On 8 August 2019, the Luxembourg Government submitted the draft law (Draft Law) implementing Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 (ATAD) as regards hybrid mismatches with third countries (ATAD 2) to the Luxembourg Parliament.
ATAD was implemented into Luxembourg law with effect from financial years starting on or after 1 January 2019. It introduced a provision dealing only with intra-European Union (EU) hybrid mismatches. The Draft Law extends the territorial scope of the anti-hybrid mismatch provision to third countries, and it addresses hybrid permanent establishment (PE) mismatches, hybrid transfers, imported mismatches, reverse hybrid mismatches and dual resident mismatches. The Draft 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 Draft Law will be effective from financial years starting on or after 1 January 2020.
With some exceptions that are noted below, the provisions of the Draft Law only apply to corporate taxpayers and to PEs of nonresident taxpayers subject to corporate income tax (CIT).
The Draft Law will now go through the legislative process, which involves the analysis of the text by a dedicated parliamentary commission, the collection of opinions from different advisory bodies (and most importantly the Council of State), the discussion and vote of the text in a parliamentary session and finally its publication in the Official Gazette (Memorial). The entire process may take several months.
This Alert summarizes the key provisions of the Draft Law.
The Luxembourg law implementing ATAD introduced a provision dealing with intra-EU hybrid mismatches with effect from 1 January 2019. The Draft Law replaces this provision by incorporating the broader anti-hybrid provisions of ATAD 2, and adds a new provision addressing the taxation of “reverse hybrids.”
Broadly speaking, the purpose of the anti-hybrid mismatch rules of ATAD 2 is to ensure that deductions or credits are only taken in one jurisdiction and that there are no situations of deductions of a payment in one country without taxation of the corresponding income in the other country concerned. The rules are typically limited to mismatches as a result of hybridity and do not impact the allocation of taxing rights under a tax treaty.
The Draft Law strictly follows, but does not go beyond, ATAD 2’s mandatory “minimum standards“ to address these hybrid mismatches. In addition, Luxembourg decided to opt in for all possible exceptions provided for by ATAD 2.
The wording of the Draft Law largely corresponds to the wording of ATAD 2. Also, in accordance with the Preamble of ATAD 2, the commentary to the Draft Law states that Luxembourg will use the applicable explanations and examples in the OECD1 BEPS2 report on Action 2 (Neutralising the Effects of Hybrid Mismatch Arrangements) as a source of illustration or interpretation to the extent that they are consistent with the provisions of ATAD 2 and EU law. Accordingly, in the commentary to the Draft Law, various references are included to relevant paragraphs of the Action 2 report.
In addition to expanding the territorial scope of the anti-hybrid mismatch provision to third countries, the Draft Law, in line with ATAD 2, expands the scope of Luxembourg’s current anti-hybrid mismatch rules. As a result, the following hybrid mismatch arrangements are addressed.
- Hybrid entity mismatches: Situations where an entity is qualified as opaque under the laws of one jurisdiction (i.e., a taxable entity under the laws of that jurisdiction) and qualified as transparent by another jurisdiction (i.e., the partners of the entity are taxable on their share of profit under the laws of that other jurisdiction).
- Hybrid financial instrument mismatches: Situations where the qualification of a financial instrument or the payment made under it differs between two jurisdictions (e.g., the instrument is considered as debt in the payer jurisdiction and as equity in the payee jurisdiction).
- Hybrid transfers: Situations where the laws of two jurisdictions differ on whether the transferor or the transferee of a financial instrument has the ownership of the payments on the underlying asset.
- Hybrid PE mismatches: Situations where the business activities in a jurisdiction are treated as being carried on through a PE by one jurisdiction while those activities are not treated as being carried on through a PE in the other jurisdiction.
- Imported mismatches: Situations where the effect of a hybrid mismatch between parties in third countries is shifted into the jurisdiction of a Member State through the use of a non-hybrid instrument thereby undermining the effectiveness of the rules that neutralize hybrid mismatches. This includes a deductible payment in a Member State under a non-hybrid instrument that is used to fund expenditure involving a hybrid mismatch.
- Tax residency mismatches: Situations where a taxpayer is resident for tax purposes in two or more jurisdictions.
The Draft Law also amends certain definitions that were introduced under ATAD. The new anti-hybrid provisions apply, for example, only in the case of a hybrid mismatch between “associated enterprises,” between the head office and PE, between two or more PEs of the same entity or under a “structured arrangement.” While the 25% minimum participation threshold introduced by ATAD will continue to apply to hybrid mismatches arising from a hybrid financial instrument, a 50% threshold applies for all other mismatches, including mismatches resulting from the hybrid nature of entities. In addition, the concept of “acting together” is introduced, which leads to aggregating the voting rights or capital ownership that different persons hold in the same entity if they are considered as “acting together.” In this sense, a person who, directly or indirectly, owns less than 10% of an investment fund and is entitled to less than 10% of the profits of the investment fund will, unless there is proof to the contrary, not be “acting together” with another person participating in the fund. An investment fund is defined as a collective investment undertaking that raises capital from multiple investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors.
The Draft Law also introduces a definition of the concept of structured arrangement. This is an arrangement involving a hybrid mismatch where the mismatch outcome is priced into the terms of the arrangement, or an arrangement that has been designed to produce a hybrid mismatch outcome, unless the taxpayer or an associated enterprise could not reasonably have been expected to be aware of the hybrid mismatch and did not share in the value of the tax benefit resulting from the hybrid mismatch.
Anti-hybrid mismatch rules addressing specific mismatch outcomes applicable as from 2020
The above-mentioned hybrid mismatches trigger corrective tax adjustments only to the extent they give rise to a mismatch outcome, meaning either a double deduction, a deduction or non-taxation without “inclusion” (i.e., taxation), or a double tax credit. Any mismatch outcome that does not result from hybridity does typically not fall in the scope of the anti-hybrid provisions.
The Draft Law distinguishes between the following mismatch outcomes:
- Double deduction: the hybrid mismatch leads to a deduction of the same payment, expenses or losses in Luxembourg (investor jurisdiction) and in another jurisdiction in which the payment has its source, the expenses are incurred or the losses are suffered (payer jurisdiction). In the case of a payment by a hybrid entity or PE the payer jurisdiction is the jurisdiction where the hybrid entity or PE is established or situated.
- Deduction without inclusion means the deduction of a payment (or deemed payment between the head office and the PE or between two or more PEs) in one country (payer jurisdiction) without a corresponding inclusion for tax purposes of that payment or deemed payment in the payee jurisdiction.
- The payee jurisdiction is any jurisdiction where that payment or deemed payment is received or is treated as being received under the laws of any other jurisdiction.
- For interpretation of the term payment, reference is made to Action 2. Accordingly, it includes distributions and accruals, as well as an amount that is capable of being paid. It also includes any future or contingent obligation to make a payment.
- As to the term inclusion, the Draft Law requires that the amount is taken into account in the taxable income under the laws of the payee jurisdiction. With reference to Action 2, the commentaries provide that if the payment is brought into account as ordinary income in at least one jurisdiction, then there will be no mismatch for the rule to apply to. Also, no hybrid mismatch should arise where the payee is exempt from tax under the laws of the payee jurisdiction. A payment under a financial instrument, for example, is not treated as a hybrid mismatch where the tax relief granted in the payee jurisdiction is solely due to the tax status of the payee (e.g., an investment fund or a sovereign wealth fund that are exempt from tax) or the fact that the instrument is held subject to the terms of a special regime. Likewise, a payment to a hybrid entity does not give rise to a hybrid mismatch when the mismatch would have arisen in any event due to the tax-exempt status of the payee under the laws of the payee’s country. The commentaries also clarify that differences in tax outcome that are solely attributable to differences in the value ascribed to a payment, including through the application of transfer pricing, do not constitute a hybrid mismatch. The same applies to timing differences for recognizing when items of income or expenditure have been derived or occurred.
- Double Tax Credit: refers to a hybrid transfer designed to produce a relief for tax withheld at source on a payment derived from a transferred financial instrument to more than one of the parties involved.
The exact rules applicable to a hybrid mismatch giving rise to a mismatch outcome depend on the type of mismatch. Below is a high-level summary of the rules:
To the extent that a hybrid mismatch results in double deduction, the deduction will be denied in Luxembourg if Luxembourg is the investor jurisdiction. Where Luxembourg is the payer jurisdiction, the deduction will be denied in Luxembourg if it is not denied by the investor jurisdiction. Any deduction will, however, remain eligible to be set off against dual inclusion income. Dual inclusion income refers to any item of income that is included under the laws of both jurisdictions where the mismatch outcome has arisen.
The anti-hybrid mismatch rules regarding double deduction shall further not be applicable where a payment is made by a financial trader under an on-market hybrid transfer provided that the payer jurisdiction requires the financial trader to include as income all amounts received in relation to the transferred financial instruments.
Deduction without inclusion
To the extent that a hybrid mismatch results in a deduction without inclusion, the following will apply:
Hybrid financial instrument mismatches
If the payment is not included by the payee within a reasonable period of time, the deduction shall be denied if Luxembourg is the payer jurisdiction. A “reasonable period of time” is defined as a period that begins within 12 months of the end of the Luxembourg payer’s tax year, or where it is reasonable to expect that the payment will be included in the payee jurisdiction in a future tax period and the terms of the payment are those that would be expected to be agreed between independent parties. The deduction will also be denied in Luxembourg if the payment qualifies for any tax relief (e.g., an exemption from tax, a reduction in the rate of tax or any credit or refund of tax) solely due to the way that payment is characterized under the laws of the payee jurisdiction. Where Luxembourg is the payee jurisdiction, and the payer jurisdiction has not denied the deduction, the amount that would otherwise give rise to a mismatch outcome shall be included in the Luxembourg tax base of the payee.
Luxembourg has taken the option provided for by ATAD 2 to include an exemption for loss absorbing capacity requirements to prevent potentially unfair situations between domestically-owned and not domestically-owned groups. The provision is targeted to the banking sector and the net tax result of applying the exclusion should be the same as it would have been, had the banking subsidiary been able to issue subordinated debt directly to the market. As such, the anti-hybrid mismatch rules regarding deduction without inclusion shall not be applicable to a hybrid financial instrument if it is not part of a structured arrangement and certain other requirements are met. The provision will be applied until 31 December 2022 and shall be evaluated by the European Commission by 1 January 2022.
Hybrid PE mismatches
If Luxembourg is the payer jurisdiction the deduction shall be denied if:
1. A payment is made to a disregarded PE.
2. A payment is made to an entity with one or more PEs and there is no inclusion because of a difference in the allocation of payments between the head office and PE or between two or more PEs of the same entity.
3. There is a notional payment made by a PE or between two or more PEs that does not give rise to a deduction because the payment is disregarded under the laws of the payee jurisdiction. In this hybrid PE mismatch situation, however, any deduction will remain eligible to be set off against dual inclusion income in a current or subsequent period.
Where Luxembourg is the payee jurisdiction in the above three hybrid PE mismatch situations and the deduction is not denied by the payer jurisdiction (e.g., because its source is in a third country), Luxembourg has opted for the possibility not to include the income in the Luxembourg taxable base. However, where a Luxembourg corporate taxpayer has a disregarded PE in an EU Member State whose income is not subject to tax in Luxembourg as a result of the application of a tax treaty with that EU Member State, the Luxembourg taxpayer must include the income that would otherwise be attributed to the disregarded PE in the Luxembourg tax base.
Hybrid entity mismatches
a. Payments to a hybrid entity
In the case of a payment by a Luxembourg corporate taxpayer or Luxembourg PE to a hybrid entity, the deduction shall be denied 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.
Where Luxembourg is the payee jurisdiction (i.e., the jurisdiction of the taxpayer participating in the hybrid entity) and the deduction is not denied by the payer jurisdiction (e.g., because the payer is in a third country), Luxembourg has opted for the possibility not to include the income in the Luxembourg taxable base.
b. Payments by a hybrid entity
In case of a payment by a hybrid entity (e.g., a Luxembourg corporate taxpayer on which an entity classification election has been made in the United States to treat it as a disregarded entity) the deduction shall be denied in Luxembourg if the mismatch is the result of the fact that the payment is disregarded under the laws of the payee jurisdiction. The deduction will not be denied, however, to the extent of the amount of dual inclusion income.
In the case of an imported mismatch, Luxembourg will deny the deduction for any payment by a taxpayer subject to Luxembourg CIT to the extent that such payment directly or indirectly funds deductible expenditure giving rise to a hybrid mismatch through a transaction between associated enterprises or entered into as part of a structured arrangement. This rule should not apply to the extent that one of the jurisdictions involved in the transaction has made an equivalent adjustment in respect of such hybrid mismatch.
Double tax credit
Where a hybrid transfer gives rise to a double tax credit, Luxembourg will limit the benefit of such relief in proportion to the net taxable income regarding the payment derived from a transferred financial instrument.
Tax residency mismatch
To the extent that a deduction for payment, expenses or losses of a taxpayer, which is resident for tax purposes in Luxembourg and in one or more other jurisdictions, is deductible from the taxable base in Luxembourg and in the other jurisdiction(s), Luxembourg will deny the deduction to the extent that the other jurisdiction(s) allows the duplicate deduction to be set-off against income that is not dual-inclusion income. However, payments, expenses or losses will remain deductible if there is a tax treaty in place between Luxembourg and the other jurisdiction(s) according to which the taxpayer is considered a resident of Luxembourg.
Taxation of reverse hybrid entities as from 2022
A transparent entity incorporated or established in Luxembourg (e.g., Luxembourg limited partnership (société en commandite simple; SCS), special limited partnership (société en commandite spéciale; SCSp)) will be treated as a corporate taxpayer if one or more associated nonresident entities holding in aggregate a direct or indirect interest of at least 50% of the voting rights, capital interests or rights to profit are located in a jurisdiction/jurisdictions that regard the entity as opaque. Such transparent entity will be subject to Luxembourg CIT on its income to the extent that this income is not otherwise taxed under the laws of Luxembourg or any other jurisdiction. This provision will not apply, however, to collective investment vehicles. In this respect, “collective investment vehicle” means an investment fund or vehicle that is widely held, holds a diversified portfolio of securities and is subject to investor-protection regulation in the country in which it is established. According to the commentaries, it covers undertakings for collective investment in the sense of the Luxembourg law of 17 December 2010, the Specialized Investment Funds (SIFs) in the sense of the Luxembourg law of 13 February 2007, and the Reserved Alternative Investment Funds (RAIFs) in the sense of the Luxembourg law of 23 July 2016. Also covered are alternative investment funds covered by the law of 12 July 2013 on alternative investment fund managers provided they are widely held, hold a diversified portfolio of securities and are subject to investor protection requirements.
As ATAD only applies to CIT, transparent entities that are treated as corporate taxpayers as a result of the rules described above will nevertheless be exempt from net worth tax.
Burden of proof
To prove that the anti-hybrid mismatch provisions are not applicable in a particular case, the taxpayer must be able to provide a declaration of the issuer of the financial instrument or any other relevant document such as tax returns, other tax documents or certificates issued by foreign tax authorities. Such documentation needs to be provided on demand of the tax authorities. The comments to the law give the example of a financial instrument, in relation to which the taxpayer is required to analyze the expected treatment in the other jurisdiction and to justify such analysis in order to confirm the application of the deduction. With reference to the Action 2 report (para 85), such analysis is “primarily a legal question that requires an analysis of the general rules for determining the character, amount and timing of payments under a financial instrument in the payer and payee jurisdictions.”
The Draft Law will now go through the legislative process, which involves the analysis of the text by a dedicated parliamentary commission, the collection of opinions from different advisory bodies (most importantly the Council of State), discussion and vote of the text in a parliamentary session and finally its publication in the Official Gazette (Memorial). The entire process may take several months and is expected to be completed before year-end.
The ATAD was an unprecedented change in European direct taxation and it has a significant effect on the taxation of businesses operating in the EU. ATAD 2 completes the picture by addressing mismatches with third countries and significantly expanding the scope of the ATAD to hybrid PE mismatches, hybrid transfers, imported mismatches, reverse hybrid mismatches and dual resident mismatches that may have far reaching consequences for taxpayers operating in the EU.
1. Organisation for Economic Co-operation and Development.
2. Base Erosion and Profit Shifting.
EYG no. 003372-19Gbl
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