INSIGHT: Luxembourg Implements ATAD 2 (Part 2)

On August 8, 2019, Luxembourg released the draft law implementing EU Directive 2017/952 of May 29, 2017 (the “Anti-Tax Avoidance Directive 2” or ATAD 2) which provides for a comprehensive framework to tackle hybrid mismatches. These new rules will replace the existing hybrid mismatch rules which have been introduced as part of the 2019 tax reform implementing EU Directive 2016/1164 of January 28, 2016 (the “Anti-Tax Avoidance Directive” or ATAD) and extend their scope to transactions involving non-EU countries.

The Context

Hybrid mismatches typically result from a different tax treatment of an entity or financial instrument under the laws of two or more jurisdictions and may result in deduction without inclusion outcomes or double deductions.

The hybrid mismatch rules target a number of different situations including direct hybrid mismatches between associated enterprises, structured arrangements between third parties, imported hybrid mismatches and tax residency mismatches. Payments that may come within the scope of the hybrid mismatch rules may include payments under financial instruments and, in some cases, other deductible payments such as royalties, rents and payments for services.

While the primary objective of the hybrid mismatch rules is the elimination of double non-taxation, these rules should also not result in economic double taxation. The latter is ensured through a number of carve-outs and limitations that discharge the application of the hybrid mismatch rules.

ATAD 2 follows the recommendations of the Organisation for Economic Co-operation and Development in regard to Base Erosion and Profit Shifting (BEPS) Action 2 that aim at neutralizing the effects of hybrid mismatch arrangements through the application of linking rules that align the tax treatment in two or more jurisdictions. ATAD 2 explicitly states that the explanations and examples in the Final Report on Action 2 may be a source of interpretation to the extent they are consistent with the provisions of the Directive (see recital 28 of ATAD 2).

Reverse Hybrid Mismatch Rules

Scope of the Reverse Hybrid Mismatch Rules

A reverse hybrid is an entity that is treated as transparent under the laws of the jurisdiction where it is established but as a separate entity (i.e. opaque) under the laws of the jurisdiction(s) of the investor(s) (see Final Report on BEPS Action 2, p. 56, No. 140).

As a consequence, the income of a reverse hybrid may be neither taxable in its establishment jurisdiction (as the income is deemed to be allocated to the investor) nor in the residence state of the investor(s) (where the income of the opaque entity is generally not included in the taxable income of the investor(s)).

The reverse hybrid mismatch rule aims at eliminating double non-taxation outcomes through the treatment of reverse hybrids as resident taxpayers (see Final Report on BEPS Action 2, p. 64, No. 174 and 175). Article 168quater of the Luxembourg Income Tax Law (LITL) may apply as from January 1, 2022 to all entities within the meaning of Article 175 of the LITL that are established in Luxembourg (in particular, partnerships).

Given that these entities are treated as fiscally transparent from a Luxembourg tax perspective, their income is generally allocated to the owners (Article 168quater (1) of the LITL; the owners may be individuals, corporate taxpayers within the meaning of Article 159 (residents) or 160 (nonresidents) of the LITL or transparent entities within the meaning of Article 175 of the LITL).

However, the reverse hybrid mismatch rule may only apply when one or more investor(s) (that are resident in a jurisdiction or jurisdictions that regard the Luxembourg entity as opaque) have effective control over the Luxembourg entity. This would be the case when the entity is owned by one or several associated enterprises within the meaning of Article 168ter (1) No. 17 of the LITL which hold directly or indirectly a participation of at least 50% in terms of voting rights or capital ownership or is entitled to receive at least 50% of an entity’s profit.

Tax Treatment of Reverse Hybrid Mismatches

Corporate Income Tax

When the reverse hybrid mismatch rule applies, the entity is deemed to be a resident taxpayer and its net income is subject to corporate income tax to the extent this income is not subject to (corporate) income tax at the level of the investors, be it in Luxembourg or abroad.

Accordingly, the reverse hybrid mismatch rules will not apply if and to the extent the income derived through the Luxembourg entity is taxable in Luxembourg as domestic income of nonresident taxpayers. This may, for example, be the case when a Luxembourg partnership performs a commercial activity that results in the constitution of a permanent establishment (PE) of its nonresident partner(s). (Here, the nonresident partners are subject to (corporate) income tax with the commercial income realized via the partnership which constitutes a PE of its nonresident partners; Article 156 No. 1 a) of the LITL in conjunction with Article 2 (3) (individuals) or 160 (1) (corporates) of the LITL.)

Therefore, the inclusion of income for Luxembourg corporate income taxes should be limited to amounts that otherwise would result in double non-taxation rather than taxing all the income of the reverse hybrid (Article 168quater (1) of the LITL).

Example: Reverse hybrid mismatch

An investor resident in State A (A-Co) invests in an entity resident in State B (B-Co). While B-Co is treated as a transparent entity from the perspective of State B, under the domestic tax law of State A, B-Co is treated as an opaque entity.

In State B, the income of B-Co is not taxed as the income is allocated for income tax purposes to the owner of B-Co. In State A, the income of B-Co is not taxable as B-Co is classified as an opaque entity. Thus, the income of the reverse hybrid is neither taxable in State A nor in State B.

In these circumstances (assuming that Luxembourg is State B), Article 168quater (1) of the LITL should result in B-Co being treated as a resident taxpayer and subject to corporate income tax to the extent the net income is not taxed otherwise under the Luxembourg income tax law or the law of any other jurisdiction.

With regard to payments to a reverse hybrid entity, the reverse hybrid mismatch rule will have as an effect that an arrangement that would otherwise give rise to a mismatch outcome within the meaning of Article 168ter (1) No. 2 of the LITL should not be subject to any further adjustment under the hybrid mismatch rules (see recital 29 of ATAD 2). This is because Article 168quater eliminates the deduction without inclusion outcome that may otherwise trigger non-deductibility in accordance with the hybrid mismatch rules.

Article 168quater of the LITL provides for a carve-out for collective investment vehicles (CIV) that are often established in the legal form of a partnership (for example, a société en commandite simple, or SCS) or a contractual fund without legal personality (fonds commun de placement, or FCP). A CIV is defined as an investment fund or a 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.

The commentaries to the draft law specify that the definition of a CIV includes the following types of entities:

• Undertakings for Collective Investment (UCIs) within the meaning of the Law of December 17, 2010 (i.e. both Undertakings for Collective Investment in Transferable Securities (UCITS), within the meaning of part 1 of the UCI Law of December 17, 2010, and non-UCITS or alternative investment funds within the meaning of part 2 of the UCI Law);
• Specialized Investment Funds (SIFs) within the meaning of the Law of February 13, 2007;
• Reserved Alternative Investment Funds (RAIFs) within the meaning of the Law of July 23, 2016; and
• Other alternative investment funds within the meaning of the Law of July 12, 2013 on alternative investment fund managers which do not already fall into one of the previous categories to the extent that they are widely held, hold a diversified portfolio of securities (so as to limit market risks) and are subject to investor-protection obligations.

Municipal Business Tax

The reverse hybrid mismatch rule has no impact on Luxembourg municipal business taxation. Instead, the tax treatment of a Luxembourg partnership depends significantly on the activities performed. Notwithstanding the fact that partnerships are deemed to be transparent for Luxembourg direct tax purposes, Luxembourg partnerships are subject to municipal business tax on profits derived from carrying on a commercial activity within the meaning of Article 14 (1) of the LITL through a PE situated in Luxembourg.

Likewise, where a general partner of a Luxembourg (special) limited partnership is a Luxembourg company owning a stake of at least 5% in the partnership, the latter is deemed to generate commercial income (Article 14 (4) of the LITL).

The commercial income realized by Luxembourg partnerships is subject to Luxembourg municipal business tax at the level of the partnership (section 2(1) of the Municipal Business Tax Law).

Net Wealth Tax

With regard to net wealth tax, the draft law provides for a specific exemption for entities that are treated as opaque in accordance with the reverse hybrid mismatch rule (section 3(1) No. 12 of the Net Wealth Tax Law). Thus, reverse hybrids are not subject to net wealth tax regardless of whether such entity is treated as a taxpayer for corporate income tax purposes.

Burden of Proof

The burden of proof that the reverse hybrid mismatch rule does not apply is on the taxpayer. According to Article 168quater (3) of the LITL, taxpayers have, upon request, to provide relevant documentation (tax returns, certificates issued by foreign tax authorities, etc.) that demonstrate that the reverse hybrid mismatch rule does not apply.

The commentary to the draft law specifies that taxpayers need to produce reasonable evidence that allows the tax authorities to verify whether or not the hybrid mismatch rules apply. With regard to the elements of foreign tax treatment of potential hybrid mismatches, taxpayers have to provide comprehensive, objective and verifiable information.

To Sum Up

As from 2020, Luxembourg will implement the comprehensive hybrid mismatch rules provided under ATAD 2 that extend the scope of the existing hybrid mismatch rules to hybrid mismatches involving third states and, in addition, include a reverse hybrid mismatch rule which may apply as from 2022.

However, Luxembourg made the right choices, adopting all available implementation options which limit the scope of the new rules for the benefit of Luxembourg taxpayers and avoid unintended collateral damage for the Luxembourg fund industry.

The hybrid mismatch rules are characterized by an extreme complexity which requires a good understanding of the overall investment structure and the foreign tax treatment of payments, entities, financial instruments, etc. Given that the burden of proof regarding the non-application of the hybrid mismatch rules is on the taxpayer, a hybrid mismatch analysis will necessarily become an integral part of each and every tax analysis.

Planning Points

With only a few months left in 2019 before the new hybrid mismatch rules will enter into force, taxpayers have to analyze existing investment structures in order to detect potential hybrid mismatches and to implement, where necessary, structure alignments before year-end. Ultimately, the complexity of the hybrid mismatch rules may also be an opportunity to manage their impact in practice.

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

The author may be contacted at: oliver.hoor@atoz.lu

The author wishes to thank Samantha Schmitz (Chief Knowledge Officer) for her assistance.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners