Luxembourg Tax Authority publishes guidance on the computation of taxable income of Reverse Hybrid Entities

Executive summary

As of tax year 2022, transparent entities or arrangements that are incorporated or established in Luxembourg are, under certain conditions, treated as corporate taxpayers (Reverse Hybrid Entity) and subject to Luxembourg corporate income tax (CIT) for the portion of their income that is not otherwise taxed in Luxembourg or in another jurisdiction (including that of the investor).

The Luxembourg Tax Authority has now released an administrative Circular¹ (Circular) that lays out how the Tax Authority intends to compute the income of a Reverse Hybrid Entity that is subject to CIT. A Circular explains the tax authority’s view on the application of the law but is not legally binding on the taxpayer. 

The Luxembourg Tax Authority also published instructions on how to fill in the new form to be filed by most Luxembourg partnerships, whether or not they are Reverse Hybrid Entities, as from tax year 2022.

Detailed discussion

Tax status of a Reverse Hybrid Entity

According to the Circular, a Reverse Hybrid Entity is not a collective entity within the meaning of the Luxembourg Income Tax Law but falls in a separate category of taxpayers. This entails that only specific provisions of the Corporate Income Tax Law apply to a Reverse Hybrid entity. Specifically, the Controlled Foreign Company rules, participation exemption, interest limitation and general anti-hybrid rules do not apply when computing the taxable income of a Reverse Hybrid Entity.

Computation of net taxable income and CIT due

Reverse Hybrid Entities may be subject to tax on income from capital (dividends and interest), rental income (including royalties) and specific capital gains (e.g., speculative gains or capital gains on a significant participation). Only the portion of income that is not otherwise taxed in Luxembourg or under the laws of any other jurisdiction can become taxable in the hands of the Reverse Hybrid Entity. 

The computation of the net income subject to tax for these three categories of income follows specific rules laid down in the law that significantly differ from those that generally apply to companies. The most significant difference is that the taxable net income must be determined on a cash-flow basis (revenues collected less expenses disbursed) rather than on an accruals basis as is the case for accounting purposes. Moreover, the net taxable income of a Reverse Hybrid Entity is to be determined for a given calendar year, irrespective of the entity’s financial year.

The Circular also addresses the question of the revenues and expenses denominated in a foreign currency. Although the applicable exchange rate should normally be established based on either the date of collection or disbursement, for simplification purposes the Circular authorizes uniform conversion of these amounts either at the year-end exchange rate or at the average exchange rate for the tax year.

The Circular also states that no step-up in asset value is available when an entity or an arrangement becomes a Reverse Hybrid Entity. Moreover, if an entity or arrangements ceases to be a Reverse Hybrid Entity, the entity or arrangement does not incur any tax consequences.

Finally, the Circular confirms that:

• Distributions made by a Reverse Hybrid Entity to its investors are not subject to withholding tax
• 50% of the dividends received from qualifying participations may benefit from an exemption without any conditions regarding holding period and/or minimum holding threshold
• Where applicable, Luxembourg and foreign withholding tax may be credited against the CIT owed by the Reverse Hybrid Entity in accordance and within the limits of Luxembourg law

Compliance requirements

The Luxembourg Tax Authority recently released a new form to be filed electronically for transparent entities. Newly published Frequently Asked Questions²  provide guidance on how to fill in this electronic form.