Circular of the Luxembourg tax authorities on the reverse hybrid rules of article 168quater LITL

Following the implementation of the reverse hybrid rules of ATAD 2 in Luxembourg tax law, Luxembourg transparent partnerships may become liable, with effect as from  tax year 2022, to corporate income tax in relation to their net income, to the extent that it is not otherwise taxed under Luxembourg domestic tax law or the law of any other jurisdiction, provided one or more associated non-resident entities (i) are holding in aggregate a direct or indirect interest in 50% or more of the voting rights, capital interests or profit entitlements in the Luxembourg partnership and (ii) consider the latter as a taxable person (article 168quater LITL).

Numerous interpretation questions were triggered by this article already at the time of the legislative process, and most of them remained unanswered until now.

The 2023 Budget Law, which contained an amendment to article 168quater LITL, already clarified that: 

• To be considered  a reverse hybrid entity, the non-taxation of the entity’s net income has to result from the actual qualification of the entity itself (i.e. transparent vs. opaque) at the level of its investors. Hence, the non-taxation of the net income of a partnership attributable to investors benefitting e.g. from a subjective exemption in their country of residence is not captured by the reverse hybrid rules since the non-taxation is not the result of the partnership being regarded as opaque by the investors; 

• In line with the prevailing interpretation among practitioners, once the conditions set out in Article 168 quater LITL are met, only the portion of the net income of a reverse hybrid entity that is attributable to an associated enterprise treating the entity as opaque should become taxable. The portion of the net income attributable to a non-associated enterprise treating the entity as opaque should thus not become taxable.

You may refer to our related Flash News: "Luxembourg Budget Law 2023 voted".

In the Circular, the LTA provided some helpful and welcome additional clarifications and confirmations :

• A reverse hybrid entity is not a resident collective entity within the meaning of article 159 LITL. It is confirmed that only some specific provisions of the LITL are applicable. In this respect, the LTA specifically confirmed that the following tax provisions are not applicable to a Luxembourg reverse hybrid entity: 
  • Article 164ter LITL: Controlled Foreign Companies (CFC) provisions;
  • Article 166 LITL: participation exemption on dividends received. A 50% exemption remains however applicable in certain cases in accordance with article 115.15a LITL;
  • Article 168 bis LITL: Interest Limitation Rules ;
  • Article 168ter LITL : Anti-hybrid rules.

• Net income potentially subject to tax at the level of a reverse hybrid entity is limited to the three last categories of income listed in article 10 LITL, i.e. net income from movable capital within the meaning of article 97 LITL, net rental income within the meaning of article 98 LITL, and other net income listed in article 99 LITL.  The income of a reverse hybrid is thus not considered to be commercial income;

• The taxable basis of the reverse hybrid entity is to be determined and assessed on the basis of its net income (in the scope of article 168quater LITL) realised during the calendar year (cash basis approach) – meaning that entities with a divergent accounting year will need to identify the relevant income and charges received/paid for the period from 1 January to 31 December;

• For income or charges not denominated in EUR, the conversion should, in principle (and in line with the cash basis approach), be performed separately for each item and using the relevant foreign exchange rate of the day the income is earned or the charged is suffered. The Circular provides however for an administrative tolerance whereby all income and charges may be converted into EUR using the same foreign exchange rate (i.e. rate applicable as of 31 December or average rate of the year);

• No step-up of the assets and liabilities of the entity is to be performed at the time the partnership acquires the status of a reverse hybrid entity. This means that any gain realised upon disposal of an asset would be computed by reference to the historic acquisition price (i.e. potentially determined before the acquisition of the reverse hybrid status). It is therefore key for the reverse hybrid entity to properly analyse the tax consequences of a potential sale of an asset, during the period it has the reverse hybrid status, before the effective disposal takes place; 

• No realisation event occurs at the time the partnership ceases to be a reverse hybrid entity (due to a change of investors for instance and the above-referred threshold of 50% of non-resident associated entities not being met any longer). No gain is therefore to be deemed realised upon such event for Luxembourg tax purposes;

• Distributions performed by a reverse hybrid entity are not subject to Luxembourg withholding tax;

• Foreign eligible taxes may be credited against the taxes due by the reverse hybrid entity in proportion of the part of the relevant income that has been subject to tax at the level of the reverse hybrid entity;

• A new tax form (tax form 205) has been recently issued by the LTA and is to be filed by reverse hybrid entities falling within the scope of article 168quater LITL.