The Luxembourg Government has been working on drafting the necessary new law for some time, and on 20 June 2018 a draft bill (no. 7318) was published, setting out the proposed text of the legislation. This text may of course be amended during the process of the bill passing through the Chambre des Députés.
The bill contains no great surprises, and covers all the provisions set out in ATAD 1 and analysed in the July 2016 PE Newsletter.
However, we can now see the ways in which Luxembourg is opting to legislate in the various areas where the Directive gives Member States either a choice of measures or discretion to include relieving provisions.
The most important points in the bill for private equity funds are summarised below. A fuller analysis of the overall contents of the bill is provided in our PwC Flash News of 20 June 2018.
Apart from the measures concerning exit taxes, all the provisions set out in the bill will take effect from the first day of the first accounting period starting on or after 1 January 2019. Thus, for companies whose tax year is the calendar year, the measures take effect on 1 January 2019.
Deductibility of borrowing costs
The deductibility of net borrowing costs in each tax period must, as a general rule, be capped at 30% of EBITDA.
Borrowing costs are defined extremely broadly, and explicitly include “any return under profit participating loans” and “imputed interest on instruments such as convertible bonds”. The text of the bill does not give any further clarification on the exact meaning of these or the other types of borrowing costs listed, and the commentary to the bill also adds little, other than to emphasise that the text is “non-exhaustive” in nature.
Consistent with ATAD 1, borrowing costs include bank and other external borrowing costs, as well as related-party borrowing costs.
Luxembourg entities with interest revenues (or equivalent) will only be affected if their tax-deductible borrowing costs (before the application of these new rules) exceed their interest revenues. Hence, most Luxembourg entities whose sole activity is intra-group financing should not be affected.
EBITDA is computed based on tax figures - so, for example, a Luxembourg company whose sole earnings are dividends covered by the participation exemption will have an "E" of nil for the purpose of applying these rules.
The draft measures include a "safe harbour" provision - to the extent that net borrowing costs amount to no more than EUR 3 million, no EBITDA-linked cap on deductibility applies. If net borrowing costs exceed this limit, EUR 3 million of costs will remain deductible even if the EBITDA-linked cap is lower.
Another important relieving provision is that net borrowing costs accruing on loans contracted before 17 June 2016 (the date on which EU finance ministers agreed the ATAD 1 text) are excluded from the amount of net borrowing costs subject to the EBITDA-linked cap. The draft text denies this relief if the loan concerned is subject to "any subsequent modification". The draft text does not elaborate on this expression, and the commentary in the bill on the draft text merely repeats the wording of a recital clause in ATAD 1. This states that the relieving clause “covers existing loans to the extent that their terms are not subsequently modified, i.e. in case of a subsequent modification, the grandfathering would not apply to any increase in the amount or duration of the loan but would be limited to the original terms of the loan”. It is hoped that the tax authority will in due course give further clarification on how it intends to interpret this grandfathering rule.
The new rules are drafted as applying on a Luxembourg-company-by-Luxembourg-company basis. Disappointingly, the draft bill has not taken the approach – available to Member States under ATAD 1 - that would allow the deductibility limit to be computed and applied to any tax unity group as if it were a single entity. Private equity funds may need to review their financing structures in Luxembourg, with a view to minimising any restrictions on deductibility arising from this company-by-company approach. No assumption should be made that any change in approach will occur during the passage of this bill into law, although there will doubtless be lobbying for change here.
The draft text also makes no changes to, or explicit references to, existing provisions in the Luxembourg tax regime that affect the tax deductibility of interest costs. It does suggest that the new rules apply after any restriction on deductibility imposed by other provisions.
However, some existing Luxembourg tax provisions only operate to the extent that interest has already been tax-deducted. In particular, the “recapture” rules under the participation exemption regime can cause exit gains on share disposals to become partially or wholly taxable if interest expenses economically linked to the participation concerned have been tax-deducted. The new EBITDA-based measures restrict deductibility on a company-wide basis, so it will not immediately be clear whether any restrictions under the new measures reduce any amount that would otherwise be tax-deductible (although subject to later “recapture”) in connection with an individual loan that finances a participation holding. It is hoped that the draft text might in due course be augmented to clarify how these sets of rules interact, or that the existing rules might be amended – or failing this, that the tax authority will in due course give further clarification.
Thus, the details of these new measures have the potential to cause restrictions on interest deductibility - and hence additional tax costs – for Luxembourg companies in a private equity fund structure. However, the impact of these ATAD 1-driven measures in other EU Member States, where funds own target investments, may often be greater. This can already be seen in situations where the target jurisdiction has already acted to introduce rules of this nature, such as in Germany and the UK.
It is already becoming clear that one effect of these new measures entering into force across the EU is that there is less incentive to fund target structures with internal debt. As (possibly scant) compensation, this may mean that by 2020, when the further rules in ATAD 2 (which deals in detail with "hybrid mismatches") come into play, fund vehicles may provide less debt financing to structures, and these structures may risk having tax deductions denied under "anti-hybrid" measures (including those concerning "imported mismatches").
The "controlled foreign company" ("CFC") regime
The bill introduces a formal CFC regime into Luxembourg tax law for the first time. The measures are intended to deter groups of companies from diverting net income to controlled or associated entities or branches set up in tax havens or other lightly taxed jurisdictions. This is done by deeming such income to be taxable as commercial income in Luxembourg, to the extent that it is not actually distributed up the chain of ownership.
Private equity funds will need to review carefully the situation of all entities and branches that form part of structures of groups in which they invest. Extra tax costs could arise in Luxembourg, even if there is an extensive chain of intermediate ownership. In particular, the rules are not disapplied even if another EU Member State involved in the ownership chain has invoked similar measures because it, too, has transposed ATAD 1.
However, the detail of the bill’s draft text implementing ATAD 1 in Luxembourg suggests that, in practice, several factors might come into play to restrict the number of circumstances in which real problems might arise.
Firstly, the way in which the draft text identifies foreign companies or branches that are in scope is based on a comparison between their actual effective tax rate and the effective tax rate that would have arisen had the foreign company or branch been a Luxembourg tax resident. Only companies or branches whose actual rate is below 50% of the notional Luxembourg rate (looking only at the 18% corporate income tax rate) are affected.
Secondly, Luxembourg has taken up “option b)”, available to Member States under ATAD 1. The only income in a low-tax entity that can be deemed taxable in Luxembourg is income that arises from “non-genuine arrangements” put in place to obtain a tax advantage. Such arrangements automatically include situations where the reason for a low-tax entity owning assets or bearing risks is because the entity is controlled by a Luxembourg company, and that Luxembourg company undertook important functions linked to those foreign assets or risks and that were instrumental in generating the income. For example, a treasury function in Luxembourg that controlled and invested funds actually belonging to a tax-haven group company, with this all being done for tax reasons, would probably result in the income falling under the new Luxembourg CFC regime.
Many commentators had taken the position that the full and detailed rules dealing with “hybrid mismatch” situations set out in ATAD 2, to be transposed into Member States’ domestic law by 1 January 2020, completely superseded the very brief set of measures in ATAD 1 (dealing only with intra-EU situations involving associated companies). Hence, it was considered that EU Member States did not have to implement any “hybrid mismatch” measures before 1 January 2020.
However, the Luxembourg Government has decided to introduce the ATAD 1 anti-hybrid provisions for the 2019 calendar year. The operative provisions simply replicate the ATAD 1 wording, and comprise only four lines of the draft text of the bill, having the following principles-based application:
a) To the extent that a hybrid mismatch results in a double deduction, the deduction shall be given only in the Member State in which such payment has its source;
b) To the extent that a hybrid mismatch results in a deduction without inclusion, the payer’s Member State shall deny the deduction of such payment.
This is a disappointing situation, resulting in potential confusion and extra work for all parties involved. Indeed, the text at one point contradicts the effect of existing Luxembourg legislation introduced in 2015, following an earlier EU-driven effort to tackle hybrid mismatches. Furthermore, it is far from clear that all other EU Member States will take the same approach, meaning that there is scope for double taxation.
Although – partially because of this previous legislation – few intra-EU hybrid mismatch situations are now found in practice, private equity funds should review internal financing arrangements in both groups that they own and fund structures. In particular, arrangements whereby a fund vehicle provides finance to a Luxembourg entity, and where the Luxembourg tax regime treats the fund vehicle as tax-transparent but a controlling investor’s tax regime does not, should be reviewed.
Other ATAD 1 measures
There are two other sets of measures covered in the Bill, each of which are the subject of a separate Article in ATAD 1. One revises existing Luxembourg legislation concerning “exit taxes” applying when companies shift residence from one jurisdiction to another or transfer the activities of a permanent establishment to a different jurisdiction. The other augments Luxembourg’s existing “general anti-avoidance rule” (“GAAR”).
This review does not examine either measure further.
Convertible debt - conversions
The bill also includes two measures not specifically covered by ATAD 1. In each case, the measure proposed changes the law in a way that appears to block tax-planning arrangements that have been challenged by the European Commission, on the grounds that the law, as it now stands, allowed Luxembourg to provide illegal State aid.
Of the two measures, the more important one for private equity funds is probably the withdrawal of the relief that currently allows convertible debt to be converted into equity on a tax-neutral basis (Art. 22bis(2)(1) LITL.). From 1 January 2019, the owner of the convertible debt (if subject to Luxembourg tax) will be taxed on the gain made if the fair market value of the convertible debt at the time of conversion into equity is greater than the base cost of the debt to its owner. (This is the consequence of the general rule for taxing asset-for-asset exchanges being applied).
In conclusion, the bill proposes that material changes to Luxembourg’s tax regime be made, and that these take effect as early as 1 January 2019 for many taxpayers. However, these changes have all been expected and anticipated, as they follow closely the ATAD 1 measures adopted at EU level two years ago.
Private Equity Leader, PwC Luxembourg
Tel: +352 49 48 48 3193
Director, PwC Luxembourg
Tel: +352 49 48 48 3057