By Sophie Richard & Adnand Sulejmani, Arendt & Medernach S.A., Luxembourg
The Luxembourg tax authorities issued long-awaited guidance in January on the application of a new interest limitation rule, which was implemented in a new Article 168bis of the income tax law (LIR), following the transposition of the EU Anti-Tax Avoidance Directive (ATAD).
The circular provides interpretative guidance with regard to the interest limitation rule, which applies to financial years starting on or after 1 January 2019.
Taxpayers with operations in Luxembourg using debt funding should pay close attention to these regulations.
Under the interest limitation rule, Luxembourg taxable companies and Luxembourg permanent establishments of non-Luxembourg resident companies with exceeding borrowing costs can only deduct that excess in each financial year up to either 30% of their annual tax-EBITDA (earnings before interest, taxes, depreciation, and amortization) or EUR 3,000,000, whichever is higher. The circular provides guidance and examples to apply this new rule correctly.
Exceeding borrowing costs
The Luxembourg tax law defines exceeding borrowing costs as the amount of a taxpayer’s tax-deductible borrowing costs that exceed its taxable interest income and other economically equivalent taxable income. The circular explains the steps to be followed in determining an entity’s exceeding borrowing costs.
As a first step, it is necessary to determine the entity’s borrowing costs. This refers to interest expenses on all forms of debt, other costs economically equivalent to interest, and expenses in relation to financing.
The circular specifies that only borrowing costs that arise entirely from the taxpayer’s business or that were incurred directly to acquire, secure, or retain revenue are subject to the interest limitation rule.
Furthermore, borrowing costs that are not tax deductible under specific domestic provisions should not be considered for the purposes of the interest limitation rule. This will typically be the case where interest expenses are requalified as non-deductible hidden dividends, disallowed under the application of anti-hybrid mismatch rules, or non-deductible by virtue of a direct link to exempt income (such as tax-exempt dividends derived from qualifying shareholdings).
Any transfer pricing adjustment having an influence on the amount of a taxpayer’s borrowing costs must be taken into account for the purposes of the interest limitation rule. Thus, for instance, any interest expenses disallowed or requalified for transfer pricing purposes should not be taken into account in determining the exceeding borrowing costs.
Any transfer pricing adjustment having an influence on the amount of a taxpayer‘s borrowing costs must be taken into account for the purposes of the interest limitation rule. Thus, for instance, any interest expenses disallowed or requalified for transfer pricing purposes should not be taken into account in determining the exceeding borrowing costs.
It is further confirmed that deductions resulting from the impairment of a bad debt or irrecoverable debt should not be considered as borrowing costs.
The circular also provides clarifications to the examples of borrowing costs detailed in the law (or the ATAD).
For instance, the category “imputed interest on instruments such as convertible bonds and zero-coupon bonds” includes the issue and redemption premiums owed by the issuer to the bondholder. The circular does not clarify whether premiums paid by the issuer for the non-conversion of convertible bonds into shares (which are not redemption premiums as such) would come partly or entirely within the definition of borrowing costs.
The category “notional interest under derivative instruments or hedging arrangements related to an entity’s borrowings” includes, for example, interest expenses calculated based on a notional value and resulting from an interest rate swap, or any other derivative instrument or hedging arrangement relating to the borrowings of an entity. Derivative instruments include forwards, futures, options, and swaps.
For foreign exchange gains and losses, only those incurred in proportion to the interest on borrowings and instruments related to financing will fall within the definition of borrowing costs (to the extent that they are included in taxable income). Thus, foreign exchange gains and losses arising from principal amounts are not to be taken into account.
The category “arrangement fees and similar costs related to the borrowing of funds” covers all financing costs incurred in a financing transaction, particularly account opening and account maintenance fees. However, the fees and commissions of intermediaries (notaries, experts, etc.) involved in financing transactions are not considered where they constitute ancillary costs to an asset’s purchase price.
Symmetrical approach
The second step is to determine the entity’s taxable interest income and other economically equivalent taxable income.
Although the interest limitation rule includes a broad definition for borrowing costs and a non-exhaustive list of examples, no definition or list of examples are provided for “taxable interest income and other economically equivalent taxable income”.
However, the circular indicates that a symmetrical approach should be followed here. In other words, interest income and other economically equivalent income constitute, in principle, the counterpart to the borrowing costs.
Thus (at least in a purely national context), if costs incurred are not regarded as borrowing costs on the part of the debtor, they are not, as a rule, regarded as interest income or other economically equivalent income on the part of the beneficiary.
The same principle would apply to amounts economically equivalent to interest. Thus, the symmetrical approach applies at the level of the taxpayer: what constitutes borrowing costs for a taxpayer should symmetrically be treated as interest income or equivalent income, and (at least in a domestic context) with respect to the same flow (e.g., between a creditor and a debtor).
The application of this principle may, in our view, be differently nuanced in an international context (as the concerned jurisdictions may have a different interpretation of the term “borrowing costs”), and where a different conclusion results when accounting principles and the substance-over-form principle are applied (for instance, where the income derived by a Luxembourg taxpayer from non-performing loans is treated as interest income).
The interest deduction limitation thresholds
The annual tax deduction of a taxpayer’s exceeding borrowing costs will be capped at 30% of its tax-EBITDA or EUR 3,000,000, whichever is higher.
The definition of “tax-EBITDA” takes the taxpayer’s total net income as a starting point. Exceeding borrowing costs, depreciation costs, and write-down deductions are then added back in. Tax-exempt income is deducted from this total amount.
As clarified in the circular, income may be exempt under a domestic tax provision (such as the participation exemption regime) or treaty-based provisions. Operating expenses that are economically related to this exempt income are therefore to be added back in (i.e., they are non-tax deductible).
The EUR 3,000,000 threshold acts as a safe harbour. In other words, exceeding borrowing costs that do not exceed EUR 3,000,000 are always deductible, irrespective of the 30% tax-EBITDA threshold. The circular provides the following example: a taxpayer records EUR 2,700,000 in exceeding borrowing costs and a tax-EBITDA of EUR 8,000,000. Due to the EUR 3,000,000 de minimis threshold, it will be able to deduct all of the exceeding borrowing costs incurred, regardless of the portion of tax-EBITDA calculated.
The interest deduction limitation thresholds apply per financial year. Where a financial year contains fewer than 12 months, it is treated as a full financial year. For example, if a collective entity that usually closes its financial year on 31 March decides during 2020 to close its financial year on 31 December, the interest deduction limitation rule will apply once for the full financial year from 1 April 2019 to 31 March 2020, and again for the financial year from 1 April 2020 to 31 December 2020.
Where the taxpayer has a holding in a tax-transparent vehicle (such as a limited partnership), whatever the nature of the activities carried out by that entity, the taxpayer realises deductible borrowing costs, taxable interest income, and other economically equivalent taxable income of that entity in proportion to the interest held in it.
The circular further clarifies how to apply the carry-forward rules, i.e., the option to carry forward exceeding borrowing costs that were not deducted and unused interest capacity. It provides several quantitative examples, some of which are reproduced below.
Carrying forward unused interest capacity
A taxpayer can carry over its annual unused interest capacity for the next five financial years.
Unused interest capacity is the portion of the figure representing 30% of the taxpayer’s tax-EBITDA that is not used up by the exceeding borrowing costs deducted for the current financial year. In other words, if during a financial year the exceeding borrowing costs deducted are less than the maximum deduction under the 30% threshold, the unused part of this deduction capacity constitutes the unused interest capacity, which may be carried forward by the taxpayer over the next five financial years, and which gives rise during that period to the same right to deduct exceeding borrowing costs.
The circular provides the following example: a taxpayer records EUR 7,000,000 in exceeding borrowing costs and a tax-EBITDA of EUR 40,000,000 – 30% of that tax-EBITDA is equal to EUR 12,000,000. The taxpayer can therefore deduct the whole EUR 7,000,000 in exceeding borrowing costs and carry forward an unused interest capacity of EUR 5,000,000. But if, for example, the taxpayer also has EUR 3,000,000 in exceeding borrowing costs that it carried over from previous years, it can deduct EUR 10,000,000 in exceeding borrowing costs and carry forward an unused interest capacity of EUR 2,000,000.
The circular clarifies that only taxpayers that incur exceeding borrowing costs greater than EUR 3,000,000 and apply the cap of 30% of tax-EBITDA can carry forward unused interest capacity.
Carrying forward exceeding borrowing costs
The taxpayer may carry forward the part of the exceeding borrowing costs that is not deductible in a given financial year (because it exceeds the applicable interest deduction limit) to subsequent financial years indefinitely. In a given year, the oldest exceeding borrowing costs carried forward are deducted first.
The exceeding borrowing costs carried forward may only be deducted by the taxpayer itself. However, in the case of a tax-neutral transformation of a collective entity into another collective entity, the exceeding borrowing costs carried forward will be maintained for the converted entity (the same is true for any unused interest capacity carried forward).
Finally, the circular provides clarifications on the material and personal exclusions from the scope of the LIR.
Grandfathering
Based on the grandfathering clause, loan agreements concluded before 17 June 2016 are not subject to the interest limitation rule, to the extent that their terms and conditions do not undergo a “subsequent modification” on or after 17 June 2016.
Where a loan has been modified on or after 17 June 2016 (this is referred to as a “subsequent modification”), the grandfathering clause will only apply to the initial terms and conditions of the loan as provided for prior to that date.
The circular clarifies what is meant by a subsequent modification to a loan. The definition does not include amendments that were foreseen in the loan agreement. Otherwise, it includes the following changes to loans taken out before 17 June 2016: (change of the maturity, change of the interest rate or interest calculation method, change of the amount borrowed, and change of the contracting parties.
Restructuring
Restructurings such as mergers and demergers do not jeopardise the applicability of the grandfathering clause insofar as these operations do not, in and of themselves, lead to a change in the initial terms of the loan.
Viewing a change of contracting parties as a subsequent modification is questionable, as loan receivables are generally transferable, and such a transfer does not inherently impact the calculation of interest. The circular further clarifies that a drawdown under a credit facility should not be considered a subsequent modification to the extent that the drawdown is made in accordance with the credit facility agreement.
The circular provides extensive detail on the scope of the exemption of borrowing costs for loans used to finance long-term public infrastructure projects where the project operator, borrowing costs, assets, and income are all located in the European Union.
It details the cumulative criteria to be met for the exclusion to apply, i.e. the project must be to provide, upgrade, operate or maintain an asset; the project asset must be large-scale and acknowledged as being in the public interest; and the project operator, the borrowing costs, the assets, and the income must all be located in the European Union.
Additional details and a quantitative example are provided to help calculate the interest deduction limit where the taxpayer carries out other non-exempt activities. The information and documentation to be communicated to the tax authorities are also detailed.
Financial undertakings
The circular clarifies that the definition of “financial undertakings” covers entities regulated by an EU directive or EU regulation, as well as alternative investment funds (AIFs) supervised under the relevant national law. Thus, Luxembourg AIFs supervised under the law of 15 June 2004 on the investment company in risk capital (SICAR) are included.
The securitisation vehicles covered by Regulation (EU) 2017/2402 have been added to the list of exempt vehicles for Luxembourg. However, in May 2020, Luxembourg received a letter of formal notice from the EU Commission stating that the inclusion of securitisation vehicles on the list of financial undertakings exceeds the scope of permissible exemptions and asking Luxembourg to amend its ATAD implementation law to remedy this. The circular is silent on this issue, but one should nonetheless expect the law to be changed at some point.
Standalone entities
Standalone entities are also excluded from the interest deduction limitation rule’s scope, given the limited risk of tax avoidance.
The term encompasses three cumulative conditions that the taxpayer must meet: the entity is not part of a consolidated group for accounting purposes; it does not have an associated enterprise as defined in the provisions implementing the rules on controlled foreign companies into domestic law (generally referring to a 25% threshold in the share capital/voting rights/entitlement to profits); and it has no permanent establishment in any country other than Luxembourg.
The circular clarifies that the term “associated enterprises” is not limited to entities in which the taxpayer holds an interest, but refers to all entities and individuals recognised as constituting an associated enterprise of the taxpayer.
Furthermore, the direct or indirect link of association must be viewed from an economic perspective (in our view, this refers to the economic owner of the relevant holding as opposed to its legal owner, by application of §11 of the tax adaptation law).
Concluding remarks
The circular is an essential first step in helping Luxembourg taxpayers to apply the new interest limitations correctly. The circular provides welcome confirmation of the approaches that Luxembourg taxpayers have generally opted for since the rule was enacted in 2019; interpretation of the rule was already facilitated somewhat by its presentation on forms for the 2019 tax return.
However, given the rule’s complexity, additional guidance is needed to increase legal certainty for Luxembourg taxpayers. In particular, further guidance and examples on the definition of “borrowing costs” and “interest income” would be helpful.
In addition, guidance and examples on the elements of the interest limitation rule that have not yet been clarified, such as its application in the context of a tax consolidation, or in conjunction with the equity escape rule, would be most welcome.
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