Publication of the draft bill of law implementing ATAD 2 into Luxembourg domestic law

The draft bill implementing EU Directive 2017/952 of 29 May 2017 amending EU Directive 2016/1164 laying down rules against tax avoidance practices that directly affect the functioning of the internal market (the “ATAD 2 Directive”) into Luxembourg domestic law (the “Draft ATAD 2 Law”) was submitted to the parliament on 8 August 2019.

Extension of the scope of the anti-hybrid mismatch rules

The Draft ATAD 2 Law aims at broadening the scope of the anti-hybrid mismatch provisions introduced into Luxembourg law earlier this year so as to also include hybrid mismatches with states outside of the EU and increase the situations targeted by the rules more generally (notably introducing rules regarding permanent establishments, hybrid transfers or imported mismatches).

In essence, in situations involving associated enterprises (or permanent establishments or a structured arrangement) where a hybrid mismatch results in a double deduction or deduction without inclusion, the effects of such a mismatch are neutralised either by refusing the deduction or by including the payment. Whilst the Draft ATAD 2 Law may still be subject to change as it goes through the Luxembourg legislative process, we would like to share with you our insights on certain selected aspects of the Draft ATAD 2 Law.

Associated enterprises

The new rules introduced by the ATAD 2 Directive aim at correcting hybrid mismatches between associated enterprises (or implemented in the context of a structured arrangement). Thus, the government has decided to introduce a new stand-alone definition of associated enterprise (point (17) of the first paragraph of the restated article 168ter of the Luxembourg income tax law (“ITL”)) applicable only to the anti-hybrid mismatch provisions to be introduced as a result of the ATAD 2 Directive, the criterion being the holding of 50% or more of the voting rights, the capital interests or the rights to a share of the profits (except for hybrid financial instruments, where the relevant threshold is lowered to 25%).

Where different persons or entities are considered as “acting together”, their participation in the voting rights, capital interests or profits are aggregated for the purpose of determining whether they can be considered as associated with the entity under review. This is to ensure that full effect is given to the anti-hybrid mismatch provisions in a situation where the effective control of a vehicle is split between different persons. In this context, it was debated whether the fact that the general partner of a fund was acting on behalf of all the limited partners in such fund could trigger the “acting together” rule. The point was of particular importance to Luxembourg due to the size of its fund industry. Given that in an investment fund context, the different investors generally do not have any effective control over the investments of the fund, it is suggested that investors in a fund which hold less than 10% (directly or indirectly) of the capital interests in a fund and are entitled to less than 10% of the profits are presumed not to be acting together with other investors in the fund, unless proven otherwise. As a result of such de minimis rule, payments to a tax transparent fund (e.g., in the form of an SCSp) should only become non-deductible in Luxembourg, if the limited partners in the fund located in jurisdictions which consider the fund as opaque hold (i) at least 10% of the interests in the fund each (or are each entitled to at least 10% of its profits) and (ii) together more than 50% of the voting rights, capital interests or profits.

Reverse hybrid rule

Whereas the application of the current anti-hybrid mismatch provisions may lead to a non-deduction or to the taxation of an income at the level of ordinary corporate taxpayers, the new reverse hybrid rule will – from 1 January 2022 – have the effect of submitting to corporate income tax entities that would otherwise be tax transparent for Luxembourg tax purposes. For the avoidance of doubt, a reverse hybrid entity is an entity treated as tax transparent in its jurisdiction of incorporation but opaque in the jurisdiction of (certain of) its investors.

Given Luxembourg’s importance as an investment fund jurisdiction and taking into account the fact that numerous fund vehicles take the form of tax transparent entities (such as the Luxembourg limited partnership (SCS(p)), the Draft ATAD 2 Law proposes to limit the scope of the new reverse hybrid rule (new article 168quater ITL) so as not to detrimentally affect the fund industry. In line with the ATAD 2 Directive, the Luxembourg government thus excludes collective investment vehicles from such provision and suggests interpreting the notion of CIV so as to encompass not only UCITS but also other types of investment funds, notably specialised investment funds (SIFs), UCI Part II and reserved alternative investment funds (RAIFs), but also any AIF which is widely held, holds a diversified portfolio of securities and is subject to investor protection obligations.

Also, given that the ATAD 2 Directive does not specifically require that reverse hybrid entities be subject to a tax other than the corporate income tax, it is currently not foreseen for these entities to also become subject to net wealth tax. We are further of the view that they should not be obliged to withhold tax on their distributions (for example dividend distributions).

Interplay of different anti-hybrid rules

In line with paragraphs (29) and (30) of the preamble of the ATAD 2 Directive, the anti-hybrid mismatch rules to be introduced by the Draft ATAD 2 Law will only apply provided that the hybrid mismatch is not already neutralised otherwise, for example by the application of the anti-hybrid mismatch rule already in place in article 166 (2bis) ITL (i.e. no tax exemption on dividend income if deductibility was granted to the distributing entity).

Similarly, if the reverse hybrid rule is triggered and the relevant reverse hybrid entity becomes subject to corporate income tax in Luxembourg on all or part of its income, no other hybrid mismatch rule will apply. 

Tax exempt status of an associated entity involved in a hybrid mismatch

The commentary to the Draft ATAD 2 Law expressly refers to paragraphs (16) and (18) of the preamble of the ATAD 2 Directive to exclude payments made under hybrid financial instruments or to hybrid entities from the scope of the anti-hybrid mismatch rules where the mismatch is not the consequence of the hybridity of the instrument or the entity, but merely the result of the specific tax status of the payee. The commentary in particular refers to payments made to tax exempt sovereign wealth funds or investment funds.