INSIGHT: Luxembourg Draft Law Implementing ATAD: Part 2

New Framework to Tackle Hybrid Mismatches

While the main purpose of the Luxembourg draft law is to implement the Anti-Tax Avoidance Directive, it also includes two additional tax law changes related to base erosion and profit shifting, aimed at removing potential double non-taxation situations.

The draft law introduces a new Article 168ter of the Income Tax Law (“ITL”) which implements the anti-hybrid mismatch provisions included in the European Union (“EU”) Anti-Tax Avoidance Directive (“ATAD”). The new article aims to eliminate—in an EU context only—the double non-taxation created through the use of certain hybrid instruments or entities.

The draft law does not implement the amendments subsequently introduced to ATAD by ATAD 2 which have replaced the anti-hybrid mismatch rules of ATAD and extended their scope of application to hybrid mismatches with third countries. ATAD 2 has to be implemented by January 1, 2020 and will be dealt with in a separate draft law to be released in the course of 2019.

Given that ATAD 2 replaced the hybrid mismatch rule included in ATAD, it is not self-evident why the Luxembourg government included the ATAD rule in the draft law. Therefore, it remains to be seen whether this provision survives the legislative process.

Purpose

The aim of the measures against hybrid mismatches is to eliminate the double non-taxation created by the use of certain hybrid instruments or entities. In general, a hybrid mismatch structure is a structure where a financial instrument or an entity is treated differently for tax purposes in two different jurisdictions. The effect of such mismatches may be a double deduction (i.e. deduction in both EU member states) or a deduction of the income in one state without inclusion in the tax base of the other member state.

However, in an EU context, hybrid mismatches have already been tackled through several measures such as the amendment of the Parent–Subsidiary Directive (i.e. dividends should only benefit from the participation exemption regime if these payments are not deductible at the level of the paying subsidiary). Therefore, the hybrid mismatch rule included in the draft law should have a very limited scope of application.

Rule Applicable to Double Deduction

To the extent that a hybrid mismatch results in a double deduction, the deduction shall be given only in the member state where such payment has its source. Thus, in a case where Luxembourg is the investor state and the payment has been deducted in the source state, Luxembourg would deny the deduction.

Rule Applicable in Case of Deduction Without Inclusion

When a hybrid mismatch results in a deduction without inclusion, the deduction shall be denied in the payer jurisdiction. Therefore, if Luxembourg is the source state and the income is not taxed in the recipient state, Luxembourg would deny the deduction of the payment.

How to Benefit from a Tax Deduction in Practice

In order to be able to deduct a payment in Luxembourg, the Luxembourg corporate taxpayer will have to demonstrate that there is no hybrid mismatch situation. The taxpayer will have to provide evidence to the Luxembourg tax authorities that either (i) the payment is not deductible in the other member state which is the source state, or (ii) the related income is taxed in the other member state.

Exit Taxation Rule

Purpose

The aim of this measure is to discourage taxpayers from moving their tax residence and/or assets to low-tax jurisdictions. In line with the exit tax provisions included in ATAD, the draft law defines the valuation rules applicable in case of exit out of Luxembourg to another country (amendment to Article 38 of the ITL) and the valuation rules applicable in case of transfer out of another country to Luxembourg (amendments to Article 35 and Article 43 of the ITL).

Rule Applicable to Transfers to Luxembourg

As far as transfers to Luxembourg are concerned, a new paragraph will be added to Article 35 of the ITL which implements Article 5 section 5 of ATAD, providing that in case of a transfer of assets, tax residence or business carried on by a permanent establishment (“PE”) to another member state, that member state shall accept the value established by the member state of the taxpayer or of the PE as the starting value of the assets for tax purposes, unless this does not reflect the market value.

The aim of this rule is to achieve symmetry between the valuation of assets in the country of origin and the valuation of assets in the country of destination. While ATAD limits the scope of application of this provision to transfers between two EU member states, the new provision added to Article 35 of the ITL covers transfers from any other country to Luxembourg.

Rule Applicable in Case of Contribution (supplement d’apport)

The same valuation principles will also apply to contributions of assets within the meaning of Article 43 of the ITL. Therefore, when assets are contributed to Luxembourg, Luxembourg shall accept the value established by the departure state of the taxpayer or of the PE as the starting value of the assets for tax purposes, unless this does not reflect the market value.

Rule Applicable to Transfers out of Luxembourg

As far as transfers out of Luxembourg are concerned, the draft law provides that a taxpayer shall be subject to tax at an amount equal to the market value of the transferred assets at the time of the exit, less their value for tax purposes in case of:

• a transfer of assets from the Luxembourg head office to a PE located in another country (i.e. other member state or third country), but only to the extent that Luxembourg loses the right to tax the transferred assets;

• a transfer of assets from a Luxembourg PE to the head office or to another PE located in another country (i.e. other member state or third country), but only to the extent that Luxembourg loses the right to tax the transferred assets;

• a transfer of tax residence to another country (i.e. other member state or third country), except for those assets which remain connected with a Luxembourg PE; and

• a transfer of the business carried on through a Luxembourg PE to another member state or to a third country, but only to the extent that Luxembourg loses the right to tax the transferred assets.

In case of transfers within the European Economic Area (“EEA”), the Luxembourg taxpayer may request to defer the payment of exit tax by paying in equal installments over five years. This new provision included in ATAD amends and replaces the existing provisions included in section 127 of the General Tax Law (Abgabenordnung). Under current Luxembourg tax law, Luxembourg taxpayers may defer the payment of the tax until the effective disposal of the assets. The deferral applied both to transfers to another EEA country and to transfers to a country with which Luxembourg has concluded a double tax treaty. Under the new rules, it will only be possible to defer the payment over a maximum of five years and the deferral will only apply to transfers to EEA countries. The deferral will be achieved by way of a payment in five equal installments. Several exceptions apply to the five-year payment deferral, which will reduce the five-year period, e.g. in case of disposal of the assets transferred.

Finally, provided that the assets are set to revert to Luxembourg (country of the transferor) within a period of 12 months, the new exit tax rules shall not apply to asset transfers related to the financing of securities, assets posted as collateral or where the asset transfer takes place in order to meet prudential capital requirements or for the purpose of liquidity management. Since the new Luxembourg exit tax rules will apply both to corporate taxpayers and to individuals, both individuals and corporate taxpayers will be able to benefit from those exceptions.

Other Non-ATAD Measures

Conversion of Debt into Shares no Longer Tax Neutral

This measure should amend the Luxembourg rules applicable to a specific category of exchange operations (rollover relief, Article 22bis of the ITL) that involves the conversion of a loan into shares of the borrower. As from 2019, such conversion will no longer fall within the scope of tax neutral exchange operations. Instead, the conversion will be treated as a sale of the loan followed by a subsequent acquisition of shares. This means that any latent gain on the loan will become fully taxable upon the conversion.

The aim of this amendment to Article 22bis of the ITL is to ensure that double non-taxation situations can no longer arise from this provision. However, instead of removing this provision, the Luxembourg legislator should limit its scope of application with a view to avoiding situations of double non-taxation.

New Definition of Permanent Establishment

The second measure amends the definition of PE under Luxembourg tax law (section 16 of the Adaptation Law). According to the draft law, as from January 1, 2019, the only criteria to apply in order to assess whether a Luxembourg taxpayer has a PE in a country with which Luxembourg has concluded a double tax treaty are the criteria defined in the tax treaty. In other words, the PE definition included in the tax treaty will prevail.

The draft law provides further that, unless there is a clear provision in the relevant double tax treaty which is opposed to this approach, a Luxembourg taxpayer will be considered as performing all or part of its activity through a PE in the other contracting state if the activity performed, viewed in isolation, is an independent activity which represents a participation in the general economic life in that contracting state.

Finally, the draft law states that the Luxembourg tax authorities may request from the taxpayer a certificate issued by the other contracting state according to which the foreign authorities recognize the existence of the foreign PE. Such certificate has to be provided in case the relevant tax treaty does not entail any provision (i.e. a provision equivalent to Article 23A(4) of the 2017 Model Tax Convention of the Organization for Economic Co-operation and Development) according to which Luxembourg is authorized to deny the exemption of the income realized (or the assets owned) by the Luxembourg taxpayer in the other contracting state when the other contracting state interprets the tax treaty in such a way that its taxing right in regard to the income or capital is limited or excluded.

However, it should be noted that tax treaty law takes precedence over Luxembourg domestic tax law and Luxembourg has to honor its tax treaty obligations. Therefore, as long as a tax treaty does not include specific anti-abuse legislation, Luxembourg has to exempt income and capital derived or owned through a PE (as defined in an applicable tax treaty) in the other contracting state.

In Summary

Overall, Luxembourg has made the right choices, using all options provided by ATAD in order to remain competitive. However, on some aspects the Luxembourg government took positions which are even stricter than ATAD. For example, instead of implementing all anti-hybrid mismatch rules provided in ATAD 2 as from 2020, the draft law provides for the hybrid mismatch rule included in ATAD, which has been replaced by ATAD 2.

Furthermore, additional work remains to be done in order to clarify the impact of some of the new measures on existing tax law. This might be done by the Luxembourg tax authorities through Tax Circulars.

Planning Points

Considering that these changes will become effective in less than six months, Luxembourg taxpayers should analyze the impact of the upcoming changes on their investments and take appropriate action if necessary.

Oliver R. Hoor is a Tax Partner (Head of Transfer Pricing and the German Desk) and Samantha Schmitz is Chief Knowledge Officer with ATOZ Tax Advisers (Taxand Luxembourg).

The authors may be contacted at: oliver.hoor@atoz.lu; samantha.schmitz@atoz.lu