Magazine du Tresorier, October 2017

Impact of the BEPS on tax liability: A practical approach

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On October 2015, the OECD published a plan composed of 15 actions which aim at countering “Base Erosion and Profit Shifting” (“BEPS”). This action plan has been endorsed by more than 100 countries and contains a set of recommendations and minimum standards to be followed by participating states. BEPS actions are expected to have a strong impact on the taxation of companies, and have already started to be implemented. While some measures focus on transparency (e.g., exchange of information), other should directly impact taxes due by companies.

In parallel, in July 2016, the European Union adopted the Anti-tax avoidance directive (“ATAD”), which directly implements some of the BEPS actions within European Union law. More recently, BEPS action 15 led to the adoption of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (“MLI”) signed last June by 68 countries.

 

The ATAD

On 12 July 2016, the Economic and Financial Affairs Council of the European Union (ECOFIN) formally adopted the ATAD. Luxembourg has to implement the provisions of the directive in domestic law before 1st January 2019[1]. The ATAD contains 5 measures which might have a direct cash impact on the tax liability of a company:

  • An interest deduction limitation rule;
  • An exit tax rule;
  • A controlled foreign company (“CFC”) rule;
  • A general anti-abuse rule;
  • An anti-hybrid rule.

 

The general philosophy behind the general anti-abuse rule is to ensure that transactions carried out by the taxpayer follow a genuine business purpose, otherwise the transactions may be disregarded by tax authorities that consider those transactions to be carried out for tax reasons. The anti-hybrid rule tackles hybrid entities and hybrid financing instruments, and may have a direct impact on the taxable base of Luxembourg companies (via income that would no longer be exempt or via expenses that would no longer be tax deductible) and, potentially therefore, on the taxes paid by those companies.

The exit tax rule is not expected to have a significant impact on the tax liability of Luxembourg companies as Luxembourg domestic tax law already contains similar provisions.

The two last rules are expected to have a significant impact on the taxes due by Luxembourg companies. According to the interest deduction limitation rule, taxpayers should not be able to deduct the net borrowing costs which exceed 30% of their earnings before interest, tax, depreciation and amortization (“EBITDA”). This means that when a taxpayer carries out its operations and has financed them by debt, it might face a higher tax liability due to the non-deductibility of a portion of its exceeding borrowing costs. Luxembourg should have the possibility to lighten this interest limitation rule as the directive offers EU member states some options in the implementation of this rule (such as the inclusion of a de minimis rule or the non-application of the rule to standalone companies).

Last but not least, the directive also provides for a so-called CFC rule. According to this rule, a Luxembourg taxpayer which controls a subsidiary (or a permanent establishment) located in a low-taxed jurisdiction might be taxed on the non-distributed income of the subsidiary (or permanent establishment). This should be the case when (i) the tax paid by the subsidiary or the permanent establishment is lower than 50% of the tax that would have been paid in Luxembourg and, (ii) when more than 50% of the subsidiary is held by a Luxembourg taxpayer (this condition is presumed to be met for a permanent establishment). Fortunately, the CFC rule contains a safeguard clause and should not be applicable to controlled foreign entities which run a genuine economic activity. Similarly to the interest limitation rule, the directive provides for some options for the EU member states, which can choose to implement a de minimis rule and/or not to apply this provision to some financial undertakings.

As Luxembourg has not yet published any bill for the implementation of these measures, it is still not known which options will be chosen by the Grand-Duchy.

 

The MLI

On 7 June 2017, 68 jurisdictions signed the MLI, which is expected to lead to an unprecedented wave of amendments to approximately 1,100 double tax treaties. Therefore, the following developments should only be applicable to taxpayers which rely on Double Tax Treaty provisions for cross-border transactions. At the earliest, the MLI is expected to be applied to some Double Tax Treaties signed by Luxembourg as from 1st January 2019.

Apart from some technical provisions which would be too complex to analyze in this article, the MLI may trigger significant cash tax impacts for Luxembourg companies. In situations where the MLI is applicable, a taxpayer may not be entitled to treaty benefits if it cannot prove that obtaining these benefits was not one of the main purposes of the transaction. This rule is called the principal purpose test (“the PPT”). In other words, in order to rely on Double Tax Treaties, a taxpayer should always follow genuine economic purposes. In practice, this means that Luxembourg companies should prepare appropriate documentation in order to prove the economic rationale behind each transaction.

 

Conclusion

Both the ATAD and the BEPS are expected to significantly change the tax environment in the world. For Luxembourg corporations, these new rules are expected to introduce more complexity in the assessment of the tax treatment of their operations and may have material (cash) tax impacts. While some of the new rules contain mechanical provisions to avoid profit shifting (interest limitation, hybrid mismatches…), others focus on the business rationale of the taxpayers, which is a vague concept. The reasoning behind the notion of genuine economic activity is intrinsically related to the well-known transfer pricing requirements. Profit should be allocated where the value is created and where risks and functions are located. In this context, it is highly recommended for each Luxembourg taxpayer involved in cross-border operations to review its structure and check the potential impacts that ATAD and BEPS measures will have on its group going forward.



 

[1] Some other ATAD provisions are however subject to a different implementation date.