The 2019 Luxembourg tax reform law implements the EU Anti-Tax Avoidance Directive and other anti-base erosion and profit shifting-related measures into Luxembourg tax law. During the legislative process, the draft law on the 2019 tax reform was subject to only a few amendments but work remains to be done to clarify some practical implications and the impact of some of the new measures on existing tax law.
Anti-hybrid Mismatch Rules
The tax reform law introduces a new Article 168ter of the Income Tax Law (“ITL”) which implements the generic anti-hybrid mismatch provisions included in the 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 law does not implement the amendments introduced subsequently by ATAD 2 to ATAD which have replaced the anti-hybrid mismatch rules provided under ATAD and extended their scope of application to hybrid mismatches involving third countries. ATAD 2 provides for specific and targeted rules which must be implemented by January 1, 2020. As such, the anti-hybrid mismatch rule provided in ATAD did not have to be implemented in 2019.
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 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 EU 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 new Article 168ter of the ITL should have a limited scope of application. However, given the generic wording of the anti-hybrid mismatch rule, the latter may create significant legal uncertainty in 2019 even if the existence of a hybrid situation is not at all linked to tax motives.
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 EU member state where such payment has its source. Thus, where Luxembourg is the investor state and the payment has been deducted in the source state, Luxembourg will deny the deduction. However, this situation should hardly ever occur in practice.
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, the deduction of the payment will be denied in Luxembourg.
In practice, income that is treated as dividend income at investor level should, in accordance with the EU Parent–Subsidiary Directive, only benefit from a tax exemption if the payment was not deductible at the level of the Luxembourg company making the payment. Therefore, these situations should generally not occur in an EU context.
How to Benefit From a Tax Deduction in Practice
To be able to deduct a payment in Luxembourg, the Luxembourg corporate taxpayer will have to demonstrate that no hybrid mismatch situation exists. 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.
This evidence is provided through the statements made in the corporate tax returns. In practice, the Luxembourg tax authorities may ask for further information and proof in this respect.
Exit Taxation Rules
The tax reform further provides for tax law changes in regard to exit taxation that will become applicable as from January 1, 2020. These measures should discourage taxpayers from moving their tax residence and/or assets to low-tax jurisdictions. However, to a large extent, Luxembourg tax law already provided for exit tax rules.
Rule Applicable to Transfers to Luxembourg
As far as transfers to Luxembourg are concerned, a new paragraph has been added to Article 35 of the ITL providing that in case of a transfer of assets, tax residence or business carried on by a permanent establishment (“PE”) to Luxembourg, Luxembourg will follow the value considered by the other jurisdiction 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 coherence 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 to Luxembourg
The same valuation principles will also apply to contributions of assets (supplément d’apport) within the meaning of Article 43 of the ITL. Therefore, when assets are contributed to Luxembourg, Luxembourg shall accept the value considered in the jurisdiction of the contributing company or 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 tax reform 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 the case of:
- a transfer of assets from the Luxembourg head office to a PE located in another 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, but only to the extent that Luxembourg loses the right to tax the transferred assets;
- a transfer of tax residence to another 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.
For transfers within the European Economic Area, the Luxembourg taxpayer may request to defer the payment of exit tax by paying in equal installments over five years. Section 127 of the General Tax law (Abgabenordnung) is amended accordingly.
Amendment of the Luxembourg Roll-over Relief
Article 22bis of the ITL provides for exceptions to the general rule that Luxembourg taxpayers have to realize latent capital gains linked to assets that are exchanged for other assets. As from 2019, the provision applicable to a specific category of exchange operations involving the conversion of a loan or other debt instruments into shares of the borrower has been abolished.
Hence, the conversion of debt instruments into shares of the borrowers will no longer be possible in a tax neutral manner. Instead, the conversion will be treated as a sale of the debt instrument followed by a subsequent acquisition of shares. Accordingly, any latent gain on the debt instrument will become fully taxable upon the conversion.
Therefore, whenever a debt instrument should be contributed by a Luxembourg company, consideration should be given to the question as to whether the fair market value of the receivable exceeds its book value. Where the amendment of the roll-over relief would result in adverse tax consequences, alternative restructuring options should be explored.
The amendment to Article 22bis of the ITL follows the state aid investigations of the European Commission in the Engie case. However, while the aim of this amendment is to ensure that double non-taxation situations can no longer arise from this provision, it would have been wise to implement more targeted measures to avoid collateral damage.
Amendment of the PE Definition
As a last measure, the definition of PE under Luxembourg tax law (section 16 of the Tax Adaptation Law) has been amended. Under the new PE definition, the only criteria to be considered in order to assess whether a Luxembourg taxpayer has a PE in a country with which Luxembourg has concluded a tax treaty are the criteria defined in that tax treaty. In other words, the PE definition included in the tax treaty will be relevant.
Furthermore, unless there is a clear provision in the relevant 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 only if the activity performed, viewed in isolation, is an independent activity which represents a participation in the general economic life in that contracting state.
However, tax treaties concluded by Luxembourg generally include the PE definition provided in Article 5 of the OECD Model Convention that does not entail such requirement, so the amendment of the Luxembourg PE definition should have no material impact in practice.
Finally, 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 is, in particular, to be produced when Luxembourg adopted the exemption method in a tax treaty and the other contracting state interprets the rules of the tax treaty in a way that excludes or limits its taxing rights. This is to avoid hybrid branch situations that are recognized in Luxembourg but disregarded in the host state of the PE.
ATAD required EU member states to implement certain anti-BEPS measures into their domestic tax law and provided some leeway to choose among a number of implementation options. Overall, Luxembourg has made the right choices, using all options beneficial to taxpayers that will help the Grand Duchy to remain competitive.
However, in a few cases the Luxembourg legislator took a position even stricter than what was required by ATAD. For example, instead of implementing the anti-hybrid mismatch rules provided in ATAD 2 as from 2020, the tax reform provides for the generic hybrid mismatch rule included in ATAD. Ironically, this rule needs to be replaced only one year later by the detailed anti-hybrid mismatch rules provided in ATAD 2.
Although the impact of this measure should be limited, the generic nature of the anti-hybrid mismatch rule may create severe legal uncertainty in some case.
Additional work remains in order to clarify the views of the Luxembourg tax authorities on the interpretation of some of the new rules and the impact of certain of these rules on existing tax law. In this regard, it is expected that the Luxembourg tax authorities will release Tax Circulars with additional guidance in 2019.
Considering that these changes became effective in January 2019, Luxembourg taxpayers should urgently analyze the impact of the upcoming changes on their investments and business activities and take appropriate action where necessary.
Oliver R. Hoor is a Tax Partner (Head of Transfer Pricing and the German Desk) and Samantha Schmitz is the Chief Knowledge Officer with ATOZ Tax Advisers (Taxand Luxembourg).