The Luxembourg draft law implementing the Anti-Tax Avoidance Directive (ATAD) 2 was published on August 9. The draft law will now go through the legislative process, which may take a couple of months, writes Dietmar Klos, partner and real estate leader at EY Luxembourg.
The draft law expands the scope of the hybrid mismatch provisions under ATAD 1 that will no longer apply only to hybrid financial instruments and hybrid entities, but also to a number of other hybrid mismatch situations.
Hybrid Financial Instruments
If we consider the financial structure illustrated, a company (designated as HoldCo) holds shares in and a receivable towards a subsidiary. HoldCo is financed with equity and a hybrid instrument - preferred equity certificates (PECs) - that are held by a fund vehicle, which could be a Luxembourg SCS, SCSp or FCP, or any other limited-partnership-type vehicle. At the level of the investor, the PECs may be treated as debt or as equity depending on the legislation of the relevant jurisdiction; in Luxembourg PECs are normally treated as debt. Where the investor jurisdiction considers the PECs as equity, there would be a hybrid mismatch as Luxembourg would grant a deduction for interest accruing on the PECs, while at investor level this would be treated as an equity return (which is often taxed at preferential rates or even exempt).
For the rules to apply, there needs to be either a structured arrangement or an ownership link of a certain size. For hybrid financial instruments that link is 25%, while for hybrid entities it is 50%. As PECs would generally fall under the definition of a structured arrangement, the ownership link should not be relevant. A structured arrangement is defined as an arrangement whose pricing reflects the hybrid mismatch or an arrangement that is designed to produce a hybrid mismatch outcome.
In case the PECs are considered a structured arrangement, any interest on the PECs in Luxembourg will not be deductible to the extent that investors have treated the PECs as equity and are therefore not taxable on the return at rates that would normally apply to interest income. Interest remains deductible when accrued or paid to investors who are taxable on the interest income. The inclusion in taxable income may under certain conditions also take place in a later tax period. Particular attention should be paid to the tax treatment of the income at the level of the investor; if tax relief, such as a foreign tax credit (excluding credits for foreign withholding taxes), is available because of the classification of the payment, the interest will not be deductible.
Many funds have exempt investors, and even though they would not be taxed on the return of a hybrid financial instrument, based on the ATAD 2 wording the return attributable to them is still not deductible. The Luxembourg draft law is very concise and does not contain a lot of commentary in this regard, but the reference to the BEPS report that is included in the draft law would seem to indicate that this also applies under the Luxembourg law.
As a result, in this type of financial structure, PECs and similar types of instruments may give rise to a disadvantage from a tax perspective.
Similarly to hybrid instruments, hybrid entities may be considered differently for tax purposes in different jurisdictions; so while a Luxembourg company may be treated as a flow-through entity in one jurisdiction (for example, in the US due to a check-the-box election), others may treat the fund vehicle as opaque. In the latter case, interest on the loan may not be included as taxable income in the same period during which the Luxembourg company deducts it.
The mismatch provisions will apply to deny an interest deduction to the extent it is paid to investors who are not taxed on the income.
Concept of Associated Enterprises
The anti-hybrid mismatch rules only apply if there is a structured arrangement or a mismatch between associated enterprises, meaning investors need to hold at least 50% in the voting rights, capital ownership or profit entitlement. Under the current rules each investor is considered individually. Under the draft law, this will change as of 2020 with the introduction of the “acting together” concept. The Luxembourg draft law contains some interesting variations to the Directive in this respect.
Under this concept, a person that acts together with another person, in respect of the voting rights or capital ownership of an entity, will be treated as holding a participation in all the voting rights or capital ownership of the entity held by that other person. There is some discussion as to what this means in the context of a fund. Based on certain statements in the BEPS report, limited partners in a partnership, where the voting rights are generally delegated to the General Partner, may typically be considered jointly. As a result, based on ATAD 2, investors in a fund will typically be considered as acting together, which means that the 50% threshold will usually be met.
The Luxembourg draft law contains an interesting nuance to this rule: investors are presumed not to be acting together if their shareholding or entitlement to profits in an investment fund is less than 10%. “Investment fund” for these purposes is defined as an undertaking for collective investment raising capital from a certain number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors. That definition is wider than UCITs and would also seem to include unregulated partnerships.
If a fund wants to rely on this rule in determining whether the mismatch rules are applicable, it will need information as to whether investors hold 10% or more in the fund.
Following the examples given in the BEPS report, if there is an investor that holds 10% or more, that investor could be considered as acting together with the General Partner, which typically would mean there is an associated enterprise because the General Partner controls at least 50% of the voting rights. As a result, the anti-hybrid mismatch rules would then have to be considered. Considering the wording of the Luxembourg draft law and the related commentaries, there are however also arguments to sustain that only investors owning more than 10% would need to be aggregated, and only if those investors exceed the 25% or 50% threshold, would they be considered as acting together. If there is no investor holding 10% or more, the anti-hybrid mismatch rules will not be applicable.
However, while this may be the Luxembourg conclusion, the mismatch provisions of other relevant jurisdictions would need to be considered if the Luxembourg company holds equity investments in the EU or any other country that has implemented BEPS-style anti-hybrid mismatch rules.
Reverse Hybrid rule
While most of the provisions of the draft law will apply as of 1 January 2020, the draft law also contains provisions that will only apply as of 2022. These rules relate to so-called reverse hybrids, which are transparent vehicles for local purposes that are held by investors in jurisdictions that view the vehicle as non-transparent. If, in the context of a Luxembourg fund, the SCS or SCSp is held by 50% or more investors that view it as non-transparent, it will become subject to Luxembourg corporate income tax – but only to the extent the income is not taxed elsewhere. To the extent there are investors that view the partnership as transparent, that income will not be subject to Luxembourg corporate income tax.
Investors would only be considered as acting together for purposes of this 50% test if they meet the 10% requirement described above.
The Directive provides for an exception to this provision that applies to collective investment vehicles, which has been taken over by the Luxembourg draft law: entities that are UCITs, SIFs or RAIFs will not be subject to the rule. And neither will alternative investment funds if they are widely held, hold a diversified portfolio of securities and are subject to investor-protection regulations.
The Draft Law strictly follows and does not go beyond ATAD 2’s mandatory “minimum standards” to neutralize hybrid mismatches. Luxembourg also decided to opt in for all possible exceptions provided for by ATAD 2. The draft law will be effective from financial years starting on or after 1 January 2020.