion outcome and:
(i) such payment is not included within a reasonable period of time; and
(ii) the mismatch outcome is attributable to differences in the characterization of the instrument or the payment made under it.
In order to illustrate the impact of this provision, let’s consider a familiar financing structure in Luxembourg, whereby a company holds shares in, and a receivable towards, a subsidiary. The company is financed with both equity and a debt instrument in the form of preferred equity certificates (PECs) or shareholder loans; the shareholder is a fund vehicle (e.g. Luxembourg SCS, SCSp or FCP, or any other limited-partnership-type vehicle). At the level of the investor of the fund, the PECs or shareholder loans might be treated as debt, or as equity, depending on the legislation of the investor jurisdiction; in Luxembourg, PECs or shareholder loans are normally treated as debt. Where the investor jurisdiction considers the PECs or shareholder loans as equity, there would be a hybrid mismatch as Luxembourg would grant a deduction for interest accruing on the PECs or shareholder loans, while at investor level this would be treated as an equity return (which is often taxed at preferential rates or even exempt).
For the anti-hybrid rules to apply, the hybrid mismatch must arise between associated enterprises, i.e., between enterprises exceeding a certain percentage of voting rights, capital rights or entitlement to profits. For hybrid financial instruments that percentage is 25%, while for hybrid entities it is 50%.
If a hybrid mismatch arises under a “structured arrangement”, the aforementioned thresholds are irrelevant; the anti-hybrid mismatch rules will nevertheless apply in such case. A structured arrangement is defined as an arrangement whose pricing reflects the hybrid mismatch or an arrangement that is designed to produce a hybrid mismatch outcome.
If PECs were considered a structured arrangement, any interest on the PECs in Luxembourg would not be deductible to the extent that investors have treated the PECs as equity and are therefore tax-exempt on the return. Interest remains deductible when accrued or paid to investors who are taxable on the interest income. The inclusion in taxable income may, under certain conditions, also take place in a later tax period. Particular attention should be paid to the tax treatment of the income at the level of the investor; if tax relief is available - such as a foreign tax credit (excluding credits for foreign withholding taxes) - because of the classification of the payment, the interest will not be deductible.
The tax-exempt status of an investor is however not harmful. In line with the provisions of ATAD 2, a payment made under a financial instrument is not treated as giving rise to a hybrid mismatch if the tax relief granted in the investor jurisdiction is solely due to the tax status of the investor and not to the way the payment is characterized. As a result, in this type of financing structure, PECs and similar types of instruments may not necessarily give rise to a disadvantage from a tax perspective. With respect to the hybrid financial instrument mismatch, an analysis of whether the instrument, or payments thereon, qualify as hybrid, should be made on an investor-by-investor basis according to the tax laws in the respective jurisdictions.
Hybrid Entities
Similarly to hybrid instruments, hybrid entities may be considered differently for tax purposes in different jurisdictions. In case of a payment by a hybrid entity (for example, in the US, due to a check-the-box election), the interest on the loan will not be deductible in Luxembourg if the mismatch arises because of the fact that the payment is disregarded under the laws of the payee jurisdiction. The deduction will however not be denied to the extent of the amount of dual inclusion, i.e., of the amount of the payment included under the laws of both jurisdictions where the mismatch outcome has arisen.
In the case of a payment by a Luxembourg corporate taxpayer to a hybrid entity, the interest will not be deductible in Luxembourg if the mismatch outcome is the result of differences in the allocation of payments made to the hybrid entity under the laws of the jurisdiction where the entity is established and the jurisdiction of any person with a participation in that hybrid entity.
Concept of Associated Enterprises
The anti-hybrid mismatch rules only apply if there is a structured arrangement or a mismatch between associated enterprises, meaning investors hold at least 50% in the voting rights, capital ownership or profit entitlement. The Law has introduced the concept of “acting together”, according to which a person that acts together with another person, in respect of the voting rights or capital ownership of an entity, will be treated as holding a participation in all the voting rights or capital ownership of the entity held by that other person. Due to this aggregation, each investor may be considered as an associated enterprise and thus subject to the anti-hybrid provisions, despite the fact that the investor’s individual voting or capital rights or entitlement to profits are below the 25% or 50% threshold.
The Law contains an interesting nuance to this rule: investors are presumed not to be acting together if their shareholding or entitlement to profits in an investment fund is less than 10%. This rule was introduced on the basis that investors in a fund do not in principle have effective control on the investments made by the Fund. “Investment fund” for these purposes is defined as an undertaking for collective investment raising capital from a certain number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors. That definition is wider than UCITs and would also seem to include unregulated partnerships.
If a Luxembourg holding company held by the fund wants to rely on this rule in determining whether the mismatch rules are applicable, it will need information as to whether investors hold 10% or more in the fund. The Law suggests that investors owning more than 10% in the fund should not automatically be considered as “acting together”. The Law follows the approach whereby investors would be treated as such if their aggregated rights or interests exceed 50%.
However, the imported hybrid mismatch provisions of other relevant jurisdictions would need to be considered if the Luxembourg company holds equity and debt investments in the EU or any other country that has implemented BEPS-style anti-hybrid mismatch rules.
Reverse Hybrid rule
The Law also introduces a specific provision applicable, as from 2022, to so-called reverse hybrids, which are transparent vehicles for local purposes that are held by investors in jurisdictions that view the vehicle as non-transparent. If, in the context of a Luxembourg fund, the SCS or SCSp is held by 50% or more investors that view it as non-transparent, it will become subject to Luxembourg corporate income tax – but only to the extent the income is not taxed elsewhere. To the extent there are investors that view the partnership as transparent, that income will not be subject to Luxembourg corporate income tax.
In line with the Directive, the Law excludes collective investment vehicles from this provision. UCITs, SIFs or RAIFs thus benefit from this derogation, as well as investment funds if they are widely held, hold a diversified portfolio of securities and are subject to investor-protection regulations.
Conclusion
The Law strictly follows and does not go beyond ATAD 2’s mandatory “minimum standards” to neutralize hybrid mismatches. Luxembourg also decided to opt in for all possible exceptions provided for by ATAD 2. The Law applies to financial years starting on or after 1 January 2020, except for the provision on reverse hybrid entities that will apply as from 2022.
